What to Think About Commercial Real Estate? How to Know When to Take A Look

The rally across risk assets at the end of 2023 spilled over into 1Q2024 as many equities continued to march higher. Once a pipe dream, the “soft landing” scenario became the base case for many market participants. Bond markets, although generally complacent in our opinion, remained slightly on edge as Treasury bonds sold off, sending the 10-Year Treasury yield from 3.88% to 4.20% in the quarter. Mortgage rates, which tend to track the Treasury bond market, were roughly flat at 6.75%, although jumbo rates narrowed given credit spread tightening in non-Agency RMBS.

However, “animal spirits” were less present in real estate-related equities as REIT indices underperformed the broader market. Stubbornly, high interest rates will likely continue to be a headwind for commercial property valuations. Most regional bank stocks, unsurprisingly to us, also posted losses for 1Q2024 as commercial real estate woes, depleted asset prices, and deposit flight risk remained unresolved issues.

Equity REITs tend to have concentrated commercial real estate exposure which we believe will be under pressure. We believe the current level of interest rates will provide challenges for most sub-sectors in the equity REIT market as dividend yields are relatively low.

Demand for offices and lower quality retail spaces will continue to decline. This fact is widely publicized at this point. The “dirty little secret” in the commercial real estate market is the need for interest rates to come down. Commercial real estate is essentially priced at the property’s net operating income divided by the cap rate (or yield). If interest rates stay high, cap rates will likely be forced even higher which will translate into lower commercial real estate prices (absent rent increases). Moreover, there is close to $3 trillion of commercial real estate coming due in the next five years which will need to be paid off/refinanced and banks will probably not be picking up their phones.

We believe investing in securities with commercial real estate risk requires caution (and staying high up in the capital structure) in the short-term but could be a significant buying opportunity if the market becomes more distressed.