Since the COVID lockdowns, one of the pervasive market narratives has been the demise of commercial real estate. With many Americans now working entirely remotely or in hybrid arrangements, offices are much less central to white-collar jobs. That impacts the market for office buildings, but also businesses in downtown areas of cities across America. Without office workers flowing in and out of city centers, businesses from sandwich shops to barbershops have taken hits.
Despite offices making up less than 5% of the real estate sector*, combining these concerns with the headwinds of rising rates has cast a pall over the entire REITs market, which has underperformed broader equities markets this year. Still, could CRE fears actually be overblown?
Analysis from Fidelity Investments suggests that despite the challenging backdrop, fundamentals in the commercial real estate space remain sound. Except for offices, demand remains strong enough to boost rental rate growth across the sector. Funds From Operations per share growth, a common metric of fundamental strength in the space, remains close to the average of the last five years, at 5.8% as of 9/30.
Supply and demand have balanced out, as new CRE supply in U.S. metro areas is declining owing to higher capital costs and tighter credit conditions. The result is often a sound fundamental backdrop, with supply and demand reasonably balanced. While some observers have noted concerns about bank exposure to CRE loans amid high interest rates, the diversity of bank lenders remains a helpful source of risk mitigation.
Plays for the Portfolios
Commercial real estate can still play an important role in investor portfolios. Whether via investing in real estate as an alternative or in real estate firms as an equity play, the space can offer potential benefits ranging from diversification to REIT-based income.
One ETF to consider, for example, may be the Fidelity Real Estate Investment ETF (FPRO). This actively managed strategy invests in global real estate firms with above-average income and long-term capital growth. Charging 59 basis points (bps), the ETF will hit its three-year milestone next year and may be one to watch. Co-managed by Steve Buller, who has over 25 years of experience investing in real estate, FPRO invests in firms like industrial real estate outfit Prologis (PLD) or shopping center real estate company Kimco Realty Corporation (KIM), and notably, has maintained a long-term underweight to the office sector.
*As measured by the FTSE NAREIT All Equity REITs Index, 9/30/23.
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