Commercial real estate recovers from long Covid

Residential real estate prices are dropping in response to higher mortgage rates, even as unit sales are increasing. While homes generally appreciate in value over the long haul, it’s a dicey proposition from an investing perspective. It’s great to know that your personal domain will be worth more when it comes time to sell it than when you bought it, but that’s not really what led you across its threshold all those years ago. You needed a place to raise a family. Anything else is a bonus.

And, cliches aside, it really is true that location is everything in residential real estate. That adds a spatial layer to the already complicated temporal layer of getting the timing right, which is part of any investment strategy. Combine the location and timing with the six- or seven- or eight-digit unit price, and you have an asset that is not easily monetized.

But what about commercial real estate (CRE) in 2023? Location is still important, but unit sizes – and thus prices – can be adjusted on the fly. And it’s fungible. While it’s impossible to fix ‘n’ flip a 60-story glass office tower, you can buy a limited interest in the company that owns it, manages it or built it. And with the sector unbowed by the post-pandemic reshaping of the economy, there’s a compelling argument to be made for adding it to your portfolio.

As what looks more and more like a rolling recession rolls along, it’s important to take a look at the CRE market as a potential investment thesis.

What is CRE? Really, what isn’t?

“CRE is a broad category that includes everything from shopping malls to office buildings to apartment complexes,” according to financial custodian American Estate & Trust. “It includes hotels, assisted living communities, warehouses, and the surprisingly fast-growing self-storage market. Investors can fund development projects, which involve [new] construction … or renovating older buildings. They can also invest in management companies that serve the traditional landlord functions of maintaining the physical plant and collecting rents.”

These opportunities usually take the form of limited liability corporations, with the investors serving as passive participants. As you might have assumed there are tax advantages to investing in these vehicles rather than regular industrial stocks. The National Association of Real Estate Investment Trusts estimates the value of CRE in the U.S. at $20.7 trillion. Investopedia offers a list of real estate crowdfunding sites, which tend to provide low buy-in barriers.

Basically, if it’s land that isn’t a private or semi-private home, it’s CRE. The world of residential real estate – which holds roughly double the valuation as CRE has wildly different economic drivers – is confined to single-family homes, duplexes, independently owned rowhomes and small apartment buildings. If it has five or more units, it’s CRE.

The outlook

Coldwell Banker Richard Ellis, the large real estate developer generally known as CBRE, makes forward-looking projections in four distinct CRE categories, and the firm’s econometrics operation is quite bullish now:

• Industrial. Vacancies are near all-time lows now because post-Covid last-mile delivery services are multiplying and need more warehouse space. Existing structures can’t support the demand and it takes a long time to design and build a 500,000-square-foot or larger space.
• Multifamily. The low overall unemployment rate is resulting in new tenants for apartment buildings and complexes. “We expect millennials moving out of their parents’ houses,” CBRE predicts, eliding over the fact that the oldest millennials are now 42 years old, “and entering their peak earning years to support the sector over the next 10 years.”
• Retail. The supply of storefronts is its lowest in 10 years. The lack of new construction has resulted in favorable fundamentals for 2023.
• Market dynamics for office space have this in common with housing: Everybody wants the newest and shiniest. Such top-tier properties – “Class A” in industry parlance – is considered the easiest to rent out to the most promising prospects. Anything less means not only lower returns, but also higher default risk. The only exception might be space leased to governmental tenants. Despite the rolling recession hitting the public sector at the moment, landlords continue to get paid because these leases extend not for months or years, but for decades.

Collecting the rent

It was an oversimplification to believe that the Covid-19 pandemic would kill the CRE market. True, it looked like the whole concept of going into the office was looking like a vestige of Mad Men days for a while, but most people did eventually get called back to their cubicles. As much as we hear that online shopping is killing retail, all that just doesn’t prove to be true. As for apartment buildings, America had a housing shortage before Covid and it has an even worse one now. And the rise of DoorDash and its competitors has done nothing but spur demand for industrial space.

There are a lot of ways into CRE investing. The easiest might be to select from any number of exchange-traded funds. These might be structured as ordinary ETFs or they might be structured as real estate investment trusts, or REITs, which have tax advantages. Direct participation in the ownership or management of a commercial property is also an option and provides even more tax shielding if done right. Of course, markets for such participations aren’t as thick as that for ETFs or REITs, but these markets do exist.

There’s no need, though, to navigate through the very complicated world of CRE and its trends on your own. Consider reaching out to one of our trusted financial advisors, who have seen a few real estate cycles.