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An Uneven Asset Class Recovery - CRE

While we are positive on the long term outlook for the US economy and investment markets, the recovery and risks over the short to intermediate period are quite different for various asset classes. One asset class that is currently and likely to see continued pressure is Commercial Real Estate (CRE).

Commercial real estate (CRE) is property that is used exclusively for business-related purposes or to provide a workspace rather than as a living space. Most often, commercial real estate is leased to tenants to conduct income-generating activities. Commercial real estate includes several categories, such as retailers of all kinds, office space, hotels & resorts, strip malls, restaurants, and healthcare facilities.

The Covid shutdowns have had numerous impacts that make CRE a risky asset class not just now but going forward. The two big factors that we feel will drive a very slow recovery are the remote work boom and the loss of retail business, especially in the consumer retail space and restaurants.

The remote work boom will level off and many workers will return to offices, but companies now can potentially run more hybrid models with various contributors no longer needing full-time office space. Some firms had already gone to 'hotelling' or numerous employees using the same desk space on different days. With numerous firms reporting an increase in productivity over the past few months, we could see companies limit the need for new office space, or even cut the amount of space they currently use. This could make some companies more profitable if they can cut the amount of office space needed and lease costs decrease. The chart below shows that very few companies are looking to increase office space capacity, many more are looking to cut.

In most places, there is a limit on indoor dining that has cut capacity at restaurants by 50-75%. It is unlikely that most restaurants, businesses that often survive on thin margins, can survive for long with the lost revenue given that other costs, like rent, did not get cut by the same amount. Restaurants that focus on takeout might actually do better in this environment as they could see increased demand.

Similarly, online purchases of goods have increased rapidly as retail stores remained closed or had their shopper capacity limited. The struggles of shopping malls was an ongoing problem even before Covid, it is likely that the acceleration to online Covid has caused is going to lead to more business failures and empty storefronts.

From a supply and demand perspective, this very likely means that demand for the building of new CRE has or will fall drastically and is unlikely to increase enough to create a shortage of space for some time as noted in the chart on office space demand. More likely, with the excess supply in office and retail space needed, rents are likely to fall, and that would make the debt servicing of some CRE loans difficult. Therefore, from an investment perspective, CRE would appear to carry more risk with less investment value in the short to intermediate period, especially those CRE vehicles focused on office, restaurant, and consumer retail space. Location could also be a factor - as always, performing thorough due dilignece is key in these decisions.

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