In the aftermath of the Great Recession, the worldwide central banks (U.S. Federal Reserve, ECB, etc.) have embarked on an unprecedented economic stimulus.

What is the future of commercial real estate over the next 5 years?

Commercial real estate (hereafter CRE) is a generally good investment opportunity for the 5 year horizon, assuming that certain conditions are met. There are other disruptions taking place that may offer rich opportunities if one is able to take the longer-term view and take risks down those paths.

Some of the longer-term (perhaps even past five years) trends:

  • Shifts in retail: the demise of major retail outlets and their effect on CRE will be important to track. Music stores were the first to go during the 2000s, followed by movie rentals (and eventually movie sales), book stores are next. Software is also on the way out. Online music, movie, book and app stores are swiftly clearing out the old retail vanguard. Big-box retailers like Wal-Mart and Best Buy have already shifted significant investment in emerging markets due to poor domestic performance. [1] Retail will shift to what needs to be tried out in a store or any other reason the transaction must stay physical. Most other outlets will fall victim to the power of Internet retailing and its long-tail economics with superior distribution/logistics. Rethinking how these existing properties will be reconfigured will lead to new investment opportunities that fit the 5 year horizon. There are some cases where certain retailers won’t be pushed out of the market completely, but will have to optimize their stores to work around at least half the space (so Barnes and Noble will definitely shrink from 26k average sq. ft. to around 10k square feet, but still exist). [2]
  • Shifts in retail pt. 2: changing demographics will also alter the market. Expect several of the aforementioned extinct retailers to be replaced by pharmacies and any other space that caters to an aging population. Healthcare spaces, spas, etc… Follow the demographic trends and you’ll be ahead of the game.
  • Shifts in office: the growing power of online collaboration and telecommunications tools are having a real impact on office space needs. Look no further than this Quora question: What will the future of offices look like in the next 5-10 years? You’ll see mention of how all sorts of service industries are able to scale back on their space needs, shift to desk borrowing (hot-desking), etc… Coworking spaces and other new office approaches will further disrupt this market.
  • Shifts in industrial: this is certainly longer-term than 5 years, but look for decentralized industrial and agricultural production to play a role in shifting CRE economics. This is definitely on the 10-15 year scale, but the roots are being planted now. An interesting space where technology meets real estate, advancements in 3D printing and a slowly emerging movement of open-sourced industrial tools will eventually result in changing property market dynamics, though it’s very difficult to predict exactly how that will play out. [3] For some ideas on what could lie ahead, it’s crucial to revisit the history books and reread how property trends and laws changed during the Industrial Revolution of the 19th century, as industry and commerce evolved away from decentralization. The next shift will be the opposite, but how that shift results in new possibilities won’t be much different.
  • Shifts in office + industrial pt. 2: the changing macroeconomic landscape will certainly affect property markets to some degree as well. Due to both high unemployment and a possible shift to a more entrepreneurial-driven workforce (sole proprietors, craftsmen, artisans, etc…), demand will shift accordingly.


Most of that is very conceptual (even intellectual). Working with something more strictly focused on the 5 year horizon, I’d like to summarize the main take-aways from a special report on property markets run by the The Economist (magazine) in March 2011:

  • Extremely low interest rates make property yields attractive.
  • CRE has cashflow from tenants, which offers stability (versus other investments).
  • Since leases can be renegotiated with tenants to reflect rising prices, CRE is a good hedge against inflation.
  • The real estate bubble that had finally poped by the late 2000s was mostly a residential property problem. There was no development boom in CRE, despite lots of liquidity. The end result was lots of acquisition movement but little actual development, so oversupply never became such a plague like it had been with residential (and continues to be).
  • If anything, there may even be an undersupply of CRE (benefitting landlords). This is due to the slow but steady increase in global economic growth, which would increase demand for office space while supply stays constant (development isn’t seen as lucrative after the financial crisis). Most new office space will emerge in Asia and not North America.
  • Despite the optimistic outlook, it should be noted that rising values are mostly confined to the upper tier of CRE (“the best buildings in the best locations, with good tenants and long leases”).
  • During the boom, these prime assets weren’t distinguished from lower-tier ones. Money was being poured everywhere with little diligence. This is now being undone, as investment will shift mostly to prime assets.
  • Due to the flight away from unsafe assets to prime ones, there may be a subsequent bubble forming in that sector (high-end CRE).
  • The major potential downside to the otherwise happy picture is the possibility of sudden interest rate hikes. That would reduce yields (especially for developers who took on greater financing to buy assets, although post-recession there’s more equity being thrown around than before).
  • The major problem with CRE is going to be the lower-tier assets (marginal structures and/or in marginal locations). Many of these assets failed to “turn over” from poor financing structures and enter the market at “true value” prices because banks, in an effort to shore up their books, have turned a blind eye to LTV covenants (see: “extend-and-pretend”).
  • The lower-tier of the market is thus still straddled with heavy debt, but there seems to be enough operational revenue generated by the properties and low enough interest rates to keep this end of the market in purgatory.
  • Here’s the 5-year outlook for this stretch of the market: “a slow, stumbling slog towards normality is the most likely outcome.”
  • On the one hand, if banks foreclose on borrowers, they would get a fraction of their money back on the sale, despite that being “the right thing to do.” On the other hand, the risk of a sudden interest hike combined with lease expiration and lack of renegotiation (due to larger macroeconomic trends) make keeping some of these under-capitalized assets a major risk.


In summary:

  • For prime CRE assets, expect healthy growth through the next 5 years, especially in North America and Western Europe. For the rest of the CRE market, including the wide swath of marginal properties, expect a mixed bag where some asset owners grind their teeth and walk down the thin wire till they come out on top again in 5 years AND some of them just lose and walk out AND some come in with equity from previous winnings and buy up assets at healthy LTVs and settle in to the 5 year stretch. After 2015, assuming the global macroeconomic picture improves, CRE assets should be maturing well and both landlords and financiers should be on much more solid footing.



[1] http://seekingalpha.com/article/…

http://www.businessinsider.com/t…

[2] Size of an average Barnes and Noble from: http://www.reuters.com/finance/s…

[3] 3D printing, see: http://www.economist.com/node/18… and http://www.economist.com/node/18…
Open-source industry, see: http://blog.opensourceecology.or…
Urban farming, see: http://www.good.is/post/is-decen… and http://www.urbanfarming.org/

[4] The Economist report was on property markets in general but featured a very informative piece on commercial real estate specifically. These points are taken from that more focused piece. It can be found here: http://www.economist.com/node/18…