by Brad Houle, CFA
Principal
Fixed Income Research and Portfolio Management
As we move further into 2024, the commercial real estate (CRE) market continues to attract investors’ attention. Often, when the Federal Reserve increases short-term interest rates rapidly, as in this cycle, some aspect of the capital markets or asset class breaks. CRE is the primary suspect for a crisis in this cycle. Although there are some obstacles in the CRE market, and there may be further issues with small banks, we don't see any indications of a systemic crisis on the horizon.
Office space is the most significant casualty due to changes in work following the pandemic and higher interest rates. As we look out our window in downtown Portland, we were reminded of a story in The Oregonian this week that according to a report by Colliers, Portland’s central city has the highest office vacancy rate in the 50 largest downtown office markets at more than 30%. The national office vacancy rate reached 19.2% in the third quarter of 2023. This has been attributed to the evolving nature of central business districts and the shift towards remote work. Not all office markets are created equal; real estate markets are hyper-local. The graph below shows the wide variance of the decline in the value of office buildings in different markets across the nation.
Source: Morgan Stanley
Multifamily or apartment real estate continues to perform well. The demand for multifamily housing is driven by the chronic undersupply of single-family homes, the cost of home ownership and new household formation.
While still stronger than pre-pandemic levels, the industrial sector shows signs of moderating demand. However, the tailwind of returning U.S.-based supply chains, the rise of e-commerce and the obsolescence of many older warehouses for today’s increased use of automation should keep the sector healthy for the foreseeable future.
Today’s commercial real estate market is a mixed bag of opportunities and challenges. We expect to continue to hear about credit issues at smaller banks due to bad commercial real estate loans. We have intentionally reduced small and mid-size banks in client portfolios. Compared to 2008, this crisis is a slow-moving crisis, and banks have already taken reserves in anticipation of the coming loan challenges. In contrast, 2008 was broad based, and homeowners were incentivized to stop paying on mortgages, whereby commercial real estate loans are often restructured.
The employment data for March, released on Friday, exceeded expectations. The number of jobs created was higher than anticipated, and the unemployment rate decreased to 3.8%. Consequently, our view that stronger economic data would delay the first rate cut by the Fed appears to have been validated. The market now anticipates the first cut to occur in either July or September of this year.
Takeaways for the Week
Commercial real estate markets are local markets – there is a wide range of market conditions that are not based on macro factors
While there is more distress coming in the CRE market, we do not view this as a future systemic problem for the banking system or economy