Opportunities exist, but it can be a challenge to navigate commercial real estate today.
Successfully investing in physical commercial real estate has typically involved juggling a number of variables (such as occupancy levels, market rent, and fluctuating property values) to help achieve a reasonable return. But the current economic environment — including inflation and interest rates, the threat of a recession, and various pandemic-driven changes — has made investing in commercial real estate even more complicated.
“One of the biggest challenges for commercial real estate investors right now is the number of variables that are unknown,” says Ryan McDowell, senior trust real estate and specialty assets advisory specialist with Wells Fargo Wealth & Investment Management. “We’re not in a traditional cycle where real estate prices go up, max out, and then come back down.”
With that in mind, what do today’s commercial real estate investors need to consider, and how might they be able to identify opportunities in today’s market? Here, McDowell and Stephen Thomas, also a senior trust real estate and specialty assets advisory specialist with Wells Fargo Wealth & Investment Management, share what to know — and where to look for guidance.
A top pain point? Interest rates.
The Federal Reserve (Fed) started raising interest rates in 2022 to combat inflation, boosting the cost of borrowing money. The Fed has continued to do so in 2023; it isn’t clear when that might change. This recent change in interest rates has created a situation where expectations between buyers and sellers are sometimes out of sync.
“Sellers are still expecting properties to command the same prices today that they did when rates were significantly lower,” says Thomas. “Investors, however, are unwilling to move forward at those prices in the new interest rate environment given the lower returns.”
That misalignment may make it tough for owners who may want to exit an investment, especially if the property isn’t in a high-demand sector. Even if they do sell, they may not be able to easily reinvest their money in another property.
Shifts in demand could bring opportunity
The pandemic sparked shifts in the kinds of physical real estate that are in demand. For example, tenant demand for office space shrank when many workers went home during the pandemic’s early days, and that demand has yet to return. This shift may have a long-term impact on office market fundamentals.
Other pandemic-driven shifts include the following:
- Warehouse space is becoming more attractive. This happened as supply-chain disruptions — remember the toilet paper shortages? — and the continued growth of e-commerce prompted many companies to make their supply chains a bit less lean and shift some inventory, and sometimes production, back to North America.
- Hotels are getting a second look. More people are traveling again as life has returned to more normal pre-pandemic patterns. And that means interest in hotels has increased. “It’s become an asset class that’s more desirable again,” Thomas says. “Even though business travel hasn’t necessarily rebounded, other kinds of travel have rebounded pretty nicely.”
Of course, those interested in investing in commercial real estate might also be focused on identifying opportunities that could combat inflation. For that, McDowell recommends looking to housing — and apartment buildings in particular.
“Apartments are typically on one-year leases or less,” McDowell explains, “whereas a lot of commercial properties like offices, retail spaces, shopping centers, and even industrial- and warehouse-type properties tend to be longer-term leases.”
That means apartment complexes may have opportunities to raise rents to meet increasing costs, unlike commercial buildings with longer-term leases.
Sellers may need patience
If you are having trouble selling a commercial real estate investment, Thomas suggests being patient if you can. “You may need to hold and let the market adjust to all the current turmoil,” he says.
While you’re waiting, Thomas also suggests working with a real estate asset manager who can assist you in making the property as profitable as possible. “A good asset manager can help make sure that your property is positioned in the most positive light to attract potential buyers,” he explains.
Remember the fundamentals
While it’s difficult to predict the future, McDowell and Thomas expect overall fundamentals to remain stable in the long term. And that means potential investors should judge individual properties on their merits.
For example, owning property in faster-growing areas of the country, such as the South and Southeast, could be a better investment.
“While investing in gateway cities like Miami and New York has often been attractive to real estate investors,” Thomas says, “investing in high-growth markets like Nashville and Atlanta has become increasingly popular among those looking for long-term stability with upside potential.”
Navigate the complexity as a team
With all the variables in play in commercial real estate, a team of advisors can help investors sort through both the opportunities and their impact on personal wealth.
Clients considering an investment in real estate should consult with a real estate advisor, in addition to their tax advisor and financial advisor or portfolio manager, to help ensure that decisions to buy or sell property make sense in the bigger context of their finances and investment goals.
“If the financial advisor knows they’ve got a piece of the portfolio committed to commercial real estate, they’re probably not going to also invest in a bunch of real estate investment trusts,” McDowell says. “Having that all play together is helpful in diversifying the client’s portfolio, in an effort to reduce risk and produce a better long-term result.”
Wells Fargo Wealth & Investment Management (WIM) is a division within Wells Fargo & Company. WIM provides financial products and services through various bank and brokerage affiliates of Wells Fargo & Company.
Real estate investments have special risks, including possible illiquidity of the underlying properties, credit risk, interest rate fluctuations, and the impact of varied economic conditions.