The Big Challenge for Commercial Real Estate

MODERNIST’S ASSET CLASS INVESTING PORTFOLIOS ARE STRATEGICALLY INVESTED WITH A FOCUS ON LONG-TERM PERFORMANCE OBJECTIVES. PORTFOLIO ALLOCATIONS AND INVESTMENTS ARE NOT ADJUSTED IN RESPONSE TO MARKET NEWS OR ECONOMIC EVENTS; HOWEVER, OUR INVESTMENT COMMITTEE EVALUATES AND REPORTS ON MARKET AND ECONOMIC CONDITIONS TO PROVIDE OUR INVESTORS WITH PERSPECTIVE AND TO PUT PORTFOLIO PERFORMANCE IN PROPER CONTEXT.

Although many economists have predicted a recession for 2023, the economy is proving resilient. Several factors are keeping the economy in expansion mode: the strong labor market, strong corporate and consumer balance sheets, and the stabilizing housing market — despite significant headwinds. The Federal Reserve paused its rate hike in June as inflation continued to show signs of steady decline (1), yet it remains well above the central bank’s 2% target. Given the uncertainties in both stock and bond markets this year, we’re seeing headlines focused on the real estate sector and its lagging performance. Let’s put context around these trends to evaluate the best course of action.

*Source: Morningstar. Data as of 5/31/23

What is driving the poor performance in real estate markets?

Despite concerns, the overall real estate sector is slightly up for the year so far. That’s because the sector tracks both residential real estate and many forms of commercial real estate. Of all the real estate sectors, office properties are taking the biggest hit this year.*

As many people are still choosing to work from home for all or part of the week, office buildings have sat half empty on average since the beginning of the pandemic. (2) This has forced building owners to lower rents and has raised their costs to attract new tenants, hurting profits. Financing costs for building ownership and maintenance have also skyrocketed as interest rates have gone up.

What is the outlook for the office real estate sector?

The office sector faces significant headwinds in the short term. A record $270 billion in commercial mortgages will need to be refinanced this year, at much higher interest rates. (3) Property owners with floating-rate agreements have already felt the sting of higher rates and have been forced to sell their buildings at deep discounts. Fixed-rate payers who have yet to refinance may need to make similar decisions soon.

What happens over the longer term is uncertain. As the labor market gradually cools, employers might enforce stricter in-office attendance policies, which would be a boon for office real estate investments. It’s possible that office owners find their way out of these troubled times as they did in the 2007-2009 Great Recession. Despite losing over 70% in value during those years, the sector went on to return 16.1% per year for the next decade. By comparison, the sector has lost nearly 54% of its value since the pandemic began through May 2023.

good news: SOURCES OF STABILITY

Fiscal policy is still stimulative. Many corporations extended the maturity of their loans during the low-rate environment of the pandemic, making them less vulnerable to higher interest rates. Households still have significant savings built up to support spending. Since the pandemic, consumers have ramped up spending on services while cutting spending on goods.

Do I need to make changes to my portfolio?

Although the headlines might urge investors to act, often the best strategy is to stick with your long-term plan. Public real estate constitutes only 3%-4% of the total U.S. stock market (4), and office buildings make up less than 5% of public real estate. (5) No matter the source of uncertainty, if you feel that the level of risk in your portfolio is too high, it’s time to review your plan, goals, and asset allocation with your trusted advisor.

Understanding the role of volatile assets in your long-term portfolio is an important element of investing. Check out how volatility has played out over the past 20 years (like Emerging Markets and alternative assets like Real Estate) in our most recent blog post and review of our 20 year asset class “skittles chart”.