Office remains a highly challenging allocation for real estate investors like the State of Wisconsin Investment Board. In a recent podcast broadcast on SWIB’s website, Jason Rothenberg, head of real estate at the $162 billion investor set out the challenges.
SWIB’s $12 billion real estate portfolio is overseen by a team of seven in a diversified strategy across type, geography and structures that spans wholly-owned assets to co-mingled funds. But only 5 per cent of the allocation is invested outside the US because taxes, legal structures and currency risk make investing at home preferable.
Although the two largest exposures in the allocation (each around 30 per cent) comprise residential and industrial, the balance lies in office, retail and a growing allocation to alternative real estate that includes thematic trends such as data centres and senior housing. SWIB also has exposure to credit strategies where the underlying collateral is in commercial real estate.
Many investors were protected from the initial impact of office shutters during the pandemic because leases for office buildings are long-term. Large tenants typically sign a lease for 10-15 years, so many companies continued to pay rent even if their employees didn’t come into the office. However, as leases have matured companies are now rethinking how much space they need.
Rothenberg noted an uptick in companies increasing the number of days employees must spend in the office and some employers are asking staff to come in full-time. However, he said in general most companies have adopted a hybrid between in-person and remote. As a result, companies are signing leases for less space and prioritising buildings that have ground-floor facilities like gyms and coffee shops to persuade people to come in.
It has driven a flight to quality in the office sector, creating an environment of winners and losers. Investors must hunt out the winners or risk investing in office buildings that are “the next candidate for demolition or conversion.”
In another market characteristic, Rothenberg said the sector is defined by pockets rather than broad opportunities. New York came back quickly and is doing well, and central business districts have rebounded in cities like Seattle, San Francisco and Denver in terms of street-level activity compared to three years ago.
But small retailers, which comprise an essential part of the ecosystem in a “winning” neighbourhood, are not out of the woods. Moreover, other areas of these same cities may be less vibrant, creating sub-markets and the need for investors to adopt a building-by-building approach that avoids buildings with low occupancy.
The impact of the pandemic continues to be felt in other sectors too. The sudden demand increase during the pandemic for sectors like warehouse space linked to the surge in consumer demand for online purchases; apartments in sunbelt cities like Austin and Phoenix, and self-storage, has now reversed, leaving over capacity.
“Developers raced to accommodate outsized demand, and now demand has normalised,” he said.
In the current market SWIB is leaning into both its reputation in the marketplace, and with its 40-50 external managers. He is also prioritising accessing the best research so the team have the right lens to evaluate long-term assets. That includes analysis of future constraints in supply that helps target the right quarter and neighbourhood, and requires digging into local knowledge.
Other factors dampening the market
Higher interest rates (another fallout from the pandemic) continue to impede returns because many investors use financing to buy real estate. He said the higher cost of borrowing means market values have moved down, and people pay substantially less for a property now than they did three-to-four years ago.
“The increase in interest rates is challenging,” he said.
Still, he said that real estate investors are supported by a vibrant debt market and competition between lenders will help reduce the cost of borrowing. Construction costs have gone up, and he said supply could also be crimped in the future once the market absorbs what is being delivered. He added that because values have already fallen to capture higher interest rates, it is a good starting point for investors.
The current policy environment is also challenging for real estate investors because corporates are delaying decision-making. Although companies are not looking for shorter leases, he observed a corporate “chill” in committing to new investments or leases in an uncertain future.
Tariffs haven’t spiked demand for stockpiling or warehouse space, and he said the US administration’s ambition to onshore manufacturing could have an impact on real estate demand. However, this will take several years to manifest because new manufacturing facilities require approvals and a suitable workforce.
