The Coming Storm for Commercial Real Estate

To many, the world appears on the brink of financial distress. Of course, to some, the world always appears on the brink of financial distress. But recent events—including Brexit, emerging market malaise, and a slowdown in China—have rattled some investors. According to Pimco, one of the world’s largest bond-holders, another challenge is on the horizon.

In a report titled U.S. Real Estate: A Storm Is Brewing, Pimco highlights the confluence of factors that may lower commercial real estate prices by as much as 5% over the next 12 months. Part of the challenge is the current valuation of commercial real estate. Rather than being driven by fundamentals, it has been driven by capital flows as investors bought commercial real estate as an asset. Since the fourth quarter of 2009, office rents have risen by about 15%, yet overall office prices have doubled—those capital inflows are growing unstable and may even reverse. Acquisitions by real estate investment trusts (REITs) have already dropped, and many REITs may shift from net buyers to net sellers.

Moreover, post-financial crisis regulation (such as Dodd-Frank) makes it more expensive for banks to hold commercial mortgage-backed securities (CMBSs). Banks have traditionally served as market makers for CMBSs, and a reduction in their holdings can cause problems with liquidity in the market, translating to higher borrowing costs for landlords. Moreover, more than $200 billion of CMBS loans will mature over the next 3 years, which will likely prompt more selling. Altogether, valuations for commercial real estate in the United States are under threat.

A Very Efficient Storm

So, what can owners of commercial real estate do in the face of falling valuations? Improving the energy performance of their buildings is a good start. A report by the Energy Efficient Buildings Hub found that buildings with LEED (Leadership in Energy and Environmental Design) or ENERGY STAR labels commanded premiums of 6% for rents and 15% for prices. Beyond better valuations, better energy efficiency also results in better net operating income. Energy savings lower utility builds, reducing operating expenses.

Performing energy efficiency retrofits can be an effective hedge against the risk of falling valuations. In its recent Energy Efficiency Retrofits for Commercial and Public Buildings report, Guidehouse Insights highlights the market for the technologies enabling better efficiency in existing buildings. Despite the benefits, though, energy efficiency has stubbornly ranked as one of the lowest motivations for performing retrofits overall. Building owners have prioritized maintaining operations and minimizing labor costs. However, the coming commercial real estate storm may bring winds of change to energy efficient retrofits.