Much has been said about the rocky issues that have befallen commercial real estate, particularly the office space sector. CRE are those real estate sectors that do not include single-family detached houses and lots, which are treated as a separate category under “residential.” However, multifamily apartments and housing and all other nonresidential real estate fall under the CRE umbrella.
But while the office sector has struggled since the pandemic, other areas of commercial real estate show promise.
Why the office sector continues to struggle
In a nutshell, the fall from grace of office space stems from the convergence of several factors. The pandemic changed work-from-home habits via technologies such as Zoom and Google Meet. Artificial intelligence has also started to reduce the need for certain types of white-collar workers.
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Although people have long since returned to the office, millions of workers maintain the WFH lifestyle to enjoy more time with their families absent the long commutes to and from work. Even many companies that asked their employees to return to the office have mandated that only part of the workweek needs to be spent there, with the rest of the week taking place in a WFH setting.
This has pushed the U.S. vacancy rate for office space to 17%, which is higher than during the global financial crisis. If before they needed to host the full workforce in that office, now maybe only a third or less are in the office at a given time. Since economic conditions are also currently murky, many companies have seized this opportunity to cut their costs and reduce their office space requirements.
This has meant that developers who took out a loan for that office space now have to contend with less than their projected income from leases and rentals. They also have to contend with higher interest rates. Hence some have actually thrown in the towel and sold at a loss or have just returned the keys to their lenders.
This has cast a pall over the CRE sector, since many of its glamor projects are in the office sector. Although many Fortune 100 companies and high-profile professional firms in the law and architectural space still spend for slick new ESG-compliant Class A office space, the problem lies in the older office spaces built decades ago that are no longer as attractive to companies. A lot of banks and other lenders, as well as many investors, still hold these older problematic office spaces in their books.
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Areas of promise in CRE
Conditions, of course, depend on the location, type and class of property since real estate is still a game of supply and demand. If too few leasers are chasing too many office spaces, the outlook is bleak. But if an area’s demand for office space outstrips the supply, then the situation there is good.
A few bright spots still exist in CRE, though. As a real estate investor, these are the CRE areas I find promising:
- Office to residential. In some situations, office spaces can be converted into residential units. Often, however, it is simpler to just demolish the old building — unless it is culturally significant and still has visual appeal — and just start from scratch.
Issues with converting office space include adding separate plumbing, sewage and HVAC provisions for each unit. There is also the question of natural light availability, since office floor spaces can be huge with no window access or natural light in the center. There are also zoning restrictions. All of these problems can be solved with money, but again sometimes, it is not worth it.
Generally, office-to-residential conversions make sense only if the eventual buyers are wealthy enough to buy large floor footprints.
- Data centers. Data centers, which house computer servers running the internet’s content needs, are in demand. As brick-and-mortar retail, for example, transitions to online shopping, then more servers are needed to handle demand. Having a data center in an area with heavy demand also speeds up the application. The growth of artificial intelligence is also driving demand for data centers.
- Warehouses. While retail stores in certain areas have become popular again, the rise of online retail is undeniable. Some companies such as FedEx, Walmart and Amazon have national warehouses. However, in certain instances, the cost of fuel or issues with delivery services can sometimes justify a small warehouse in certain areas to place certain items near their target buyers. These warehouses can oftentimes feature the latest technologies, such as sorting robots and blockchain-based data tracking. As online retail grows, so does the warehouse sector.
- Multifamily dwellings. As prices for standalone houses and lots have risen, some families opt to live in multifamily properties for the security, convenience and amenities.
- Special purpose. Sometimes a piece of land that is properly developed is all it takes for someone to derive income. These include open parking lots and garages, golf courses and the like. Note, however, that this is still location-dependent as some areas may exhibit growth, while others show decline.
CRE may have its problematic areas, such as the lower-grade office spaces in certain cities where there is an oversupply, but reports of its demise may have been overstated, in my opinion. CRE meets many needs, and I expect the areas above to be promising for years to come.
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The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
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