The US office market faces a tough road ahead. Corporate tenants are considering scaling back, higher interest rates are hurting valuations, and many property owners face looming debt maturities that they may struggle to refinance. That’s all concerning, but just how bad can it get? Private and public markets disagree to a jarring extent, and the truth is probably somewhere in the middle.
First, consider the physical market — also known as the real world. The pandemic unleashed drastic changes in remote and hybrid work, and they’re turning out to be surprisingly durable. Office badge-ins are still well below pre-pandemic levels, and many companies are reconsidering their real estate needs. Others are reallocating employees to parts of the Sun Belt (which comprises the southern tier of the US) to address changing geographic preferences.
And that comes amid an unprecedented fast jump in the Federal Reserve’s (Fed) key interest rate and now a potential bank credit crunch. Brookfield Corporation and Pacific Investment Management Co (PIMCO) have already defaulted on office mortgages in recent months, and there is a looming wall of around US$180 billion ($238 billion) of office mortgages coming due this year.
Somewhat surprisingly, this hasn’t — as of yet — had an extreme effect on office property values themselves. The NCREIF Office Property Index has lost just about 5.4% from its peak in mid-2022. As Rich Hill of Cohen & Steers explained on a recent episode of Odd Lots with Joe Weisenthal and Tracy Alloway, buyers and sellers are in the form of a standoff.
At the early start of a correction, sellers don’t want to sell at the level buyers want to buy. There’s a huge bid-ask spread between the two. It’s like the grieving process: Denial, anger, and acceptance. Ultimately, the market can’t go down much if it’s essentially frozen.
Performance gap
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Next are public markets — the real estate investment trusts that trade on stock exchanges — where investors aren’t waiting around to see how this plays out and have been selling almost indiscriminately. The Bloomberg REIT Office Property Index is down by about half from its 2022 highs on a total return basis. This was a reflexive and haphazard reaction to higher government bond yields for much of last year.
But in recent weeks, short sellers have begun circling office REITs with special zeal, particularly those with portfolios centred on New York and the West Coast. New York-based SL Green Realty Corp — which counts Credit Suisse as its second-largest tenant — has become an especially popular short, given the bank’s forced sale to UBS. SL Green and New York-based Vornado Realty Trust are among the office REITs with the highest interest expense relative to earnings.
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The performance gap between REITs and physical real estate can’t endure forever. REITs include leverage that magnifies returns, but that alone doesn’t explain the gap. As Bloomberg Intelligence Senior Analyst Jeffrey Langbaum told me last week, REIT shares have potentially “overshot the actual decline in property values that are coming.” That would be consistent with 30 years of history in which REITs tend to overcorrect. From 1993 until around 2017, the long-term total returns of office REITs have closely tracked the NCREIF index.
All real estate assets reaped the benefits of the Fed’s near-zero interest rates policies in the early 2010s. Office REITs started to lose ground in 2017 as soon as the Fed got off the zero bounds, and they’ve faced one headwind after the next since then: The arrival of Covid-19 shutdowns, the emergence of inflation and the highest interest rates since 2006; and now the expected decline in banks’ willingness to lend in the aftermath of the run on Silicon Valley Bank.
It’s hard to find a perfect precedent for today’s circumstances, but the financial crisis provides one example of how securities can perform relative to physical real estate in times of extraordinary stress. In that episode, office REITs posted a peak-to-trough loss of 74% (including dividends), about three times worse than the top-to-bottom loss for the NCREIF.
The REIT declines started around February 2007 and bottomed two years later in March 2009, while the NCREIF losses started in the second quarter of 2008 (14 months after the REITs) and bottomed in the last quarter of 2009 (some seven months after REITs).
By that timeline, REITs may have more months of pain ahead, and there’s a chance that the selloff could get a bit deeper, too. But it’s hard to believe there isn’t long-term value in the shares at these levels.
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There are also significant strategic differences within the subsector, and the looming risks will influence the shares to varying extents. So if an investor believed, for instance, that New York’s best days were behind it, she could instead invest in Cousins Properties, which has assets across the Sun Belt, including Atlanta, Austin and Tampa. At the margin, that may partially help explain why Cousins has outperformed their peers in the past year. Is the post-pandemic market a zero game in which the Sun Belt prevails at New York’s expense? That’s not my bet, but there are ways to play it that way without dodging real estate altogether.
If the US is heading for a recession in the next year, as many economists project, it’s hard to imagine any risky asset will be immune, and the commercial real estate market could well experience some of the worst of it.
Likewise, if the Fed takes the policy rate meaningfully higher than the expected 5% to 5.25%, the market will see another leg down. But when the dust finally settles, it’s hard to believe that history won’t repeat itself and actual office returns won’t converge with REITs, almost certainly to the benefit of the latter. — Bloomberg Opinion
