Investors are celebrating what some say is a new bull market for the broad US equities market, but the party remains on ice for commercial property shares.
Last year’s bear market that hit risk assets the world over has yet to end for commercial real estate shares, based on Vanguard Real Estate Index Fund ETF Shares (NYSE:VNQ).
The fund’s portfolio of real estate investment trusts (REITs) of companies that own office buildings, hotels, and other properties remains caught in strong downside bias through yesterday’s close (June 12).
The combination of rising interest rates and a surge in employees working from home is creating stronger headwinds for the commercial property sector. Goldman Sachs CEO David Solomon, in an interview with CNBC on Monday, said,
“There’s no question that the real estate market, and in particular commercial real estate, has come under pressure,"
Office occupancy rates have rebounded from pandemic lows, but only partially. Kastle Systems, a workplace data firm, reports that occupancy is still roughly half the level compared with the pre-pandemic period for the major cities in the US.
“If office and retail owners are having trouble generating rental income because people just aren’t going into the office and shopping, then it increases the odds that they aren’t going to be able to pay back those loans in timely way,” explains Mark Zandi, chief economist for Moody’s Analytics. “That means losses will start to mount on those loans. And because the banking and financial system more broadly is already struggling with lots of other problems … there’s going to be more banking failures.”
A return to normal is unlikely in the near term, based on expectations for office demand from the world’s biggest companies. A recent survey by Frank Knight, a real estate company in the UK, finds that around half of firms with 50,000 or more employees plan to cut office space.
A risk for commercial property owners is that half-empty offices raise the risk of delinquencies. Signs of rising stress in this corner are mounting. The delinquency rate for commercial mortgage-backed securities (CMBS) — fixed-income investment products that are backed by mortgages on commercial properties — rose 53 basis points in May to 3.62%, reports Trepp, a financial data firm. That’s the highest level since March 2022.
Commercial real estate isn’t going away, of course. But the industry is adjusting to a post-pandemic world, and the adjustment has a ways to go. Commercial REITs will, at some point, bottom and offer attractive expected returns, but the downside bias in VNQ and other funds targeting this industry suggest it’s too early to go bottom fishing.
That’s not only a message coming from VNQ’s technical profile, but it also sums up the fundamental outlook, according to Fitch, which recently cut its 2023 outlook for REITs from “neutral” to “deteriorating.”