“Commercial real estate is headed for a crisis worse than 2008, Morgan Stanley analysts say.”
Headlines like this are becoming more prevalent in the mainstream media. While there are some elements of truth to these fear-mongering statements, they often lead to widespread misunderstandings and inaccurate investment assumptions about the state of commercial real estate as a whole.
Office spaces are experiencing some tough times. This is not a secret. But what does this mean for other sectors of the commercial real estate industry? And perhaps more importantly, what do investors perceive this means for other commercial real estate sectors?
We’ll dive into this below, but here’s the gist: An office space “apocalypse” does not spell doom and gloom for sectors such as multifamily real estate. And despite what the mainstream media will have you believe, there’s evidence to support the opposite. While no one has a crystal ball (and we do not claim to know the future), the fate of the commercial real estate sector is not as certain as these pessimistic headlines would have you believe.
Let us explain.
Office Space Apocalypse
First, let’s address the elephant in the room. Office spaces are going through a hard time (that’s an understatement). Office investors across the nation are defaulting on their debt, and finding themselves with office properties that are underwater with no life jackets in sight.
The decline of office space is nothing new, and it isn’t the result of just one factor.
Earlier this year, a major office landlord defaulted on their floating rate mortgage “...on seven office buildings in California, New York and New Jersey,” according to USA Today. This was due to the Fed’s actions of increasing the federal funds rate, which led to spikes in interest rates on commercial loans.
A major California office investor defaulted on their loans on two buildings, choosing to do so instead of refinancing “...due to weak demand for office space.”
So, the decline of offices can’t solely be blamed on The Fed.
Other factors that contributed to a decline in office spaces includes remote work (popularized by the pandemic), and higher cost of maintenance.
Since trillions of dollars worth of commercial loans will face a refinance in the next 48 months, things aren’t looking so good for struggling office building owners. A Morgan Stanley executive recently wrote in a report that “new lending rates are likely to be 3.5 to 4.5 percentage points higher than they are for many of CRE’s existing mortgages.” This spells trouble for properties that are already struggling or negative cash-flowing.
And of course, this might apply to real estate, but as we just mentioned, office spaces were already seeing a decline in general demand. Strong demand for apartment units suggests that multifamily will remain resilient. More on that later, but first - let’s define commercial real estate before we move any further.
What Do You Mean “Commercial Real Estate?”
Commercial real estate is an asset class that encompasses a variety of property types. This includes shopping centers, multifamily apartment complexes, hotels, office buildings, distribution centers, manufacturing facilities, warehouses, and data centers.
So when you see a news article describing the “fall of commercial real estate,” it’s important to question what exact types of commercial real estate they are referring to. Making blanket statements like “commercial real estate will face a massive downturn” is like saying “Schools are facing a staffing shortage.” Does this mean private schools? Public schools? Is this only in certain states? While these statements may technically be true, specificity can help consumers draw accurate conclusions and apply the information provided with more assurance and clarity.
Misleading Media
As we mentioned in our introduction, many news outlets are leading consumers to drawing blanket conclusions about the commercial real estate sector as a whole. Headlines like “Elon Musk: House prices will plunge, commercial property in meltdown”, “Jamie Dimon warns of a commercial real estate downturn”, and “Bracing For A Possible Commercial Real Estate Crash” are all misleading, whether intentional or not.
And before you say “Well most investors will understand what they mean,” I thought the same thing. But the reality simply does not support this line of reasoning. Don’t take my word for it.
Charlie Munger, the billionaire investor, aka “Warren Buffet’s right-hand man,” said in an interview that he foresees struggles in the real estate space. In the interview, he said, "A lot of real estate isn't so good anymore. We have a lot of troubled office buildings, a lot of troubled shopping centers, a lot of troubled other properties. There's a lot of agony out there." Many investors interpreted his words as a red flag regarding REITs, which invest in commercial real estate.
But in reality, a small percentage of REITs invest in office spaces, single family real estate, or shopping centers. 10%, according to an article from Seeking Alpha. Most REITs invest in strong sectors like multifamily real estate and distribution centers. This article is by no means “REIT” promotional propaganda. But this misunderstanding of REITs can be used to reflect the widespread mindset of investors regarding commercial real estate as a whole, and the miscalculations in their reasoning.
REITs are crashing as a result of this pessimistic outlook among investors. This phenomenon makes it seem like commercial real estate sectors (besides office spaces) are experiencing 2008-like hardship. But the evidence says otherwise.
Offices vs Multifamily
Starwood, one of the biggest real estate investors in the world, says “Other than the office asset class, real estate is actually performing really well. Apartments are full. Single family rentals are full. Hotels are REALLY full.” For context, Starwood owns over $10 billion in real estate. Multifamily real estate is seeing challenges relating to softening rents and debt issues for those with short term, floating rate debt. Increasing interest rates is bad news for deals with this type of loan. But there remains a shortage of housing in the U.S., suggesting strong rental demand for the foreseeable future.
According to Business Insider, multifamily real estate experienced an increase in vacancy of 1.7% over the past year. This resulted in a decline in rent growth, but rent overall remains stable. Rental projections suggest that multifamily will have a stronger performance in years to come. While this by no means is a claim that multifamily real estate will not be impacted by economic hardships or a recession (if there is one), multifamily has proven to be a resilient asset class throughout various historical periods.
So, while the office space is experiencing some challenges, and there’s a chance that the sector does not bounce back, it isn’t fair to group property types like multifamily in with offices through blanket statements about commercial real estate.
And while this might not seem like a big deal, it is! Caution and diligence are always recommended when it comes to approaching any investment decision. But panic and paralysis can lead to missed opportunities and fundamental misunderstandings that can cripple your path in real estate.
Instead of believing every headline, my brothers and I turned to industry experts and sources that had on-the-ground experienc in real time.
And that’s what we’d encourage anyone looking to be resilient during uncertain times like these to do. Get out there, network, and don’t let fear keep you on the sidelines.
Even if you’re not actually jumping into the game, always be on the lookout for the bus of opportunity. Or else, you might just miss it.
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