Commercial Real Estate Bubble?

As we continue to see volatility in multiple markets, the commercial real estate market may be the next in line for a crash. The combination of rising interest rates, the push for more remote working, struggling regional banks and the ever-looming threat of a recession and you have all the ingredients for a major market crash. Professional economists and prominent investors are already issuing warnings and alarm bells are ringing.

Commercial Real Estate – The Warnings

Elon Musk tweeted that the state of the commercial real estate debt market is “by far the most serious” threat to the U.S. economy. According to a study out of Columbia and New York University reported by the New York Times, “The value of U.S. office buildings could plunge 39 percent, or $454 billion, in the coming years.”

Charlie Munger, vice chairman of Berkshire Hathaway, also believes there is trouble ahead for the U.S. commercial real estate market. In an interview with The Financial Times Munger said that U.S. banks are “full of… bad loans”. Munger went on to say “We have a lot of troubled office buildings, a lot of troubled shopping centers, a lot of troubled other properties. There’s a lot of agony out there.”

A new report from Morgan Stanley is predicting an economic crash worse than the 2008 financial crisis for the commercial real estate sector. "Commercial real estate, already facing headwinds from a shift to hybrid/remote work, has to refinance more than half of its mortgage debt in the next two years," Lisa Shalett, chief investment officer for Morgan Stanley Wealth Management, wrote in a weekly report published on May 1, 2023.

Commercial Real Estate – Lower Occupancy Rates

Commercial real estate had already taken a huge hit due to the COVID pandemic. In the spring of 2020, many offices closed to contain the spread of the virus. But even after mandates were lifted and doors reopened, not all workers returned to in-person work, leaving many buildings empty.

As we see office vacancy rates have reaching over 20 % in some markets, the profitability of commercial properties are taking major hits. A recent CNBC report showed commercial office properties have suffered 23.5% losses in 2023. As the work-from-home model is becoming more commonplace, there is a permanent shift in occupancy rates for the commercial real estate sector.

As offices are sitting empty, the value and liabilities of those properties continues to plummet. Nationwide office properties lost nearly 6% in value this year according to the National Council of Real Estate Investment Fiduciaries.

Commercial Real Estate – Refinancing

There is an estimated $2.4 trillion of debt in the commercial sector that will mature over the next five years, far more than at any five-year period in history. According to The Kobeissi Letter, a weekly commentary on global capital markets, in 2025 more than $1.5 trillion of the debt will mature while interest rates are being forecast to still be at very high levels.

The largest commercial real estate lenders are small- and medium-sized banks, which hold an estimated 70% of new loans on commercial properties according to Kobeissi.

With regional lenders banking on commercial real estate to buoy their balance sheets the market viability of investment vehicles like REITs are becoming risky investments.

Impact on U.S. REITs

Empty offices, rising interest rates, and inflation have left REITs [Real Estate Investment Trusts] quite battered. During the year 2022, U.S. REITs, lost 24% of their value, as reported in our newsletter “2022 Review and Outlook 2023” in January 2023.

U.S. REITs are generally represented by the Vanguard Real Estate Index Fund, which invests in U.S. real estate investment trust companies that purchase office buildings, hotels, and other real estate properties.

In 2023, the Vanguard Real Estate Index fund has seen quite a rollercoaster ride. It opened the year at $81, gained 14%, and peaked at $92 in late January, only to drop by 16% during February and March to hit a trough at $77. Since then, the index has recovered a bit and is trading around its opening value. On May 9, it closed at $82. See chart “Vanguard Real Estate Index Fund” for details.

sector. The high volatility of the Vanguard Real Estate Index fund underlines these risks.

Investors have become nervous when it comes to investing in REITs, and as a result newly raised capital has declined significantly. While in 2021, U.S. REITs were able to raise new capital upwards of $30 billion per quarter, they could only raise $11 billion or less as of the second quarter of 2022. See chart “U.S. REIT Capital Raising” for details.

It is important to keep in mind that REITs are made up of different types of properties that offer different returns. According to Nareit Research, the three sectors that struggled the most on a March 2023 YTD basis are offices (-17%), infrastructure (-15%), and hotels (-3%).

Gains in other areas, such as self-storage (+16%), health care (+7%), and data centers (6%), have partially offset the losses above.

Housing was also a positive contributor to the overall results of U.S. REITs. Single-family housing gained +5% and multifamily +0.5%.

What Does it Mean for Investors?

So, what does all this volatility mean for the average investor looking for the former stability of REITs as a safe place for their money? The majority of REITs are heavily loaded with commercial investments and forecasters are projecting these as the weight dropped on the middle of the line, as it drops it will pull everything else in the REIT down with it.

Whether people are working in an office or a bedroom one this is certain, they all still need a place to live. As interest rates look to remain high in 2023 and 2024 the average American is finding the financially responsible thing to do is stay in the rental market. This increased profitability is continuing to attract investors from all sectors.

As a first trust deed investor you get the security of an asset backed investment without the burden of a portfolio dragging down your bottom line. As record rent returns continue to come in, there has never been a better time to be the bank. Ask a Safeguard representative today how you can make your money work for you!