Caleb Richter, CEO of MyEListing.com.
Recent events have strained the U.S. commercial real estate (CRE) market, from the pandemic’s effects to the Federal Reserve’s battle with inflation. As financing costs soar and commercial vacancies rise, echoes of past crises, like those in the 1980s, 2000 and 2008, resonate.
Yet, to fathom the potential depth of an impending CRE dip, one must examine historical parallels.
How Markets Move
Broad market shifts often arrive in three distinct phases: denial, migration then panic. Denial is self-evident. Migration occurs when increasing numbers navigate to the opposite polarity, and panic is where everyone runs for the exit at once.
We have seen denial, and we are seeing migration, as evidenced by transaction volume having plummeted and spreads between what buyers will pay and sellers will accept having widened. Panic can be averted temporarily, but such capitulation actually serves viable economic purposes. Once it occurs, the real work can begin.
The US CRE Market
As of Q2 2021, estimates put the U.S. CRE market’s aggregate value at a staggering $20.7 trillion. For context, this approximates the nation’s GDP in 2022, which was $25.46 trillion, as stated by the Bureau of Economic Analysis.
Though liquid markets fluctuate swiftly, more cumbersome assets, like commercial properties, change hands more slowly. In turbulent times, these slow-moving, leveraged giants can spell both massive losses and unprecedented opportunities.
Changing Needs
Here’s what’s different today: A profound shift in the use of mostly office, but also retail spaces dominates today’s CRE landscape. The pandemic, with its resulting lockdowns, served as an epiphany for many.
Many office-goers realized the feasibility of working remotely without the accompanying daily expenses; expenses, they discovered, that only accrued to them, not employers. Given Americans’ propensity for luxury and quality as underlying drivers, I think we are unlikely to see a shift back to less remote and more office work. Some estimates expect remote work to be embraced by nearly a quarter of workers by 2025, suggesting even less office space will be needed going forward.
And retail spaces faced lower demand as homebound consumers relied more upon e-commerce for their daily needs, prompting new business creativity in responses.
Bargaining Power Shifts For Employees
Concurrently, the boomer generation’s entering mass retirement combined with a healthy entrepreneurial climate and structural worker shortages tilted the bargaining scales, allowing employees to negotiate better working parameters, often from the comfort of their homes.
This new normal, however, left vast office spaces underutilized or unused, yet still accruing costs and foreshadowing the erosion of value.
Office Buildings As The Linchpin
These commercial structures aren’t merely concrete and glass: They signify value for property owners and their lenders; value, that is, if they are utilized as intended.
Should they become redundant, a significant portion of the economy stands at risk. Given Nareit’s 2021 estimate that the office market hovers around $3.2 trillion in value, even if half of it falters, the ripple effects could be monumental. And office buildings today are only about half occupied, on average, according to Kastle Systems.
A domino effect could ensue: Foreclosures, strategic defaults, selloffs, layoffs, bankruptcies, and regional weaknesses could be magnified. Cities—reliant on property taxes—could face economic stagnation or even bankruptcy, requiring bailouts.
Increased federal spending on items without economic return could crowd out better expenditures. All these are likely in some measure. It paints a potentially grim picture, but is it the likeliest outcome?
America’s Silver Lining
Amid the looming shadows, several factors position the U.S. uniquely for ultimate recovery:
• Demography: The U.S. has a robust millennial population of about 72 million, ensconced on either side by slightly smaller generations.
• Economic influence: As the anchor of the global economic order, the U.S.’s command over the world-reserve U.S. dollar and dollar-denominated assets is unrivaled. Contrary to semi-popular belief, there is no actual rival to the U.S. dollar’s function in the world.
• Inherent strength: Millennials, about two times more likely to possess a college degree than their boomer counterparts, are the torchbearers of the new era. The freedom and optionality of remote work, combined with the potential of intercity high-speed rail, promise a lifestyle revolution akin to the suburban migration facilitated by the Interstate Highway System for the boomers.
What CRE Leaders Can Do
Today’s CRE leaders can use the current set of circumstances to demonstrate their adherence to sound investment philosophy and to guide future leaders as they should guide others when their moment arises. Warren Buffett’s oft-repeated aphorism to be greedy only when others are fearful and vice versa rings quite poignantly today.
But they must also be careful; it is an important skill to recognize when something fundamental has shifted such that things are not likely to cycle back as they normally would. Office property is a good example. Remote work has fundamentally shifted how we produce and deliver certain value types. This is unlikely to revert.
Office properties are, therefore, too prevalent, and their market is unlikely to normalize until many are repurposed or replaced. To maximize one’s chances of success in CRE, it is important to be able to discern between cyclical and secular market machinations.
The Bigger, Longer-Term Picture
Geographically blessed, demographically poised and economically resilient, the U.S. faces a potential real estate challenge that could be severe and possibly contagious. Yet, when considering the multitude of strengths at its disposal and the promise held by the millennial generation, a bright horizon appears evident. Anxieties remain, but so does an unyielding optimism for the economy’s long-term trajectory.
So how bad could it get? The potential exists for a sub-optimal scene to unfold and conflate, certainly. But in the real world, we deal in likelihoods instead of potentials. Given the systemic inputs as I’ve outlined them, I believe the risk lies more in missing the next move than avoiding any impending one.
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