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, aka the real world. The Covid-19 pandemic unleashed drastic changes in the form of 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 to address changing geographic preferences. And that comes, of course, amid an unprecedentedly fast jump in the Federal Reserve’s key interest rate and now a potential bank credit crunch. Already, Brookfield Corp. and Pacific Investment Management Co. have defaulted on office mortgages in recent months, and there’s a looming wall of around $180 billion of office mortgages coming due in 2023.
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 a form of 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 sort of like the grieving process: There’s denial, anger, and then acceptance.
Ultimately, the market can’t go down much if it’s essentially frozen.
Next, there 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. For much of last year, this was a reflexive and haphazard reaction to higher government bond yields.
But in recent weeks, short sellers have begun circling office REITs with special zeal, particularly those with portfolios centered on New York and the West Coast. New York-based SL Green Realty Corp., which counts Credit Suisse Group AG as its second-largest tenant, has become an especially popular short, given the bank’s forced sale to UBS Group AG. SL Green and New York-based Vornado Realty Trust are among the office REITs with the highest interest expense relative to earnings.
The performance gap between REITs and physical real estate can’t endure forever, of course. REITs include leverage that magnifies returns, but that alone doesn’t explain away the gaping performance gap. As Bloomberg Intelligence Senior Analyst Jeffrey Langbaum told me last week, REIT shares have potentially “overshot the actual decline in property values that’s 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.
Clearly, 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 bound, and they’ve faced one headwind after the next since then: the arrival of Covid 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 the 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 7 months after REITs.) By that timeline, REITs may yet 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.
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 Inc., which has assets across the Sun Belt, including Atlanta, Austin and Tampa. At the margin, that may partially help explain why Cousins has outperformed peers in the past year. Is the post-pandemic market truly 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.
To be clear, 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 yet 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.
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