Commercial Real Estate investment securities are available in two major forms, which are publicly traded as Real Estate Investment Trusts, commonly referred to as REITs, as well as Closed-End Interval Funds with Real Estate. A good article titled “When Your Lookalike Funds Don’t Act Alike” [01] explains the difference between the two. A quick summary of said article is that publicly traded REIT securities trade on investor sentiment, which is affected by the greed and fear emotions of investors. On the other hand, Closed-End Interval Funds with Real Estate[02] , which tend to be less volatile, are valued by Mark-to-Market pricing using observable market data as well as periodic appraisals of properties. However, Closed-End Interval Funds may have liquidity restrictions because they are intended to be long-term investments.
Commercial Real Estate as an asset class, referred to asCRE throughout this Newsletter, has historically provided an inflation hedge[03] and diversification benefit[04] because of its low correlation with other asset classes, such as stocks and bonds. The economic slowdown from the COVID-19 Great Lockdown has softened certain sectors of CRE investable securities[05].
In typical rate hiking cycles, the FED has historically taken a more measured approach over a longer period allowing slow motion price adjustments to dampen the effect of a higher risk-free rate and borrowing costs. Because the FED initially believed inflation to be transient, the FED had to aggressively raise rates to combat rampant inflation, which are still working its way through the valuation process for various asset classes.
Last year was an absolute train wreck with few investable places to hide. Headwinds that normally impact Commercial Real Estate as an asset class, such as overleverage, over-supply and high unemployment are NOT prevalent in this business cycle. However, credit tightening because of Bank failures may negatively impact financing[06]. CRE, as tracked by the NCREIF website[07], plateaued during the third quarter of 2022 and has been declining ever since albeit at a slower rate as of late.
CRE has a long market cycle[08], which historically has been around 18 years[09], because of supply unresponsiveness resulting from the lag time between permitting and building to occupancy. CRE as an Asset Class is tracked on a quarterly basis on the NCREIF website, which monitors CRE valuations. CRE is typically broken into categories, such as Office, Industrial, Retail and Apartment securities, which the NCREIF website can break down the quarterly valuation changes by region and/or category.
Online commerce and the virtual workplace became much more prevalent during the 2020 COVID shelter-in-place mandates, which benefited certain type of properties, while hurting others, such as office and retail space. Because the forced transition to a virtual workplace went fairly smoothly, CEOs may evaluate the benefits&drawbacks[10] of the virtual office and employees working remotely. Fortunately for property owners, Commercial Office space is usually under multi-year lease[11] contracts, of five years on average, with cancellation penalty clauses. Vacancy rates are creeping higher as leases come up for renewal with distress in the Office market recently spreading to High-end properties[12] as well.
As the virtual workplace gains momentum[13], less physical office space needs will be detrimental to office and retail securities but beneficial to telecommunication, streaming and video conferencing services and associated infrastructure securities, such as internet backbone facilities and telecommunication towers. The build out of the 5G communication network with much higher bandwidth may hasten the trend to the virtual office.
Because of tariff inflicted supply chain problems[14] further exacerbated by COVID, corporations may alter supply chains between countries and even continents. Corporations may also consider switching from just-in-time to just-in-case inventory[15] to shun fragile business models[16] as well as sourcing supply production domestically. The passage of the CHIPS Act has encouraged onshoring production of semiconductor chips[17], which should bolster National Security. Changes to the supply chain regarding where supplies are sourced will benefit production facilities and warehousing as well as increase employment associated with those activities. These changes will have long-lasting implications but take time to implement.
It is uniquely different this time and how the world does business will likely change because of this pandemic and the problems that it uncovered. We monitor asset class valuations on a periodic and on-going basis, especially when conditions warrant doing so, like now. CRE valuations[18] will need to be monitored because of recent developments[19] and possible lingering effects of COVID.
Chance favors the prepared mind[20]! Where markets go from here depends on many unknowns. If you have any concerns about CRE valuations and how they may affect your overall portfolio, a member of the Iron Belt Partners Team will gladly discuss any concerns with you. We can be contacted via phone at (724) 493-9473 or via Email at:
Lindsay M. Turchetta LTurchetta@lpl.com
John D. Martin JDMartin@lpl.com
Working as a team to better serve our clients!
This communication is meant to be general in nature and should not be construed as investment or financial advice related to your personal situation. You should consult your tax, legal, and/or financial advisor prior to making any financial decisions. The views expressed here are those of the authors, John Martin & Lindsay Turchetta, and not necessarily those of LPL Financial. Information is based on data gathered from what are believed to be reliable sources. The opinions and other information contained in this article are subject to change continually and without notice of any kind. Forward-looking statements are subject to numerous assumptions, risks, and uncertainties, which change over time and may not come to pass. Past performance does not guarantee future results.
Investments are not guaranteed and are subject to investment risk including the possible loss of principal.
The index references herein are unmanaged and cannot be directly invested in. Past performance does not guarantee future results.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
Investing in Real Estate Investment Trusts (REITs) as well as Interval Funds involves special risks such as potential illiquidity and may not be suitable for all investors. There is no assurance that the investment objectives of this program will be attained. Investments in Commercial Real Estate may be subject to a higher degree of market risk because of concentration in a specific industry, sector, or geographical region. Other risks can include, but are not limited to, declines in the value of real estate, potential illiquidity, risks related to general and economic conditions, stage of development, and defaults by borrower.
Securities and investment products and services offered through LPL Financial, member FINRA/SIPC.
Iron Belt Partners is a name used by independent advisors associated with LPL Financial.
[04] Source: “When Your Lookalike Funds Don’t Act Alike” on wsj.com by Jason Zweig
[02] Source: “Interval Funds and Nontraded Closed-End Funds” on bluevaultpartners.com by Jared Schneider
[03] Source: “How Commercial Real Estate can be seen as an inflation hedge” on amnestymedia.org
[04] Source: “Portfolio Diversification through Real Estate” on equitymultiple.com
[05] Source: “What Does a Softening Market Mean for Commercial Real Estate Investing?” on montegra.com
[06] Source: “Bank Crisis Could Cast Pall Over Commercial Real Estate Market” on nytimes.com by Matthew Goldstein
[07] Source: “Quarterly Returns under NCREIF Property Index (NPI)” on ncreif.org/data-products/property
[08] Source: “Where are we in the Commercial Real Estate Market?” on pioneerrealtycapital.com
[09] Source: “The GREAT 18-year Real Estate Cycle” on CATO.org by Steve H. Hanke
[10] Source: “Understanding the Pros and Cons of Virtual Office Spaces: Part 1 & Part 2” on stat.international
[11] Source: “What does COVID-19 mean for Commercial Real Estate?” on geophy.com by Nils Kok
[12] Source: “Distress in Office Market Spreads to High-End Buildings” on wsj.com by Konrad Putzier
[13] Source: “The Pros and Cons of Virtual Offices” on business.com
[14] Source: ”The United States Needs to Reshape Global Supply Chains” on foreignpolicy.com by Aaron Friedberg
[15] Source: “Just-in-time vs “just-in-case parts inventory management” on acumentfl.com
[16] Source: “Companies should shift from “just in time” to “just in case”” on ft.com
[17] Source: “CHIPS ACT could be a shot in the arm for the U.S. semiconductor industry” on finance.yahoo.com by Frank Holmes
[18] Source: “Bank Crisis Could Cast Pall Over Commercial Real Estate Market” quote on nytimes.com by Matthew Goldstein
[19] Source: “Commercial Property Debt creates More Bank Worries” on WSJ.com by Konrad Putzier
[20] Source: “Chance favors the prepared mind” quote by Louis Pasture