🏢 Commercial real estate's on shaky foundations

Cracks are showing in the commercial real estate sector, but you can still find opportunities if you know where to look | May 01 · [Read in Browser]( Investor Edition 🏖 Monday the 1st was a public holiday in the UK, so we took the chance to soak up some rays (through heavy clouds) here at Finimize HQ. That means there's no Daily Brief today, but lucky you: Stéphane's prepared some very special analysis to keep you busy. ANALYST INSIGHT Commercial Real Estate Is On Shaky Ground: Here’s What You Need To Know By Stéphane Renevier [Cover image for Commercial Real Estate Is On Shaky Ground: Here’s What You Need To Know] Commercial real estate’s long been considered a profitable bet, with super-low interest rates providing the scaffolding for strong returns. But in recent months, the cracks have really started to show across these assets – and many now fear that the wider damage could be intense. Here’s what you need to know about the current risks – and what you might do to profit from this market... For starters, what exactly is commercial real estate? Unlike residential real estate, which focuses on homes, apartments, and condos, commercial real estate (CRE) is all about buying income-generating properties that are leased to businesses. And unlike what most people believe, it’s actually a very diversified asset class, with a lot of subsectors and characteristics. Overall, there are four main types of commercial properties: Office buildings: The corporate HQs where the magic happens, from swanky “Class A” skyscrapers to the outdated, less desirably located “Class C” offices, each catering to different business needs and budgets. Retail properties: All your retail therapy hotspots, encompassing mammoth shopping centers, vibrant strip malls, and charming stand-alone stores, providing consumeristic heaven for savvy shoppers everywhere. Industrial properties: These behind-the-scenes stars – housing everything from heavy-duty manufacturing plants and agile light-assembly facilities to vast warehouses and adaptable flex buildings – keep the cogs of the economy turning. Multifamily properties: The urban jungles where we live, work, and play, featuring inviting apartment complexes, stylish townhouses, and snug condominiums, all offering a slice of the rental life. It’s like residential real estate, but on a bigger scale. Now, there are other categories too, often designed for specific purposes, like luxurious hotels, cutting-edge medical facilities, secure self-storage units, gleaming car washes, and hulking data centers powering our online existence. Now if the sector’s been especially hot over the past few years, it’s because: it offers a stable income stream through rent payments, it’s perceived to provide a decent hedge against inflation (rent and leases can be adjusted for it), and it has the potential for strong capital gains too, particularly since transactions can be highly levered. So what’s the problem, then? The seeds of today’s crisis have been planted over recent years, when extremely cheap money (i.e. ultralow interest rates) made it easy for developers, investors, and banks to finance and invest in new properties. That drove a huge boom in commercial real estate, with hordes of investors drawn to the asset class for its perceived attractive risk and returns characteristics. Then the pandemic happened. Despite lockdowns that kept people away from many of these properties, unprecedented monetary and fiscal stimulus made financing even more outrageously cheap, and boosted demand for properties as investors hunted for yield and diversification. Property prices across different geographies and styles all skyrocketed. For office buildings, the first cracks started to appear when it became clear that the old go-to-the-office work routines wouldn’t completely return after lockdowns, with millions of employees being granted the freedom to work from home. With many offices standing half-empty, the demand for office buildings started to collapse. Of course, this also had some knock-on effects on other sectors, with hotels, retail stores, and condos in commercial areas also seeing a drop in demand. But the real trouble started when the Federal Reserve’s (the Fed’s) aggressive interest rate hikes shoved mortgage and other borrowing rates sharply higher. Those changes hurt CRE from two angles: First, it made investing in risk-bearing assets a lot less attractive relative to cash. Suddenly, investors were deciding that if they were going to risk their money investing in a commercial property, they’d only do so if they could expect a higher return. For that to happen, rents would have to rise, or the price to buy properties would have to fall. The current adjustment is coming mostly from the latter. Second, those higher interest rates increased the costs of servicing existing loans for property owners, whether making current payments on a floating-rate mortgage or rolling over the debt. Since the deals tend to be highly leveraged, the combination of falling property values and skyrocketing costs can wipe out an owner’s equity pretty rapidly. So this is where we’re at: while the operating income earned by property owners has been remarkably resilient until now, property prices are down by double digits across almost all property types, volumes have collapsed, and investors are either looking for the exits or hoping just to weather the storm. Does this mean the market’s going to collapse? While the answer is more nuanced than what you read on Twitter, it’s still unfortunately pretty likely. The CRE market – office space in particular – is exposed to some pretty significant threats right now: First, imminent refinancing risk. Roughly 40% of US mortgages (about $1.5 trillion of debt) will come up for refinancing over the next two years – at higher interest rates. And, many of the mortgages issued during the pandemic (when rates were at their lowest) were variable-rate ones and will likely need to be refinanced at much higher rates over the next two to five years. If borrowers can’t refinance, they’ll have to find other sources of loans, new capital, or (more likely) will be forced to sell. Second, tighter lending standards. Since commercial real estate is a levered business that requires lots of debt, ease of getting credit is extremely important. The issue is, commercial banks – which are the main lenders in the space – have been facing an increasingly challenging environment (and that was even before the Silicon Valley Bank debacle), and they’ve started to tighten their credit conditions. As a result, it’s much more difficult to get a loan today. That’s not just an issue for future projects, but also for existing ones that need refinancing. And sure, some private lenders might be happy to step in, but they’re only going to do so at higher rates (and even then, only for projects that are in good enough shape). With almost all lenders in self-preservation mode, thanks to the slowing economy and rising default rates, lending activity is likely to drop further, and that could have a big negative impact on the sector. Third, a worsening slowdown. When you combine higher refinancing costs, tighter lending standards, and a slowing economy, defaults are likely to rise. Commercial real estate is a cyclical asset, after all, and a downturn hampers tenants’ ability to pay their rent and shrinks demand for new buildings. What’s more, many developers have an incentive to default on their investments (to get better terms in their negotiations with lenders), so default rates could increase quite rapidly, and that would put further pressure on the market. Fourth, overly rich valuations. While stocks can be valued using the price-to-earnings (P/E) ratio (or its inverse, the earnings yield), real estate can be valued using the “cap rate”, which divides the property’s net operating income (i.e. its revenue minus costs) by its market value. Like the earnings yield, it provides an indication of the profitability and likely return of the investment, so the higher the better. As you can see in the chart, cap rates remain extremely low compared to Treasury yields, meaning that prices would have to drop lower for it to become an attractive investment again. Fifth, its illiquid nature. CRE isn’t exactly like a stock: investors can’t just decide to sell a hotel chain before the end of the day. That lack of liquidity means that sellers have to sell their property at a huge discount if they want to find an immediate buyer. If there are many forced sellers – whether it’s due to investors redeeming all at once, or banks selling properties that their clients defaulted on – prices could collapse rapidly. So, overall, the outlook is pretty bleak for commercial real estate, and unless the economy achieves a soft-landing scenario (in which inflation and interest rates fall, but economic growth holds up), a further drop in CRE prices between 10% and 30% wouldn’t be surprising. That said, it doesn’t have to be a sharp and sudden drop: it could happen gradually over many months. Commercial real estate is a particularly slow (and relatively predictable) asset class, after all. It’s also worth noting that not all commercial real estate is equal. For instance, most of the horror headlines you read on Twitter are specific to the office sector, which, remember, represents only a quarter of this market. Other sectors are still seeing decent cash flows (which can offset a drop in the price of properties) and most investors are buffered by the strong gains they’ve seen in previous years. With a market this big, is there a risk of a financial crisis? If commercial real estate prices take a nosedive, banks – especially smaller, regional ones – could be in for a bumpy ride. They're the ones dishing out most of the market’s financing. Thanks to leverage and a feedback loop between banks and commercial real estate (when small banks face more defaults, they cut back on lending, which stresses property owners, and then worsens bank problems), rising defaults and falling property prices could spell trouble for these lenders. Plus, banks might not want to own defaulted properties and could sell them, adding to the sector's woes. Toss in the risk of deposit flight and the fact that there’s looser regulation for smaller banks, and you can see why some folks are feeling antsy. But before you panic: recent stress tests by JPMorgan and Strategas suggest that most US and European banks should be OK, even in extreme scenarios. They’re well-capitalized, have healthy debt-servicing coverage ratios, and generally aren’t overexposed to CRE assets. Plus, the risk is spread across various players – big banks, small banks, insurance companies, government agencies, and REITs – reducing the chance of a single point of failure. So, while things could go south, it's not as doom-and-gloom as some Twitter posts might suggest. Another risk arises from shadow banks – nonbank financial institutions that play a significant role in the CRE market by providing financing and credit to borrowers outside the traditional banking system. One particular risk highlighted by various financial stability watchdogs is coming from real estate investment funds specifically, which are a particularly hefty player in European CRE markets (although their importance varies by country). A key vulnerability with those funds arises from the mismatch between the daily liquidity offered to their investors and the illiquid nature of their underlying assets. Should investors all decide to redeem at once, it could create huge selling pressures and amplify stress in the CRE market, plus create contagion to other markets and geographies because of the many linkages. Other shadow banks (for example, hedge funds, private lenders, or even insurance companies and pension funds) may also pose problems: they’re less regulated, more opaque, often involved in complex transactions, loaded with leverage, and tightly linked with other financial institutions. And because of all that, it’s difficult to get a full picture of the real risks they could represent. But as the stunning collapse of investment fund Archegos Capital Management demonstrated, the failure of a single player may stress the overall system. Add to that the fact that negative sentiment tends to spread extremely quickly today, and you know that things could escalate in a heartbeat. So should you be worried about the threat to financial stability? Sure, potentially: just don’t make it your base case. Look, when a sector as big, as levered, and as tightly linked to smaller and shadow banks as commercial real estate ends up in trouble, there are going to be risks to financial stability. It’s worth remembering that our [new-look financial system]( remains mostly untested, so you can’t entirely dismiss the possibility of rather [extreme scenarios](. But the risk of an extreme credit event – where feedback loops and exacerbating factors turn a fall in CRE prices into a full-blown 2008-type credit crash – is still relatively low, in my view. (And if bigger accidents are to happen, they’re likely going to come from somewhere more [unexpected](.) So what’s the opportunity, then? Since commercial real estate is likely to face more headwinds over the next few months, it makes sense to try to profit from its fall. Unfortunately, there’s no easy way to bet against commercial real estate (a fact that’s particularly true for retail investors). But here are a few ways you could play this, along with some important caveats to keep in mind: 1. Short (or buy “puts” on) real estate ETFs. There are very few pure-play ETFs for commercial real estate. In fact, the only one I found was launched less than a month ago: the DoubleLine Commercial Real Estate ETF (ticker: DCMB; expense ratio: 0.39%). Of course, you can always short a broader real estate ETF (either directly or through a contract for differences “CFD” or spread bet), like the Schwab US REIT ETF (SCHH; 0.07%), or buy an inverse real estate ETF like the ProShares Short Real Estate (REK; 0.95%). In Europe, the iShares European Property Yield UCITS ETF (IPRP; 0.4%) invests in real estate companies and investment trusts of developed European countries, excluding the UK. Unfortunately, broader real estate funds are also heavily exposed to residential real estate and more resilient sectors of commercial real estate, like multifamily, logistics, data centers, and cellphone masts. If your broker allows it, shorting an ETF can be a more effective play, as inverse ETFs generally make bad long-term investments (they tend not to track closely their underlying assets over a longer period and usually have higher fees). Two other potentially interesting shorts are the Emles Real Estate Credit ETF (REC; 0.48%), which tracks the performance of corporate bonds issued by US real estate companies, and the iShares CMBS ETF (CMBS; 0.25%), which offers targeted exposure to commercial mortgage-backed securities (essentially, bundled commercial property loans that are sold to investors.) 2. Short (or buy “puts” on) US commercial banks. A more indirect way to benefit is to short the banks that are most exposed to commercial real estate. Goldman Sachs crunched the numbers and identified the US commercial banks with the highest exposure relative to their total loans: BankUnited (BKU), Synovus Financial (SNV), First Hawaiian (FHB), Zions Bancorporation (ZION), M&T Bank MTB), Citizens Financial (CFG), Wells Fargo (WFC), Huntington Bancshares (HBAN), the PNC Financial Services Group (PNC). Or, to get a more diversified exposure, consider the SPDR S&P Bank ETF (KBE; 0.35%). 3. Short (or buy “puts” on) the most levered European property firms. Here’s a handy list of some of the most levered firms (highest loan-to-value ratios) across Europe, according to Bloomberg: Samhällsbyggnadsbolaget, Wihlborgs Fastigheter, Fastighets AB Balder, Wallenstam, and Sagax (all of Sweden); Vonovia and LEG Immobilien (Germany); Allreal Holding (Switzerland); Cofinimmo (Belgium); and Kojamo (Finland). 4. Short (or buy “puts” on) nonbank stocks. You could also short nonbank stocks that are exposed to commercial real estate. JPMorgan analysts identified these ones as potential candidates: Cushman & Wakefield (CWK), Jones Lang LaSalle (JLL), Vornado Realty Trust (VNO), SL Green Realty (SLF), Boston Properties (BXP), Trimble (TRMB), Blackstone Mortgage Trust (BXMT), CVS Health (CVS), Walgreens Boots Alliance (WBA), and Caterpillar (CAT). 5. Bet on broader contagion. Maybe the stress in commercial real estate is a harbinger of things to come in other markets. At the end of the day, one thing is certain: the transition from a zero-interest-rate environment was always unlikely to be smooth, and not just in CRE. Not all assets seem to be accurately reflecting the rising credit and growth risks out there: namely, corporate bonds and stocks. So you could consider shorting, or buying “puts” on, a high-yield corporate credit fund like the iShares iBoxx $ High Yield Corporate Bond ETF (HYG; 0.48%), or a stock index like the Vanguard Russell 3000 ETF (VTHR; 0.06%). If you want to specifically bet on (or protect your portfolio from) more extreme tail scenarios, you could also implement the [1x2 structure]( on those indexes. Or, as a long-trusted hedge, you could consider buying gold via the abrdn Physical Gold Shares ETF (SGOL; 0.17%). 6. Wait for the storm, and then buy commercial real estate. Now, the investing options above aren’t perfect. Many of them are indirect plays, and could seriously disappoint you if the CRE market doesn’t sharply sell off. And, look, prices across commercial real estate already have fallen quite a bit, and investors are already pricing in some pretty bad scenarios, so they might not fall a whole lot more. What’s more, since there are already a huge number of investors that are shorting real estate, you could find yourself exposed to a short-squeeze, hopelessly watching prices actually shoot higher, if those players are forced to close their positions. And, finally, shorting real estate stocks is very expensive: those assets pay high dividends (which you’d have to pay) and are often associated with high fees. In my view, the best option might be to wait on the sidelines for now and gradually start to buy when (and if) prices collapse. A generational “reset” in an asset class – where prices have to drop by more than the fundamentals suggest to rebalance things – doesn’t happen often, but when it does, it offers a unique buying opportunity for investors with a long time horizon. We’re probably not close to that point now, but when sentiment is so resoundingly negative and investors so fearful, you know we may be getting closer to it, and that’s when it’s time to start to switch to a “buy” mentality. In fact, there are several factors that may help create a strong rebound further down the line. Tighter lending standards are impeding new construction – and that could prevent supply from meeting a rebounding demand. Buildings are gradually being adapted for different uses (in some places, firms are finding it’s possible – although not easy – to turn offices into apartments). And the market's other challenges – the rise of remote work and stricter environmental standards – may prove surmountable as well. Overall, commercial real estate isn’t a bad asset class. It’s just currently not trading at attractive enough prices. So be patient and make sure to add commercial real estate to your watchlist, because it might provide you with a tantalizing buying opportunity over the next few months. If you want to avoid trying to time this market perfectly, consider using dollar cost-averaging, perhaps buying in at the start of every odd-numbered month, to reduce your entry price risk. [Ask a question](mailto:questions@finimize.com?body=Ask us a question: Where are you writing from? 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