Is Commercial Real Estate ACTUALLY in Danger?
With rising rates, there has been an increasingly negative rhetoric regarding the CRE market. However, diving into the data paints a different picture.
Before diving into the data, let’s first take a birds-eye view of what’s driving this uncertainty:
Higher interest rates, paired with declining revenue from foot-traffic makes defaults more likely as companies need to pay more for rent with less income to offset.
If commercial mortgage backed securities (CMBS) begin to default in large numbers, it has a systemic effect as they are used as collateral for other financial contracts.
Now, commercial real estate is a very large umbrella term. The term covers shopping malls, office towers, amusement parks, and anything that isn’t lived-in. Let’s see how the performance breaks down by category:
Now we start to see a more nuanced picture; there have been losers in the space, but clearly, there are also winners. Let’s take a look at one of them:
Industrials: A Winner
STAG Industrial is a real estate investment trust (REIT) focused on the acquisition and operation of single-tenant industrial properties in the United States. Their portfolio is primarily constituted of properties that are used for distribution, warehouse, and light manufacturing:
Since STAG follows a single-tenant strategy, each property is typically leased to just one tenant. This strategy provides stability and long-term income streams for the company, however, it does introduce some level of tenant concentration risk, as the financial health of the tenants can impact the performance of the portfolio. STAG minimizes this by primarily leasing to stable, large corporations like Amazon, FedEx, and Ford:
So, it seems that there are glimmers of positivity within at least the industrial CRE market. The strong positioning of this sub-sector makes sense, even in an environment of increased rates:
Strong Fundamentals: Industrial properties often have long lease terms with reliable tenants, leading to stable cash flows. Demand for industrial space remains high due to factors such as e-commerce growth, logistics, and supply chain optimization.
Limited Substitution: Generally, companies will make highly-specific changes to mold the property to their productivity needs. An example of this is:
Workflow Optimization: This includes reorganizing the floor layout, streamlining processes, and minimizing unnecessary movement or transportation of goods. So, even in a higher interest rate environment, businesses are less likely to relocate or build new facilities, reducing the risk of vacancies and maintaining property values.
Lower Sensitivity to Interest Rates: Unlike other real estate sectors, such as residential or commercial office properties, the demand for industrial properties is less sensitive to interest rate changes. Industrial tenants typically focus more on factors like transportation costs, proximity to customers, and access to supply chains. As long as the cost of capital remains within a reasonable range, industrial property leases can still be attractive to businesses.
Limited Speculation: The industrial sector has traditionally exhibited more disciplined development practices compared to other real estate sectors. Developers are typically cautious about oversupplying the market, ensuring that new construction is driven by genuine demand rather than speculative motives.
As of June 10th, 2023, STAG remains an over-performer within the broader CRE market:
So, we’ve seen where a bright spot within the market exists, now let’s zoom out and take a larger view of the data.
Big Picture Data
Every week, the Federal Reserve publishes data on lending activity by the commercial banks. This lending data includes: the total dollar values, issuance size, and geographical information.
The major fear is that because of commercial real estate’s “decline”, banks and institutions become less willing to issue new loans related to commercial real estate. This would lead to a further disintegration of the sector as it would lead to less projects, less frequent repairs, and consequently; lower values for the properties.
But let’s see what the data says:
There’s a few things to unpack from this data:
In times of distress (2020) lenders flock to value. Riskier consumer loan issuance plummeted, while comparatively stable industrial loans skyrocketed. This confirms that lenders change their behaviors acutely as environments change, which adds credence to using this data to analyze current environments.
Commercial loans, as a whole, has grown at an almost 10% faster rate than both traditional real estate and consumer loans. The y-axis represents the cumulative change in loan issuances; so, a value of 105 means a 5% growth, and a value of 95 means a -5% decrease.
Starting from January 1st, 2020 to June 9th, 2023; the issuance of real estate and consumer loans increased by ~15%
In that same interval; the issuance of commercial loans increased by ~23%
While for 2023 the rate of industrial loans has decreased, the loans for the greater commercial market has increased (also decreased at a slower rate).
Final Takeaways
So, is commercial real estate in trouble?
While there have been local weaknesses in offices and retail spaces (driven by changing work and consumer trends), the general commercial market is actually in better shape than even residential real estate. Commercial banks have increasingly continued to lend to commercial developers, and CRE firms with strong fundamentals continue to out-perform.
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Happy trading! :)