The Real Estate Reel: Is office as problematic as you think?

This month we are digging into everyone’s favorite question: What about office? Let’s take a closer look at office as a percentage of commercial real estate, bank exposure to mortgages secured by office, and office fundamentals.

First, it’s important to recognize that while office commands a lot of attention given the headwinds facing the sector, it’s not a very big part of the commercial real estate market.

In private real estate, open ended funds that own core commercial real estate, known as ODCE funds, have 18% exposure to the office sector as of 1Q24 (Exhibit 1).

This is down from a peak of nearly 53% in 2000.

By comparison, ODCE funds have the greatest exposure to industrial at approximately 34% and apartments at around 29%.

At March 30, 2024. Source: NCREIF, Cohen & Steers
Data quoted represents past performance, which is no guarantee of future results.

Listed REIT exposure to the sector is much smaller at around 3% of market cap in the United States. This is more than five percentage points lower than six years ago (Exhibit 2).

By comparison, U.S. listed REITs now have almost 60% exposure to what we refer to as Next Generation property types including data centers, cell towers, seniors housing and single-family rentals.

At December 31, 2023. Source: Mortgage Bankers Association, Cohen & Steers.
Data quoted represents past performance, which is no guarantee of future results.

The second point I’m watching is that bank exposure to office is a lot lower than the media headlines would suggest.

To level set, the Mortgage Bankers Association estimates that there are approximately $4.7 trillion of commercial mortgage loans outstanding across lender types, as of the end of 2023.

Of these loans, less than 40% are held by banks, and only around 16% are office.

More than $900 billion of these loans (or 20% of total) are scheduled to mature in 2024.

Banks have exposure to less than 50% of these maturing loans.

But the devils in the details. Ultimately, banks have lower exposure to CRE as a percent of total assets than may be assumed and their exposure to office as a percent of total assets is even lower. 

This is important to note because the risk of loss to lenders on commercial real estate generally and office more specifically may be not as bad as feared.

Let’s dig in.

In our March 2023 report ‘The commercial real estate debt market: Separating fact from fiction’, we estimated, in collaboration with the Mortgage Bankers Association, that the more than 4,700 banks across the US had average office exposure of just 1.2% of total assets.

The top 25 largest banks had fifty basis points of exposure to office, while smaller regional and community banks had around three percentage points of exposure to office.

A more recent Morgan Stanley analysis of 30 banks of various sizes shows average office exposure as a percent of total assets at 2.7% ranging from a minimum of seventy basis points to a maximum of 9.5%.

In fact, not only do banks have lower than expected exposure to office, we think a major misconception among investors is that banks have significant exposure to commercial real estate in total.

That’s not true in aggregate (Exhibit 3).

They have nearly 20% on average vs. 4% for top 25 banks

At March 23, 2024. Source: Mortgage Bankers Association, Cohen & Steers.
Data quoted represents past performance, which is no guarantee of future results. The information presented above does not represent the performance of any fund or other account managed or serviced by Cohen & Steers, and there is no guarantee that investors will experience the type of performance listed above. There is no guarantee that any historical trend illustrated above will be represented in the future, and there is no way to predict precisely when such a trend will occur.

We estimate that the 25 largest banks by total assets hold 13% of CRE mortgages, and their exposure to CRE as a percentage of total assets is small at around 4%.

Regional and community banks hold 31.5% percent of all CRE mortgages, and their exposure is much higher at around 20% of total assets.

We acknowledge a handful of smaller banks have greater than 50% exposure to CRE, with some standing at more than 70%.

Even then, however, the more than 4,600 banks outside the largest one hundred hold 15–20% of all CRE mortgages.

This diversity is underappreciated and helps mitigate risk. They finance smaller properties in smaller markets rather than larger core properties owned by institutional investors.

This leads me to my third point. The market does not appreciate that all office is not the same.

We expect unlevered office valuations to decline around 45% peak-to-trough, going back to their peak in late October of 2022.

This shouldn’t come as much of a surprise.

We estimate that office valuations from that peak are already down more than 30%, while office REITs, which are a leading indicator, are down around 41% on a total return basis with stock prices down more than 50%.

This is after considering that listed office REITs have rebounded almost 30% since the 4Q 2023 trough, making them the fifth-best performing listed REIT sector over that period.

What may surprise people is how concentrated high vacancies are within a relatively small collection of properties.

One percent of office buildings comprise nearly 17% of total U.S. office vacancies according to JLL.

Ten percent of buildings comprise over 60% of total office vacancies, and 30% of buildings comprise over 90% of total office vacancies.

By contrast, 40% of buildings have no vacant space at all, indicating a widening separation between winners and losing.

So what type of office properties are working?

First, buildings that were developed in 2015 and after are seeing strong demand as evidenced by positive net absorptions that are approaching 115 million square feet (Exhibit 4).

New vintage buildings approach 115 million square feet of positive net absorption

At December 31, 2023. Source: JLL, Cohen & Steers.
Data quoted represents past performance, which is no guarantee of future results. The information presented above does not represent the performance of any fund or other account managed or serviced by Cohen & Steers, and there is no guarantee that investors will experience the type of performance listed above. There is no guarantee that any historical trend illustrated above will be represented in the future, and there is no way to predict precisely when such a trend will occur.

This means that demand for space is greater than supply leading to higher occupancies.

By comparison, buildings that were delivered prior to 2015 are seeing negative net absorptions.

It’s a flight to quality, and most of the buildings previously built to accommodate the Baby Boomer generation are ill-suited for the increasingly millennial-dominated workforce.

Second, according to JLL, office buildings located in high growth markets such as Atlanta, Austin, Charlotte, Dallas, Denver, Miami, Nashville, Phoenix, Raleigh, and San Diego are seeing much stronger leasing trends than the nation overall and gateway markets like New York, Chicago and San Francisco in particular.

Finally, office located in Central Business Districts are outperforming suburban markets.

CBDs have base rent growth of 6.5% percent since 1Q20 with effective rent growth of 3% while suburban markets have negative 3.8% percent base rent growth with effective rent growth of -6% (Exhibit 5).

At May 31, 2024. Source: Bloomberg, Cohen & Steers.
Data quoted represents past performance, which is no guarantee of future results.
U.S. REITs represented by the FTSE NAREIT All Equity REITs Total Return Index.

CBDs where people live, work and shop are performing even better.

A lot of this is driven by what type of tenants are coming back to work more than others and
markets where employers offer the best environments both inside and outside the office.

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Watch June 2024 The Real Estate Reel: What’s actually driving listed REIT returns

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