Bright Spots Amid Commercial Real Estate Struggles

The landscape for commercial real estate may look dismal from afar with high interest rates and an office space market still in shakeout mode, but pockets of opportunity remain for investors with the right approach and strategy.

Some — but by no means all — commercial real estate segments (particularly the office market) bore the brunt of the post-COVID upheaval. Even prime properties have seen ratings downgrades. Community and regional banks have been reluctant to enter the space as bank regulators and rating agencies keep a keen eye on exposure to deals on shaky footing.

But in spite of those developments, there are categories that look attractive for investors, including the retail, industrial and hotel sectors.

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Major fund sponsors are creating new vehicles for investment. Sellers are accepting deals they wouldn’t have considered a year or even six months ago. The seemingly unyielding rise in interest rates may be coming to an end, considering Fed officials’ recent comments.

“Hot” markets such as Austin and Phoenix are still relatively highly valued and probably best avoided. But potential returns are inviting in some smaller markets like San Antonio, Albuquerque, Birmingham and Tulsa.

Some long-term opportunities

There are some good long-term opportunities, too, in the Northeast and Midwest. Milwaukee and Detroit have stabilized. Minneapolis has a stable of Fortune 500 companies, a strong university presence and a great recreational market, making it an interesting prospect. Indianapolis is among the Rust Belt communities seeing growth with what appears to be a resilient economy that is home to several companies with staying power.

Boston, Philadelphia and Atlanta have diverse business bases, as does Washington, D.C., which is also getting Amazon’s HQ2 and has the federal government ordering workers back to the office. Newark, N.J., still gets a lot of bad press, but the logistics and industrial market there is second to none.

Still, there aren’t shiny deals under every rock. Lenders won’t touch San Francisco, for example. The city has lost a material portion of its talent base, and the appeal of its natural beauty has waned in view of other detractions. It’s going to take a lot to bring the city back.

Financing and interest rates are a hurdle

More broadly, despite the opportunities and the easing of rising interest rates, financing remains a hurdle. When debt isn’t available, a potential buyer needs to find a seller that’s willing to carry the mortgage while the property is leased, renovated or otherwise set up to make money. It’s going to take creative financing to make the market come back to full health.

A buyer who is fiscally prudent on the management side — that means not spending money on amenities that have no value to a tenant — and a reasonable medium- to long-term view on real estate will be able to find deals that generate positive cash flow, even before tax benefits.

There remains a great deal of uncertainty and turbulence in the commercial real estate sector. As the bottom fell out of the office market, rates were changing so fast people couldn’t figure out what buildings were worth.

But by this time next year, it should be clear that cap rates and yields have peaked. Property values are very likely to rise, and many investors will wish they had been more aggressive. Those who did buy will be able to refinance and see respectable returns.

Be aware, too, there are new complexities. Artificial intelligence, for example, will be a game changer for real estate just as it will be in other industries. Not only will the way properties are analyzed and managed changed — the tenants and users of buildings are likely to be changed by AI, too.

What will become of the office market?

As for the current ugly duckling: The office market will at some future point come back. Many people are finding it’s not as easy to work from home now that not everyone is doing it. Companies and bosses are fully cognizant that innovation and productivity were higher with workers gathering in proximity to one another. While versions of remote work will persist, there’s now a clear trend back to a more traditional direction.

The pandemic created a wildly distorted market, and investors are always spooked by market distortions. Some commercial real estate sectors have taken the brunt of that impact, but commercial real estate overall will continue to be a stable asset class.

And any investor who’s not searching for cash flow-positive deals is likely to regret it next year.

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