U.S. Office Distress Hits $24.8B, Tops Hotels & Malls

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Good morning. U.S. office sector distress tops hotels and retail for the first time in half a decade. Public pensions pivot, injecting a massive $1.6T into alternative assets such as real estate and veering away from stocks. In parallel, industrial tenants are expressing concerns over sky-high occupancy costs.

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$24.8B of US Office is Distressed—Now More Than Hotels & Retail

In a somewhat anticipated development, U.S. office spaces now claim the top spot in the distressed assets race, amassing nearly $25B in troubled assets. This exceeds the former leaders in CRE distress - hotels and retail.

By the numbers: Based on the data from MSCI Real Assets, the financial stress in the office real estate sector escalated to a whopping $24.8B in Q2 2023, marking a notable increase of about 36% from the first quarter of the year. For some perspective, distressed retail properties and hotels, by the end of June, amounted to $22.7 billion and $13.5B, respectively. Taken together, $72B of U.S. CRE is distressed right now, up 13% from Q1. But it’s the first time since 2018 that office surpassed both retail and hotels.

Looking ahead: The situation seems set to worsen for office buildings. As MSCI economist Jim Costello suggests, investors don't seem optimistic about a return to the pre-pandemic office life or the prospects of affordable debt. Alarmingly, an additional $162B of properties are potentially on the brink of distress, grappling with late loan payments, high vacancies, or looming debt maturity. The rise of remote work and weak demand makes US office spaces more vulnerable than other real estate sectors.

➥ THE TAKEAWAY

The clock is ticking: The U.S. office real estate sector is in a critical state with vacancies rising to 20% by the end of June, and property values dipping by 27% year-to-date, significantly outpacing the 12% drop in the overall commercial real estate sector. Coupled with the imminent maturity of $189 billion in office debt this year and an additional $117 billion due in 2024, the shift towards remote work is exacerbating the sector's challenges. As a result, property investors and landlords urgently need to rethink their strategies and seek innovative solutions to navigate through this unique market turbulence.

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US Public Pensions Throw $622B Into PE, $1.6T Into Alternatives

U.S. public pensions have boosted their stakes in alternative investments to an unprecedented $622B, a trend not seen in at least the past two decades.

Record-breaking levels: Public pensions pooled $622B into private equity last year—the highest investment level in nearly 20 years—in their search for higher returns, according to Equitable Institute. PE made up 13% of local retirement plan investments in 2022 and 11% in 2021. Alternative assets, which include PE, hedge funds, and real estate, account for ⅓ of pension portfolios, or $1.6T.

Cautious approach: While private equity (PE) investments might not inherently be a safer strategy, any decline in private value could potentially occur at a slower pace compared to a plunge in public markets in a worst-case scenario. Equable forecasts an average return of 5.3% for retirement plan funds this year if they choose a conservative strategy, falling short of the earlier anticipated returns of 6.9%. In June, Connecticut's state pensions allocated $350M to two HarbourVest Partners PE funds. At this meeting, the state treasurer also authorized private market commitments totaling a substantial $725M.

➥ THE TAKEAWAY

Read the room: Pension funds clearly don’t believe in the stock market right now and are perhaps in agreement with old-guard talking heads who believe the current AI hype is overblown and the NASDAQ’s runaway bull market is unsustainable. Meanwhile, several economists and analysts believe the worst of the bear market may have already come and gone.

The Crucial Role of Property Managers in Influencing Industrial Tenants' Profit Margins

While the industrial sector has outperformed compared to much of CRE over the past few years, higher occupancy costs are forcing industrial tenants to be pickier than ever.

You get what you pay for: At the end of 2022, a CBRE survey found 75% of 100 prominent industrial tenants marked occupancy cost as the main factor in selecting an industrial site. This is in light of continued expansion across the U.S. and escalating occupancy costs in a tight market. A late 2022 report by Newmark highlighted a substantial 42.2% rise in costs over the previous half-decade.

Aligning values (and prices): It's crucial for cost-conscious industrial tenants to select the right landlord and property manager. Analysts advise tenants to seek landlords who invest personally in construction and capital improvements, intending to hold properties long-term. Proactive property managers, who prevent small issues from turning into significant problems, can provide substantial cost savings.

Why it’s not just the building: The physical property undoubtedly matters. However, given the triple-net leases typically signed by industrial tenants, the selection of a reliable landlord and property manager becomes more crucial. These leases place most operating costs on the tenants, excluding structural repairs, thus presenting greater risk than in other tenant-landlord relationships.

➥ THE TAKEAWAY

Fighting the ‘common enemy’: The era of landlords leveraging high sector demand to impose terms on tenants is fading. With occupancy costs unlikely to drop to pre-pandemic levels anytime soon, tenant service has taken center stage. Landlords and property managers must focus on being responsive to tenant needs, especially unanticipated expenses that may arise during a lease, highlighting the importance of competent property management.

• Taking the L: Even though office makes up a small portion of Goldman Sach’s (GS) $14B real estate portfolio, they nevertheless wrote down $1.15B in property losses in Q2.

• Buyer’s remorse: Downtown LA’s iconic, 52-story Gas Company Tower has lost 57% of its value in 2 years, sinking from $632M to $270M. Now it’s worth less than the loans tied up with it.

• Getting serious: After failing to reach an agreement on affordable housing with the state, NY Governor Hochul signed executive orders to get her agenda over the line.

• New listing: The 36-story Bixel Tower in Downtown LA has just hit the market with 422 residential units and 4.9 KSF of commercial space.

• Dumb or corrupt? Crowdfunding platform Crowdstreet is in hot water after $60M raised from 800 investors for two deals that never closed may have been ‘misappropriated.’

• Bigger than many banks: Blackstone (BX) will soon be the first PE firm to manage more than $1T. Back in 1985, the newest asset manager on Wall Street was handling just $400K.

• Plodding along: U.S. retail sales rose just a little bit in June, while receipts at service stations and building material stores went down, according to the Commerce Dept.

• Who doesn’t like Mexican? Chipotle (CMG) is ready for small-town USA, where it plans to open 700–800 new locations, representing 20% of a projected 3,800 stores across N.A.

• Building back confidently: Building confidence is up to 56 points in July as low inventory continues to support demand for new housing construction.

• Stakeholder selling: Airbnb (ABNB) co-founder Joe Gebbia has sold $1B of his stake in the global home-rental platform since stepping down last year.

• Evergrande catastrophe: Remember how Chinese developer Evergrande was drowning in deep water during the pandemic? Well, now we know by how much money it lost—$81B.

• Say it ain’t so: Single-family rental home (SFR) and build-to-rent (BTR) operators are discovering that easy rent gains over the past few years may already be a thing of the past.

• $100M commitment: The $10.5B San Diego City Employees’ Retirement System (SDCERS) approved $100M for non-core real estate in 2024, bringing its real estate allocation to 11%.

• The bigger they are: Starwood (STWD), with more than $115B in AUM, defaulted on a $212.5M Atlanta office tower loan that matured in July.

There are many ways you can measure the recent reversal of fortunes for formerly neglected Southern and Midwestern states. For example, if you look at the change in national GDP contribution per state from 2012–2022, it’s easy to see that the pandemic only accelerated existing economic and migration trends.

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