Commercial Real Estate: Gauging the Market Impact

10 August 2023
4 min read

In our most recent AB Disruptor Series webcast, we explored the commercial real estate arena. What are its implications for markets?  

Commercial real estate is a dynamic investment space where we shop, eat, work and play. In many ways, this market segment has been front and center as the aftereffects of COVID-19 disruptions continue to ripple through the economy. Ominous headlines and worried investors point to legitimate concerns—particularly with office space. 

But the devil is in the details, because the market isn’t homogenous. And it’s an investment truism that an unsettled landscape and looming risks also create opportunities for discerning investors. In our most recent AB Disruptor Series webcast, “Real Estate’s Present and Future—the Commercial Market,” we go in-depth on the current state, path forward and potential horizons for this critical market segment. 

We also think it’s helpful to share highlights of how developments in commercial real estate are affecting major segments of the capital markets.

Taxable Bonds: Navigating the Impact on CMBS 

Commercial mortgage-backed securities (CMBS) are an important component in many types of fixed-income strategies. In today’s environment, we believe that investors should focus on higher-quality CMBS tranches and more seasoned vintages. 

Generally speaking, some property types are better positioned than others. Office is our highest concern, as demand for space has fallen. Newer CMBS vintages have more exposure to office space than older vintages, which have also benefited from deleveraging. We remain cautious on regional malls with lower sales. Beyond malls, retail CMBS have benefited from factors such as strong consumer spending and nondiscretionary outlays. 

Cost cutting and reduced business travel have put the squeeze on full-service hotels; limited-service hotels have benefited from higher domestic and leisure travel as well as lower break-even costs. A housing supply shortage, high single-family home prices and relatively high mortgage rates have been catalysts for strength in multi-family housing. Higher costs could slow construction ahead, further supporting existing home demand, so we expect slow but steady rent growth to support loan performance.

Warehouses and data centers have been among the biggest winners, thanks to the growth of online retailing and cloud computing. Although rents have risen steadily, we expect growth in this segment to slow if the economy weakens and if larger tenants pull back on new leases.

Municipal Bonds: Cities Adapt to Shrinking Offices 

In the municipal bond space, commercial real estate concerns naturally focus on cities, with their shrinking office footprints as the aftereffects of COVID-19 continue to affect work patterns. However, most US cities don’t depend as much on commercial and office taxes as many investors may believe. Municipalities can also tap other revenue sources, such as user charges for services.

Even if office properties were to experience steep valuation declines, cities do possess mechanisms that they can use to cushion against the effect on property taxes. These pathways include setting property taxes independently from real estate values and rolling out measures that evolve the tax base more gradually, spreading out the impact over time. 

Like many investors, we’re concerned about the value of office properties in the new world of hybrid work and work from home. But because commercial real estate is less liquid, potential declines in value tend to be realized over a longer time frame. This works to cities’ benefit. Also, bear in mind that large municipal bond issuers such as government entities can change the rules, enabling them to adapt to economic shifts. This could translate into collecting taxes from online retailers without physical locations or, as we expect to happen, shifting their tax regimes away from offices toward more active uses.

Private Credit: Bank Pressures Bolster Opportunity Pipeline

Over the past decade, small US banks drove the bulk of loan growth in the US banking system—much of that growth came in the form of commercial real estate loans. 

Banks lent money at yesterday’s low fixed interest rates but are now paying today’s much higher yields on customer deposits. That situation has created pressure that’s compounded by the decline in commercial real estate values and headwinds for those borrowers. We think this challenge will lead to further banking consolidation and put more pressure on banks’ balance sheets. 

In some cases, banks will look to sell non-performing loans, creating an opportunity for private capital to purchase high-yielding assets at a discount. In other cases, banks may not have the balance sheet to keep up with loan growth. The good news is that small banks have established strong origination and servicing models, presenting private capital with the opportunity to provide the front book, effectively serving as the balance sheet for the origination platforms of banks and non-banks.

All told, we think this environment sets up a sizable pipeline of strong opportunities for private credit in the coming quarters. But these deals are highly specialized and negotiated directly. Given the complexity of risk involved, as well as a lack of liquidity, it’s crucial to have the proper infrastructure and knowledge in place to execute on opportunities.  

Equities: Diverse Exposures, but Focus on REITs and Some Banks

Commercial real estate exposure varies greatly in public equity markets, extending beyond office space to warehouses and manufacturing sites. Nearly all issuers are affected by real estate in some way, either directly or indirectly. However, two direct impact areas to note are public real estate investment trusts (REITs) and select banks.

Office properties are a relatively small percentage of the FTSE EPRA/NAREIT Developed Index, mostly in highly occupied and coveted Class-A buildings, so risk exposure is relatively low. Within REITs, we see several high-conviction sectors, including industrial properties, data centers and self storage—each having benefited in its own way from the internet era. 

With banks in general, the smaller they are, the bigger the challenge. Less than 10% of large US banks’ loan portfolios are in commercial real estate; for regional banks, it’s 20%. Smaller banks have more exposure, but we think it’s largely manageable; the office segment is only about 5% of all loans. An uptick in non-performing assets has put stress on some sponsors, but equity infusions and additional collateral outlays are helping.

We think the Fed’s spring actions have addressed the liquidity issues from regional bank collapses. Deposit flows have stabilized, and better-positioned banks have ample liquidity to address further pressure. High-quality issuers with geographic diversification seem more sensible in a weakening environment, and bank valuations are attractive.

AB’s Disruptor Series is designed to provide distinctive perspectives on critical issues facing the capital markets today.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to change over time.

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