In this episode of “Investment Management Foundations,” Wealth Enhancement Vice President of Portfolio Consulting Gary Quinzel discusses how various parts of the commercial real estate sector have performed over the last couple years, as well as some underlying conditions to explain this performance.

VIDEO TRANSCRIPT BELOW

Hello. My name is Gary Quinzel, Vice President of Portfolio Consulting at Wealth Enhancement. Welcome to the latest episode of “Investment Management Foundations.” Today's topic is going to be commercial real estate, which has been in the news for the last year or two due to some of the struggles that the sector has been exposed to. The main reasons why commercial real estate in general has been hurt has been due to the “higher for longer” interest rate narrative that's affected valuations of commercial real estate. Another important element that significantly impacted certain segments of commercial real estate has been some of the shifts and trends that have changed in the post-pandemic world that we live in. Most notably within the office sector, there's been significant shifts and trends in working from home and hybrid workers that have significantly increased the number of vacancies at office complexes.

So, according to the Federal Reserve's April 2024 financial stability report, the U.S. commercial real estate market was around 22.5 trillion as of the fourth quarter of last year. Of that amount, the amount of debt outstanding was around $6 trillion, and according to Trepp Analytics, which covers the commercial real estate sector, roughly a third of that amount, about $1.7 trillion of that outstanding debt, is expected to mature from 2024 to 2026. We often refer to this amount as the “looming maturity wall.” That references the amount of debt that's going to be due, and that means the borrowers are going to be exposed to refinancing that debt at much higher interest rates. Of course, we don't expect interest rates to go significantly lower anytime soon, so this poses a threat to many of those borrowers.

So, I'm going to dig in and talk a little bit about some of the different sectors. And so, as you can see on the chart that we have referenced here, we have the commercial real estate delinquencies of retail, multifamily, office, industrial hospitality, and overall. And we can see that overall, the delinquency rate is still relatively low. We're still nowhere near that 9% level that we reached coming out of the global financial crisis. But we can see that some sectors have seen a notable increase, again, most notably within the office space, but it has leveled off a little bit. We see that delinquencies are quite low, in fact, for multifamily, as well as industry and hospitality.

On the other hand, which was doing quite worse, is actually leveled off some notable observations as we look a little bit deeper into some of these sectors, office, we mentioned the challenges overall absorption, which is the number of units that are occupied or not occupied within a specific time period, has been quite negative for some time. We are continuing to see very steady rent growth due to the limited supply of housing and, of course, high mortgage rates, which have impacted the ability for new buyers to purchase homes.

Looking at retail, we've actually seen notable strength there. Retail has done quite well, and a big factor of that is because of the limited amount of supply that's available. So, the reach, the 4.7% of retail space that's available today, according to the National Association of Realtors, is the lowest level on record. Last thing I want to point out is that for industrials, we've actually seen a little bit of weakening, and a lot of that has to do with some of the shifts that we've seen coming out in the last couple of years. So, coming out of the pandemic, we saw a notable shift towards goods purchases. We're actually seeing some of that shift going towards services. Most recently, that's having a little bit of an impact overall. But we don't see that as troublesome. We still see overall, the industrial space being quite strong.

So, to wrap things up here, I just want to talk a little bit about the looming maturity wall and the exposure to different banks. It's important to note that the majority of commercial real estate loans are with smaller banks that have asset bases of less than $20 billion. A few notable banks have up to 60 or 70% of their total debt balance within commercial real estate. So, that could pose a challenge as that debt becomes due. Now, a lot of the larger banks also have larger total amounts exposed to real estate, but as a percentage of their total asset base, it's much, much smaller.

So, in conclusion, it's important to note that the commercial real estate market is a giant market, and it can be an important part of any investor's portfolio. However, there are certain segments within real estate that are posed with challenges in the coming months and years. However, not all segments are created equally. We talked about how certain asset classes within real estate should continue to do better than others. The rising tide can always lift all boats, but the opposite can also apply. So, if we see continued pressure on the office sector that could also pull down other sectors within real estate, especially as long as interest rates remain high. However, the asset class in general has a lot of attributes that are ideal for investors, especially the overall price stability, the income elements, and preferred tax treatment. So, we think it can be a great investment, but it's important to separate the winners from the losers and understand the risks involved when investing in real estate. We hope you found today's episode of Investment Management Foundations useful, and please tune in again for future episodes. Thank you.

This information is not intended as a recommendation. The opinions are subject to change at any time and no forecasts can be guaranteed. Investment decisions should always be made based on an investor's specific circumstances. Investing involves risk, including possible loss of principal.

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