There's been a significant slowdown in commercial real estate, igniting concerns among investors about the health of this industry. Investors are on edge after the failure of three regional banks since March, as banks and businesses grapple with high interest rates.
CBRE Group (CBRE 0.29%) is the world's largest commercial real estate company. Management discussed the slowdown in the industry during its recent earnings call. The company shed light on several key factors that have led to a downturn in the market. Here's an overview of those factors and the investment opportunities you might consider.
CBRE provides commercial real estate services and investments globally. The company is involved in property sales, mortgage origination, servicing, and property management for investors and occupants of commercial real estate. With more than 117 years in the industry, CBRE has the experience and knowledge to help us understand what's happening in commercial real estate.
CBRE released its earnings at the end of April, and the results were lackluster, to put it kindly. In the first quarter, net revenue declined 4.5% from a year earlier, but its bottom line took a big hit, and net income fell 70%. While it performed better than expected, the company saw a greater-than-expected decline in property sales of 41% during the quarter.
During its earnings call, Chief Executive Officer Robert Sulentic reviewed three factors weighing on commercial real estate.
1. Inflation and higher interest rates
In the past couple of years, the U.S. and the rest of the world have seen an uptick in inflation. Last year, inflation reached the highest level in the U.S. since 1982. The Federal Reserve's dual mandate requires it to maximize employment and stabilize prices. It does this by controlling interest rates, which influence the amount of money in the economy.
The Fed began raising interest rates in March 2022, which signaled the end of its easy monetary policies and ultra-low interest rates. Since then, the Fed has raised its federal funds rate, the overnight lending rate banks use among themselves, from nearly 0% to 5.25%. This change in interest rate is the fastest in at least 40 years, and mortgage rates reached their highest level since 2007.
Data source: YCharts US Consumer Price Index YoY
According to Goldman Sachs, $3.1 trillion in commercial real estate loans is outstanding. As these loans come due, they will have to be refinanced at higher rates. Higher interest rates make it more expensive for those investors looking to refinance their commercial real estate properties.
2. Stress in the banking system
Higher interest rates have put stress on the banking system as well. The rapid pace of interest rate increases and poor risk management are the primary reasons SVB Financial's Silicon Valley Bank failed this March.
Since then, investor have sold off bank stocks. Not only that, but banks are reconsidering their investment portfolios. Regional banks are giant lenders to commercial real estate. As reported by The Wall Street Journal, these banks hold about 67% of all commercial real estate loans outstanding
Regional banks continue to lend to commercial real estate, but they are being much more selective about the loans they approve. As a result, those in commercial real estate are finding it more challenging to get funding.
Image source: Getty Images.
3. Return to office and office utilization
Finally, longer-term trends have affected commercial real estate, specifically office properties. During the pandemic lockdowns, office workers began working from home. Today many employers have set up remote work, or hybrid work arrangements where employees can work some days in the office and some days from home.
As a result, the same amount of office space can support more workers. And for some businesses, they no longer need the office space at all. According to CoStar Group, 12.9% of office space is vacant -- which is a record high. As many of the leases on properties come up for renewal, tenants are reducing their office space.
Investor takeaway
The commercial real estate space faces some considerable headwinds. Loans are being refinanced, and at higher rates. Finding funding is getting more difficult as regional banks are more selective about who they lend to. Finally, trends toward work from home or hybrid-work arrangements reduce how much office space companies need.
Some segments of the industry are faring better than others. According to CBRE, values for industrial and multifamily properties could recover over two to three years -- twice as fast as during the Great Recession. On the other hand, office properties will take twice as long to recover their lost value compared to the Great Recession.
While the commercial real estate sector will continue to face challenges, patient investors should seek opportunities to buy good companies at discounted prices in those more resilient commercial real estate segments. I would avoid investing in companies specializing in office properties for the foreseeable future. However, the sell-off could be an excellent opportunity for long-term investors to invest in industrial and multifamily companies such as Prologis and Walker & Dunlop while their valuations are depressed.
