De-Bunking the Doomsday Delusion

A rising chorus has proclaimed the death of U.S. commercial real estate (CRE) — and the banks that lend on it. But to paraphrase Mark Twain, rumors of real estate’s death may be greatly exaggerated. Much of the recent anxiety stems from profound misconceptions.

A rising chorus has proclaimed the death of U.S. commercial real estate (CRE) — and the banks that lend on it. Naysayers fear a “doom-loop” of falling prices and contracting credit, leading to further losses. The concern is understandable: Like most asset classes, real estate has suffered from higher interest rates. Bank failures— though not caused by real estate — have underscored the risks posed by longer-duration assets to liquidity and balance sheets. And high-profile defaults in Los Angeles, San Francisco, and New York have raised the specter of mounting distress.

But to paraphrase Mark Twain, rumors of real estate’s death may be greatly exaggerated. Much of the recent anxiety stems from profound misconceptions. Consider the following:

CLAIM: Work-from-home is killing commercial real estate.

COUNTER-POINT: CRE fundamentals are about the strongest on record.

There is no denying that the U.S. office market is challenged. Office-utilization rates are mired at around 50% of pre-pandemic levels nationally (albeit higher mid-week and outside major coastal cities).[1] Layoffs in the technology and financial industries — big users of office space — have worsened the blow. But the world of real estate is much larger than office buildings. The share of offices in the core real estate fund index is 19% and falling.[2] Industrial (32%) and residential (29%) are much larger, and along with retail (10%), are in very good shape.[2] Collectively, the vacancy rate for U.S. property is near its lowest level on record (since 1988) and net operating incomes (NOIs) are growing briskly.[2]

CLAIM: Bad real estate loans will cause a financial crisis.

COUNTER-POINT: Banks have considerable protection against real estate losses.

Higher interest rates and lower asset values may strain some borrowers’ ability to service and refinance existing debt. Yet many loans have plenty of cushion to absorb these pressures. Over the past five years, core real estate cash flows have increased 21% and prices 15% (after recent declines).[3] The Federal Reserve has observed that loan-to-value (LTV) ratios average about 50%-60% across lenders, and its 2023 stress tests concluded that even under draconian assumptions – prices falling 40% and unemployment soaring to 10% — loan losses at large banks were easily manageable.[4] To be sure, smaller banks have more exposure, but like their larger peers, they sport near-record levels of capital.

CLAIM: Real estate faces a credit crunch.

COUNTER-POINT: Credit is tightening, but the effects are uneven.

It seems reasonable that banks could retrench amid heightened investor and regulatory scrutiny. A net 68% of senior bank loan officers reported a tightening of lending standards in the third quarter of 2023, on a par with Global Financial Crisis (GFC) and COVID peaks.[5] Yet there is little evidence of a credit crunch so far: Spreads on core real estate loans have barely moved, remaining in line with historical norms and well below COVID peaks.[6] Why? Perhaps because insurance companies, government sponsored entities (e.g., Fannie Mae and Freddie Mac), CMBS, and private credit, which together account for half of the mortgage market, are filling the void.[7] Still, we will likely see greater impacts on construction financing, where banks have traditionally played a significant role.

In some ways, prospects for real estate are improving. Cooling inflation may herald an end to Federal Reserve rate hikes, providing relief to valuations. That is not to say that CRE is out of the woods. A recession could hamper leasing and COVID-delayed construction will temporarily lift apartment and industrial supply. But lower prices and tighter financing are curtailing new projects, and any recession may be mild. If so, then real estate’s positive momentum will only slow, not stop, and then re-accelerate next year. Taking a longer view, chronic housing shortages, burgeoning Sun Belt migration, a nascent retail renaissance, relentless e-commerce expansion and efforts to bolster supply chains are just a few of the forces that will drive demand for different types of real estate for years to come.

The next 12 months might be somewhat choppy as improving capital markets collide with a soft patch in fundamentals. But conflicting signals are the hallmark of inflection points, where opportunities are often at their greatest. Fortune may favor the brave investor who can seize the moment, capitalize on attractive valuations, and ride the next cycle.

Additional Resources

1. Kastle Systems. As of September 2023.

2. NCREIF (NFI-ODCE). As of June 2023.

3. NCREIF (cash flow); GSA (prices). As of March 2023.

4. Federal Reserve, “2023 Federal Reserve Stress Test Results.” As of June 2023.

5. Federal Reserve. As of September 2023.

6. CBRE. As of June 2023.

7. Federal Reserve. As of June 2023.

For institutional and registered representative use only. Not for public viewing or distribution.

The information contained in this document is based on material we believe to be reliable; however, we do not represent that it is accurate, current, complete, or error free. Assumptions, estimates and opinions contained in this document constitute our judgment as of the date of the document and are subject to change without notice. Any projections are based on a number of assumptions as to market conditions and there can be no guarantee that any projected results will be achieved. Past performance is not a guarantee of future results. You may not distribute this document, in whole or in part, without our express written permission.

This material was prepared without regard to the specific objectives, financial situation or needs of any particular person who may receive it. It is intended for informational purposes only. It does not constitute investment advice, a recommendation, an offer, solicitation, the basis for any contract to purchase or sell any security or other instrument, or for DWS or its affiliates to enter into or arrange any type of transaction as a consequence of any information contained herein. Neither DWS nor any of its affiliates gives any warranty as to the accuracy, reliability or completeness of information which is contained in this document. Except insofar as liability under any statute cannot be excluded, no member of the DWS, the Issuer or any office, employee or associate of them accepts any liability (whether arising in contract, in tort or negligence or otherwise) for any error or omission in this document or for any resulting loss or damage whether direct, indirect, consequential or otherwise suffered by the recipient of this document or any other person.

The views expressed in this document constitute DWS Group’s judgment at the time of issue and are subject to change. This document is only for professional investors. This document was prepared without regard to the specific objectives, financial situation or needs of any particular person who may receive it. No further distribution is allowed without prior written consent of the Issuer.

Investments are subject to risk, including market fluctuations, regulatory change, possible delays in repayment and loss of income and principal invested. The value of investments can fall as well as rise and you might not get back the amount originally invested at any point in time.

An investment in real assets involves a high degree of risk, including possible loss of principal amount invested, and is suitable only for sophisticated investors who can bear such losses. The value of shares/ units and their derived income may fall or rise.

War, terrorism, sanctions, economic uncertainty, trade disputes, public health crises and related geopolitical events have led, and, in the future, may lead to significant disruptions in US and world economies and markets, which may lead to increased market volatility and may have significant adverse effects on the fund and its investments.

Investment products: No bank guarantee | Not FDIC insured | May lose value

The brand DWS represents DWS Group GmbH & Co. KGaA and any of its subsidiaries, such as DWS Distributors, Inc., which offers investment products, or DWS Investment Management Americas, Inc. and RREEF America L.L.C., which offer advisory services.

DWS Distributors, Inc.

222 South Riverside Plaza, Chicago, IL 60606-5808

CIO View