Caution and Opportunity

With stock valuations stretched and bonds being called back into question, U.S. investors will face tough asset allocation decisions in 2025. One simple solution is to maintain balance and avoid making any extreme moves.

This isn’t paralysis by analysis, rather it is a reasonable position based on facts. While stocks look expensive, economic and market conditions don’t justify an underweight. Likewise, bond yields may be rising again but they’re already at attractive enough levels to justify holding.

As such, our Macro Allocation (MA) portfolios maintain their strategic target risk exposures heading into 2025. Meanwhile, we continue to seek opportunities within our risk allocations, albeit cautiously.

For example, we’re avoiding the FOMO rally in frothy risk assets but also recognizing there may still be some pockets of value in U.S. markets. One such area is U.S. commercial real estate (CRE). CRE is a broad category and some sectors have done fine, but the office space sector has not.

The remote and work-from-home trend that began during the pandemic has led many businesses to re-evaluate their office space needs. From Salesforce to Bank of America, companies from all sectors are reducing square footage.

One survey found that as many as 75% of U.S. businesses expected to reduce office space in 2024. That’s led domestic office space vacancies to an all-time high of more than 20%. Vacancies combined with one of the most aggressive interest rate hiking cycles in decades mean trouble for CRE owners.

Unlike the 30-year, fixed-rate mortgage that dominates residential real estate, CRE is typically financed with shorter-term, variable-rate loans that need more frequent refinancing. With lower rent revenue and higher interest rates, many CRE owners have difficulty servicing debts and finding banks willing to refinance.

It’s a vicious cycle producing shocking developments. In 2019, the renowned Union Bank Building at 350 California Street in San Francisco was valued up to $300 million. In 2023 it sold for $61 million, more than 75% below the initial asking price!

In 202,4 an office building at 135 W 50th St in Midtown Manhattan, New York, sold for $8.5 million with an eyewatering discount of 97%! The same building last sold for $285 million in 2019.

But as bad as the headlines look, CRE could also be turning around. The fact that we see transactions with massive losses shows us the market is thawing and washing out the weakest positions, which must happen before the market can recover.

The chart below shows the CREMI Index from the Federal Reserve Bank of St. Louis, which monitors the strength of the U.S. CRE market (office sector highlighted). It looks like the worst conditions were back in 2020 during the height of the pandemic. While conditions are weaker now than 24 months before they are still relatively better than 48 months ago.

I expect more pain in CRE and I do not know when the office sector will find a definitive bottom. However, as more distressed owners are forced to liquidate at substantial discounts, there will also be opportunities for those with the risk appetite and wherewithal to buy when everyone else is selling.

Publicly traded REITs and funds provide broad exposure to CRE, but many have already rebounded from their lows based on the same points summarized in this post. Still, I suspect there are opportunities in physical properties, and direct investments may be where the best values can be found.

Of course, that comes with a whole set of different risks, issues, and considerations. If you go that route, do your homework, get professional help as needed, and don’t bite off more than you can stomach.

As 2024 comes to a close, I’d like to thank all our clients at BCM who continue to invest trust and confidence in us. Your support drives us to improve and do better year after year. Thank you for a great 2024, and we look forward to serving you in the years ahead.

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Victor K. Lai, CFA