Global Weekly Commentary: Commercial real estate: going granular
A granular view
Financial cracks from rate hikes have led to jitters over commercial real estate. Yet granularity is key. We see opportunities in some U.S. industrial properties.
Market backdrop
The Federal Reserve signaled a pause may follow last week’s rate hike. Yet jobs data showed a tight labor market. We expect a pause but no rate cuts this year.
Week ahead
We expect U.S. inflation data out this week to show services are keeping inflation sticky, while survey data should gauge how U.S. consumers are holding up.
The fastest rate hiking cycle since the 1980s is causing financial cracks. This has caused bank turmoil and raised concerns over U.S. commercial real estate due to its high vacancy rates and reliance on bank loans. Yet we see varied risks across sectors, regions and investment choice. So we use our new playbook and get granular. We favor selected sectors such as industrial real estate as we see long-term forces like e-commerce and geopolitical fragmentation fueling demand.
Not a monolith
Capitalization rates by real estate sector, 2008-2023
Source: BlackRock Investment Institute, with data from Green Street Advisors, May 2023. Notes: The chart shows the nominal capitalization rates for industrial, office and retail properties as implied by transaction values per quarter. Nominal cap rates are used to gauge the yield of property transactions.
We went underweight private growth assets from a view of five years and over in 2022’s first quarter. That includes broad commercial real estate – a sector we’ve projected negative returns for since June 2022. Yet we know commercial real estate is not a monolith. Case in point: Capitalization rates – a yield metric that rises when valuations fall – have diverged. We expect retail cap rates to keep rising (green line in chart) due to pressure from e-commerce growth. Office cap rates (yellow line) are likely to rise too as they have since 2022. Investors are requiring higher cap rates for offices given rising interest rates and higher vacancy rates due to remote work. We expect industrial cap rates (dark orange line) to stay low relative to peers as we see higher earnings growth for the sector. Private assets can play a sizeable role in long-term portfolios, with potential to diversify returns, in our view. Private markets overall are complex, with high risk and volatility, and aren’t suitable for all investors.
Varied impact
The impact of the pandemic and bank turmoil on commercial real estate sectors has varied, too. Shifting work habits have cut demand for U.S. offices, based on a high vacancy rate of about 13% in March, National Council of Real Estate Investment Fiduciaries (NCREIF) data show. Banks’ exposure to real estate added to market jitters. Banks held 40% of outstanding real estate debt as of 2022’s third quarter, the Mortgage Bankers Association found. That has raised fears high-vacancy or highly-levered U.S. properties will struggle to refinance debt, causing some to hit the market at cheaper valuations or default. That dynamic may create a funding gap but also chances to scoop up discounted assets – with risks. We see the gap as a bigger concern for U.S. assets: Private European valuations are cheaper than U.S. peers, MSCI and NCREIF indexes show.
We’re cautious on private commercial real estate valuations: We think they need to fall more as rate hikes raise financing costs and cool inflation. That combo will likely bite into commercial real estate income growth. Exchange-listed real estate valuations are largely lower across the U.S., UK and Europe as real estate investment trusts (REITs) sold off with stocks in 2022, indexes show. Public REIT values tend to lead private markets by a few quarters. Yet REITs’ near-term correlation with stocks means they diversify portfolios less and may see more volatility when stocks fully price in economic damage.
Getting granular
Industrial assets – referring to warehouses used for distribution, manufacturing and research and development – have fared better than office. Industrial assets have a vacancy rate around 2% as of March and their share of the commercial real estate market has doubled since 2016 to take up roughly a third of the market now, according to NCREIF data. This differentiation is why we get granular. We like industrial assets that could see structural trends feeding demand in the long term, like distribution and last-mile logistics centers. The expansion of e-commerce looks set to keep on driving demand as it has for decades, in our view. We also think geopolitical fragmentation will likely shift supply chains and prompt companies to re-shore operations – bringing manufacturing closer to home. Companies have already been storing more goods locally to prevent renewed supply chain snarls, U.S. Census Bureau data show. Some may aim to widen their web of warehouses to cut transportation costs and to support new manufacturing plants. Construction spending on the latter rose to about $147 billion annualized this March vs. $90 billion in March 2022, U.S. Census data show.
Bottom line
Financial cracks have fed concerns over commercial real estate’s outlook. We’re cautious on the sector. Yet we go granular in our portfolio views. We see better value in real estate sectors that may see long-term demand, like industrial.
Market backdrop
The Fed signaled a pause may follow last week’s rate hike. The U.S. two-year Treasury yield sank 0.5% percentage points near 2023 lows before reversing about half the fall by Friday when April U.S. payrolls beat market expectations. The data also confirmed a tight labor market and wage pressure keeping inflation sticky. That makes rate cuts unlikely this year, in our view. We think that’s true for the European Central Bank, too: It pointed to more hikes after raising rates again last week.
All eyes are on U.S. inflation data this week. We expect services to keep inflation sticky even as interest rates stay higher. We’re also watching survey data to see how the consumer is holding up. We expect pandemic savings to dwindle and further crimp spending. We see the Bank of England hiking again this week as inflation remains stubbornly high.
Week ahead
Source
Past performance is not a reliable indicator of current or future results. Indexes are unmanaged and do not account for fees. It is not possible to invest directly in an index. Sources: BlackRock Investment Institute, with data from Refinitiv Datastream as of May 4, 2023. Notes: The two ends of the bars show the lowest and highest returns at any point in the last 12-months, and the dots represent current year-to-date returns. Emerging market (EM), high yield and global corporate investment grade (IG) returns are denominated in U.S. dollars, and the rest in local currencies. Indexes or prices used are: spot Brent crude, ICE U.S. Dollar Index (DXY), spot gold, MSCI Emerging Markets Index, MSCI Europe Index, Refinitiv Datastream 10-year benchmark government bond index (U.S., Germany and Italy), Bank of America Merrill Lynch Global High Yield Index, J.P. Morgan EMBI Index, Bank of America Merrill Lynch Global Broad Corporate Index and MSCI USA Index.
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