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Investment Strategy

Is commercial real estate the next black swan?

Apr 13, 2023

Cross Asset Strategy

Markets are looking for direction as competing narratives around disinflation and recession continue to push markets in a range-bound direction. Much focus was on the March U.S. CPI report and Fed minutes looking for signs of whether the Fed will continue its hiking path in May. The report showed that while inflation is still too high, it is continuing to moderate. The headline number slowed more than anticipated, dropping to a +5.0% year-over-year pace as the core measure (ex-food and energy) rose to +5.6% year-over-year as expected. The details were more encouraging – while energy and used auto prices fell, shelter (rents) grew at the slowest rate since a year ago. Markets so far are taking the numbers in stride, as they give investors room to focus on the looming corporate earnings season that kicks off today with some highly anticipated U.S. banks.

Our take on the recent data is that inflation is slowing, but prices are still too high. Assuming no further banking system stress, we expect the Federal Reserve to hike one final time in May. After that, we expect a pause. Rates are already elevated, and banking strains could do more to restrict credit to the economy. In terms of investment positioning, we remain defensive, but not fearful. We believe bonds are still in a once-in-a generation dip. We’re focused on the opportunity to lock in elevated short-term yields, or look to extend duration to protect against a potential economic downturn. Equity market resilience is a welcome surprise for many investors. The upside may be limited from here, so investors might have an opportunity to protect gains through hedges that offer downside protection, or transition index exposure to structured notes that may offer a better risk-reward profile. Further, strength in many mega-cap tech names means that there may be a chance to take some profits and diversify across regions, such as Europe and China.

Strategy Question: Is commercial real estate the next black swan?

Renewed stress in the banking sector has focused attention on the balance sheets of regional banks, or more specifically, their exposure to commercial real estate (CRE). Compared to large banks, small banks hold 4.4x more exposure to CRE (and CRE loans make up 28.7% of assets at small banks, compared to only 6.5% at large banks). This leads to the question: Is commercial real estate the next shoe to drop? Will empty office buildings create renewed pressure on regional banks and lead to a larger crisis?

Our bottom line: the office sector is challenged; however, problems in the office sector should not be generalized to other sectors within CRE, which have considerably stronger fundamentals. In addition, the office sector represents a small part of the overall economy, from both a GDP and physical wealth perspective. That said, the impact on small bank lending is a macro risk, but it’s hard to precisely quantify this risk, and the uncertainty surrounding potential offsets is high.

The tide has turned on the office sector

The primary source of the challenges in the office sector is obvious: it’s the rise of remote work. In 2022, more workers did return to offices, however, the outright level of remote work is still running at roughly 7x above the pre-pandemic level. Layer on top of this the Fed’s historically rapid pace of interest rate rises over the last year, the recent layoffs that are acutely impacting office workers (e.g., in the Technology sector), and it’s not hard to see pain in the office sector getting worse. 

These trends are driving vacancies near all-time high levels. Vacancies soared in the early stages of the pandemic, and have only kept rising since. Today, the vacancy rate in the office sector, at 12.5%, is comparable to where it was in 2010 after the Global Financial Crisis. Importantly, the office sector is very bifurcated. The pain is concentrated across certain geographies (Chicago & San Francisco are much more challenged than Miami, Raleigh and Columbus, to name a few) and across vintage (newer office builds, particularly those built after 2010, are seeing much stronger net absorption rates than older builds). 

Broader backdrop: Fundamentals solid outside offices and malls

Our view is that the office sector is unique within the commercial real estate complex. Other sectors, most notably the industrial and retail sectors, are tight, with vacancy rates well below where they were prior to the pandemic. Industrial construction activity has been booming, and the current level of construction is at a secular high relative to GDP.

OFFICE IS MOST CHALLENGED WITHIN CRE

Commercial real estate vacancy rates, percent

Sources: CoStar, J.P. Morgan. Data as of December 31, 2022.

Retail, on the other hand, is tight, and it’s more due to a lack of supply as retail construction projects have languished ever since the GFC (in large part due to rising e-commerce activity). While retail in the aggregate is in a better place today than after the GFC due to a lack of supply, there are still challenges, particularly as it relates to malls.1 Distress continues to be high in this subset of the Commercial Mortgage Backed Securities (CMBS) market, which accounts for approximately 5-10% of the overall CMBS market. A key question for the broader retail sector (which applies to multifamily as well) will be how well the consumer holds up over the next 12 months in the context of elevated recession probabilities.

The apartment sector has already cooled, and the vacancy rate has risen close to where it was prior to the pandemic. However, this is less a function of distress like we see in the office sector, and more a function of a slowdown in migration patterns. The apartment market is likely to continue to loosen, especially given the supply backdrop (there are currently more than 950k multifamily projects under construction, the highest level of activity since the 1970s), but demand is unlikely to fall like it has in the office sector given favorable secular dynamics, including renting trends in the Millennial generation in the context of low home buying affordability. Like in the office sector, the demand backdrop for apartments is becoming increasingly bifurcated, with strong tailwinds in the South and Southwest of the United States, while coastal markets are softening given recent Tech layoffs.2

The office sector represents a small part of the overall economy

If we zoom out of CRE and place the office sector into the context of the broader economy, the backdrop becomes reassuring. From a wealth perspective, office structures represent a low share of the value of all physical capital in the United States, at only 2.4% (they represent about 14% of total CRE structures). Another way of thinking about this is that the market capitalization of one company, Apple, at $2.4 trillion, is larger than the entire capitalization of the US office sector (just over $2 trillion).

Office construction represents an even lower share of overall US GDP, at only 0.4%. In the mid-2000s, single family residential investment soared to more than 3.3% of GDP, but once the housing bubble burst, it crashed and bottomed out at around 0.7%. That swing was the source of a major aggregate demand deficit contributing to the 2008-2009 recession. The office sector, in isolation, will not have anywhere near the same impact, because it’s just not big enough.

PRIVATE OFFICE BUILDINGS ACCOUNT FOR ~2.4% OF PHYSICAL CAPITAL WEALTH

USD billion (2018)

Source: World Bank, Bureau of Economic Analysis, Bloomberg Finance L.P., Haver Analytics. Data as of 2023.

How bad can it get? Regional banks in focus

While we can feel confident that the office sector isn’t likely, in isolation, to be a significant source of GDP weakness, there are broader and legitimate concerns about uncertainty and confidence in the banking system, particularly when it comes to smaller banks and the credit to the overall economy they provide.

SMALL VS. LARGE BANKS: BREAKDOWN OF LOAN EXPOSURES

Loan exposure, %

Source: Haver Analytics. Data as of March 22, 2023. Note: Large domestically chartered commercial banks are defined as the top 25 domestically chartered commercial banks, ranked by Call Report to which the H.8 release data have been benchmarked. Small domestically chartered commercial banks are defined as all domestically chartered commercial banks not included in the top 25. 

As mentioned, these banks have about 4.4x more exposure to CRE than do large banks. While exposure to the weakest links of CRE (offices and vintage malls) varies by bank, those with over 100% of their capital in these buckets are concentrated among smaller regionals.

The key concern market participants are trying to assess is if potential stress in segments of the CRE market will be enough of a drag to impair capital for certain players. The driving factors will be 1) the size of exposure, 2) the magnitude of losses across vulnerable sectors, and 3) the severity and speed of the losses. Applying GFC-like loss content (11% cumulative losses) and speed (3+ years) to only office and retail CRE would not rise to the level of a capital event for the space. However, if severity and speed is worse than a GFC-like scenario, capital events for small and more heavily exposed banks are possible.

What can we learn from the past? CRE price cycle vs GDP

CRE prices across all sectors are currently down just 3.5% from the peak in 2021 (according to data from NCREIF). Given higher interest rates, we will likely see more price deflation on a go-forward basis. However, history suggests that CRE down cycles are less detrimental to GDP than residential real estate down cycles, given there is less spillover from CRE to the consumer. The early 1990s recession is a good illustrator of this. CRE prices fell by more than 20% from their peak in 1989 to a trough in 1993. At the same time, the US economy experienced one of the shallowest recessions in history, with real GDP falling by only 0.1% in 1991.

GDP WAS BARELY AFFECTED BY DRAWDOWN IN CRE

Sources: Bureau of Economic Analysis, Federal Reserve Board, Haver Analytics. Data as of April 3, 2023.

Furthermore, there are offsets to a weak office sector. In short, the weaker office real estate is, the stronger residential and remote-work related sectors are. This is because the underlying source of the disruption to the office sector is technology. Technological shocks usually aren’t recessionary/detrimental to aggregate demand; on the contrary, they create winners and losers.3

We saw this before with brick and mortar retail. Throughout the 2010s overall GDP in the sector continued to rise, but more of it was going to e-commerce platforms, while brick and mortar was shrinking. The upshot is that this represented more of a micro recession for brick and mortar, but not a macro recession for either the retail sector as a whole or the overall economy. The same logic should apply to the office sector as well (if we are considering the sector in isolation).

Investment implications

From an equities and credit perspective, we are cautious on the U.S. regional banking sector. With regards to the overall index and real estate, wobbles in office real estate aren’t enough to impact our overall view. Public real estate stocks comprise a small part of the capitalization-weighted indices, with the REIT sector representing just 2.55% of the S&P 500. Within REITs, office and retail make up a combined 15% of the sector, or 0.38% of the SPX. Are there any opportunities amid the stress? We have a positive view on Industrial REITs, where current rental prices are materially higher than lease prices. Healthcare, Gaming and Leisure also offer differentiated and secular growth at reasonable cap rates.

1Don’t Forget About the Malls, Barclays Credit Research, 22 March 2023.

2https://blinks.bloomberg.com/news/stories/RRM135T1UM0Z

3This technological shock (remote work) is also a source of the bifurcation in the office sector between newer builds and older vintages. Amid the war for labor talent, companies have tried to use newer office space in prime locations as a way to lure employees back into the office

All market and economic data as of April 13 , 2023 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.

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JPMorgan Chase Bank, N.A. and its affiliates (collectively "JPMCB") offer investment products, which may include bank-managed accounts and custody, as part of its trust and fiduciary services. Other investment products and services, such as brokerage and advisory accounts, are offered through J.P. Morgan Securities LLC ("JPMS"), a member of FINRA and SIPC. Insurance products are made available through Chase Insurance Agency, Inc. (CIA), a licensed insurance agency, doing business as Chase Insurance Agency Services, Inc. in Florida. JPMCB, JPMS and CIA are affiliated companies under the common control of JPMorgan Chase & Co. Products not available in all states. Please read the Legal Disclaimer in conjunction with these pages.

 

INVESTMENT AND INSURANCE PRODUCTS ARE: • NOT FDIC INSURED • NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY • NOT A DEPOSIT OR OTHER OBLIGATION OF, OR GUARANTEED BY, JPMORGAN CHASE BANK, N.A. OR ANY OF ITS AFFILIATES • SUBJECT TO INVESTMENT RISKS, INCLUDING POSSIBLE LOSS OF THE PRINCIPAL AMOUNT INVESTED

Bank deposit products, such as checking, savings and bank lending and related services are offered by JPMorgan Chase Bank, N.A. Member FDIC. Not a commitment to lend. All extensions of credit are subject to credit approval.