A sign is posted outside the gates of the Army’s Ranger School in Columbus, Georgia. It is painted bright yellow and black and offers a simple yet somber warning: “Not For The Weak Or Fainthearted.” Though I didn’t find that warning label particularly reassuring when I entered training in the summer of 2006, I can attest to its validity.
Most things in life don’t come with warning labels, though investors in commercial real estate (CRE) might well have wished for one after the roller coaster ride of the last 18 months. Since 2022, publicly traded real estate investment trusts (REITs) are down nearly 30%, trailing the S&P 500 by more than 22% over that same span. Office REITs, hard hit by the remote work trend, have lost more than half their value (Figure 1). A recent Wall Street Journal Article calls office ownership a “disaster.”
FIGURE 1: REITs are down nearly 30%, trailing the S&P 500 by more than 22% over that same span.
Recently, our clients have wanted to know if – and how – Balentine invests in CRE. In this month’s Top of Mind, we'll discuss the CRE landscape, explore the hurdles CRE investors face, and identify promising avenues they can explore to maximize their returns.
What’s Plaguing Commercial Real Estate?
The biggest challenge facing CRE is undoubtedly the sharp rise in interest rates we’ve seen since the beginning of 2022. Over the last sixteen months, the Federal Reserve has raised short-term interest rates by more than 5%.
Longer-term rates like the 10-year Treasury yield are at their highest level since 2007, while 30-year mortgages eclipse 7%. All these moves make the cost of borrowing more expensive, which is becoming a rude awakening for CRE investors used to above-average returns at the expense of artificially low debt.
CRE investors’ hearts will be further tested over the next several years as $2.75 trillion of this low debt matures from 2023-2027 and must be refinanced at these higher rates. The real estate deals robust enough to support higher rates will thrive, and those underwritten only due to low rates will struggle.
Another cause of CRE’s woes is remote work. Though the office sector only comprises 15% of the industry (Figure 2) and just 3% of the publicly traded REIT market, with office vacancy rates topping 25% in markets like San Francisco and Chicago, some investors question whether these offices will ever refill.
FIGURE 2: Offices comprise 15% of the Commercial Real Estate Market.
CRE has also been impacted by less access to capital. Historically, banks have been an important partner for CRE, providing a meaningful amount of the industry’s lending. The Fed’s decision to raise short-term interest rates has created competition for bank deposits. As depositors “cash sort” into higher-yielding assets, they reduce the available capital for banks to lend. This, coupled with the defensive posture that regional banks are in after the SVB collapse, makes it easy to see why lending standards are up, and access to capital is down.
FIGURE 3: Change in Bank Lending Standards, By Hiking Cycle
Cumulative percentage point change for commercial and industrial loans to medium and large firms; according to the Federal Reserve Senior Loan Office Opinion Survey
Does Balentine have Exposure to Commercial Real Estate?
Balentine’s exposure in public markets to the real estate sector totals about 2% of the portfolio, split equally between domestic and international. Thus, our exposure to CRE over the last eighteen months has been minimal in public market portfolios.
But after recent price dislocation, the sector is getting more attractive, especially as dividend yields eclipse 4%, nearly double the S&P 500. Still, at this stage,opportunities look most attractive in private markets where skilled active managers can navigate both a challenging macro environment and changing tenant preferences to produce a higher return.
For qualified investors, Balentine’s private capital team recently underwrote Harbert Fund VIII, which invests in “value-add” real estate. Value-add real estate is the purchase of properties with below-market rents and above-market vacancies that need capital improvements. The buyer gets the asset at a discount, works to improve those metrics over a specified period, and aims to sell the properties back closer to market price. Value-add Real Estate is particularly attractive because, unlike other cash-flowing real estate assets, it is an area that was not as inflated, making the entry point into the space more compelling.
Another attractive part of Harbert’s highly active approach is positioning themselves to invest at attractive entry points for different sectors. Currently, they’re taking advantage of the opportunities in multifamily and industrial sectors.
Investors can also benefit from the lack of bank financing in real estate. As banks tighten lending standards, non-bank lenders such as private credit funds can step in to provide financing and offer compelling returns for investors who are willing to provide financing to companies, including real estate firms, that can’t issue debt in public markets. One of Balentine’s private credit offerings for qualified investors, Monroe Private Credit Fund IV, offers 5% exposure to real estate, double the sector’s weight in the S&P 500.  Yields can top 10%.
Another way to get exposure to real estate through private credit is asset-based lending, where a company might pledge its real estate in exchange for credit. Balentine is taking advantage of this dynamic with Credit Opportunities 2023, an investment vehicle created to capitalize on dislocations caused by higher interest rates. We have partnered with distressed and asset-based lenders who will make loans based on the conservative value of assets, like real estate. In the event of a default, they will take control of the asset and sell it to cover the value of the loan. The partnership could also create opportunities to exploit the looming wall of maturity for direct real estate debt.
Commercial real estate investment presents a mosaic of challenges and opportunities that investors must carefully consider. As always, thorough research, a well-defined investment strategy, and a long-term perspective are key to thriving in this dynamic market.
Thank you for taking the time to read this monthly update. My team and I are always available and happy to answer questions as they arise. Please do not hesitate to reach out.