As Office Cashflows Decline, Niche Real Estate Evolves to Anchor CRE Portfolios

Typical Class A office buildings have served as the backbone of CRE portfolios for decades. But for three years since the height of the pandemic, investors have watched tenants downsize and office usage numbers plateau, with many now accepting that the future will indeed look different from the past.

Illustrating the level of distress in office properties, CoStar (the publisher of LoopNet) indicates that there are 8,355 Three- and Four-Star office buildings in the U.S., measuring 200,000 square feet or greater, and vacancy among them currently averages 15.3%. This is a rise of roughly 500 basis points over the ten-year average vacancy rate of 10.6% for those buildings, most of which are Class A, non-trophy assets.

One effect of this new reality is that typical Class A office buildings will no longer anchor portfolios to the degree they used to. As investors shed office buildings to recalibrate their portfolios, they are rethinking the definition of a core asset and are on the hunt for new property types to stabilize their holdings.

“That is part of the great reset,” Anita Kramer, senior vice president for capital markets at the Urban Land Institute, told LoopNet. Kramer also serves as coeditor-in-chief of the publication “Emerging Trends in Real Estate,” which is jointly produced by ULI and PwC.

“There are Class A buildings that are doing really well, but there aren't that many [of them],” Kramer said. So, determining what can replace office as a core investment “is going to be a really big conversation.”

For decades, traditional office buildings served as a fortress investment that could be counted on to provide a steady stream of cash. So, what are some of the alternative CRE asset classes that investors are now considering as substitutes?

Speaking on a panel at the ULI 2023 Fall Meeting in Los Angeles, Mary Ludgin, a senior managing director and head of global research at real estate investment management firm Heitman, said that one approach is to structure a portfolio with a variety of assets that respond to market forces in complimentary ways.

Niche CRE alternatives such as student housing, senior living facilities, medical office buildings, data centers, self-storage and manufactured housing are just some of the product types that investors are considering or already incorporating into their portfolios.

Ludgin said that investments into alternative assets will continue, “in part because what the experience in those sectors will show is that what appears to be risky — some of them have short lease terms — tends to turn out to be an advantage more often than not.”

“I have a slide in my standard deck that shows a picture of a limestone office building in downtown Chicago versus a cinder block self-storage [building],” Ludgin said. “We're drawn to the beauty of the limestone that looks so solid.” But it turns out, she added, that even before COVID, “office cash flows were hit by the fact that office tends to get vacant at the wrong moment,” and it was expensive to re-lease those buildings then, just as it is now.

During recessions, Ludgin continued, self-storage units are cleared out because people want to stop paying $150 a month for items they don’t remember they have. “So, your vacancy rate tends to rise in storage when a recession hits,” Ludgin said.

But then she added, “the other dynamics that create demand for storage begin to unfold: death, divorce, military deployment and downsizing (the four “Ds”). And all of the sudden, your vacancy rate is declining [and] your rents are rising. Meanwhile, your office sector is just heading into trouble.”

“By no means will office not be in portfolios going forward,” Ludgin emphasized. “But I think there's a recalibration of expectations for sectors like office and retail [because] they were perceived to be more stable in their cash flows than they are.”

However, there are challenges with alternative assets, as well.

“Within the alternatives, there's a lot of variability and some of them have been discovered globally and therefore there's the risk of oversupply; data centers have hit some of that, that's for sure,” Ludgin said.

She cautioned to be careful and watch the supply and demand mix. “Generally, if you're looking to move out of office and retail and into something else, I would say look at sectors like storage that move with the economic cycle, but slightly differently.”

Ludgin suggests focusing on demographically induced demand for properties like medical offices and figuring out what people under the age of 15 are interested in because, she said, “that demographic is growing.”

“’Have a mix of things in your portfolio,’ is what we tell our clients.”

Kramer noted that alternative CRE properties “are smaller sectors.” But taking money out of office and investing it somewhere else is not always easy. “We'll have to watch to see how far that goes, or if it becomes overbuilt because too much capital is going in,” she said.

Choosing alternative CRE properties to invest in will “differ by location and where we are in the cycle,” Kramer added. She noted that one question to ask going forward is, are there enough small properties in any one sector to replace the reliable cash flow generated by the traditional Class A office building, with long term leases and tenants interested in renewing?

An institutional fund adviser quoted anonymously in Emerging Trends said that to solve for this, portfolios need to be the focus. “You don’t buy two truck stops and then another two and then another two,” he said. “You buy 100 truck stops, or you buy a 20 percent interest in 400. Or you buy large properties like data centers and life science buildings.”

Kramer noted that another approach is to do the hard work necessary to purchase numerous small properties and create your own portfolio.

She indicated that this can and has been done, citing the move of institutional investors into the for-rent single-family housing sector during the pandemic, “a business that no one ever thought the institutional investors would get into.”

Kramer added that prior to the pandemic, it was more of a mom-and-pop business centered on buying a few single-family properties to rent out. But during the pandemic, institutional investors “put in the sweat equity to buy as many properties as they could and turned it into a business,” noting that now, “it’s a true business model.

Despite the tremendous interest in alternative CRE property, getting a commitment from a capital provider to invest in niche sectors is not as easy as one might think.

“It's harder to commingle assets … when you go out and raise closed-end funds,” said Andrew Yoon, chief operating officer and managing partner at BGO, a global real estate investment company. Speaking on the same panel with Ludgin, Yoon said "there are definitely alternative asset classes that we think are very strong and have demand, but there's a limited investor base.”

“People know what they are comfortable with,” Yoon added. “And when you're telling a 30-year veteran that has been in the core office space that you’re really excited about secondary cities for college growth or student housing, their minds kind of explode.”

Yoon said that despite these types of reactions, his firm does invest in alternative real estate sectors. “It’s typically with one like-minded lead client that says: ‘We agree with your analysis, so let's do it.’”