Popular media outlets often reinforce a message that the pandemic has left the U.S. commercial real estate (CRE) sector grievously damaged, especially in cities. As hybrid working spurs companies to jettison office space, these sources typically note, tax revenue drops and businesses that depend on in-person workers (such as coffee shops, cleaners, banks, restaurants, etc.) continue to die, potentially fueling a “doom spiral” that generates both urban blight and long-term woes for the CRE sector — made all the worse by an impending recession or major economic slowdown. March’s banking crisis only served to enflame these fears given CRE’s dependence on capital flow.
Despite these negatives, however, many analysts see a different picture. While there is wide consensus that the CRE sector will face heavy near-term challenges, sources such as Morningstar believe that it will prove far more resilient and enjoy a much rosier long-term future (looking out 15 years and further) than these gloomy accounts describe.
For example, in its February 2023 issue of Financial Services Observer, Morningstar makes a multi-faceted argument that CRE service firms — or large companies that help corporate clients buy, sell, lease, and manage commercial real estate — are actually in quite strong shape, and should fare better and recover far faster than they did during previous recessions.
Undue pessimism brings opportunity
The report — entitled “Are CRE Service Firms Ready for the Downturn? An Analysis of Market Dynamics, Growth Prospects, Valuation, and Recession Preparedness”— uses analysis conducted by Pitchbook (a Morningstar company) to argue that large CRE service firms are currently undervalued by overly-pessimistic investors and stand to benefit from several positive factors and long-term trends in the coming years. As the CRE service industry serves as a bellwether to the wider CRE sector, this outlook has implications for all players in CRE.
The large companies named in the Morningstar report include CBRE Group (CBRE), Cushman and Wakefield (CWK), and Jones Jang LaSalle (JLL). Even though they posted record profitability in 2021 before interest rates rose, many investors believe that the CRE service industry will fare poorly amid high interest rates and a slowing economy. Due in large part to this sentiment, companies such as these have seen their stock prices drop as much as 40% since their 2021 highs.
In this report, however, Morningstar points out that these firms have evolved significantly in recent years, have revamped business models and expanded revenue streams, are fortified with strong balance sheets, and are well-positioned to thrive in the coming years. Accordingly, they believe the market is undervaluing key sector players by as much as 30% (such as CBRE), which presents an opportunity for investors. The report states:
…The market seems to be excessively focused on the near-term factors impacting the industry while ignoring the long-term opportunity. In our opinion, the current market valuation of the CRE service industry reflects undue pessimism and offers a comfortable margin of safety for long-term investors who are willing to hold the stocks for a few years.
…We agree that the prospects of CRE service firms are murky in the near term given the macro environment, but we are confident about its recovery and long-term growth prospects given the various structural tailwinds impacting the industry.
Well prepared for a downturn
As the U.S. braces for a steepening economic slowdown later in 2023, many investors worry that such adversity will deliver a severe body blow to the CRE service sector, similar to what it suffered during the 2008 Global Financial Crisis (when share prices of CRE service firms plunged by more than 80% and didn’t rebound for several years). According to Morningstar’s report, these investors may fail to appreciate just how much the sector has changed in the last 15 years — as well just how robustly prepared many CRE service companies currently are to navigate the rocky road ahead.
Since the GFC, Morningstar notes that leading CRE service firms have evolved “from transaction-based brokerage service providers to account-based full-spectrum real estate service providers,” adding noncyclical business lines that can offer recession-resilient cashflow. Even more importantly, the CRE service firms that Morningstar covers have significant financial strength to weather a long slowdown. To be specific, the report notes that CBRE Group had total debt of $1.8 billion and cash equivalents of $1.1 billion in December 2022, for a net debt position of $0.7 billion with a liquidity profile of about $4.5 billion. And Jones Lang LaSalle had total debt of $2.2 billion and cash equivalents of $0.5 billion for a net debt position of $1.7 billion and liquidity of about $2.2 billion.
To add flexibility to financial strength, CRE service firms such as these also have a far greater ability to manage expenses during slowdowns than they possessed during the last recession, Morningstar points out:
…The industry has significant operating leverage, but its cost structure provides flexibility to reduce expenses during economic downturns. The built-in expense control flexibility in the CRE service business model protects the industry from catastrophic losses during severe recessions.
Are hybrid work fears overblown?
Morningstar is among the analysts that believe the threat that hybrid working poses to CRE is being exaggerated, and that its long-term impact to the CRE service sector will be weaker than many investors anticipate. Why?
For one obvious factor, office brokerage is just one revenue stream for the industry, albeit a major one (Morningstar’s report notes that offices contributed about 70% of leasing revenue for the CRE service sector prior to the pandemic). Secondly, there are no signs that corporate offices are fated to join the dodo bird: Morningstar believes that U.S. offices should maintain a steady utilization rate of at least 65% of prepandemic levels, and current trends show this is likely conservative.
Third, CRE service firms are seeing increased revenue from other areas — such as the well-publicized boom in industrial-space leasing, and the surge in outsourcing activities in helping companies redesign and manage offices to meet evolving needs. “In our base case we believe that the additional outsourcing demand due to hybrid work will mostly cancel out the impact of overall office footprint shrinkage,” Morningstar states in the report.
Finally, Morningstar believes that the worst consequences of the work-at-home transition have already struck the CRE sector and been factored (perhaps excessively) into its valuations and prognostications. “Most of the impact of hybrid work disruption on the office sector has already been felt by the [CRE service] industry,” Morningstar’s report states. “We believe that the hybrid work dynamic will have limited incremental impact on CRE.”
CRE service firms enjoy “secular tailwinds”
While a prevailing market view expects lagging growth among even the most effective CRE service firms, Morningstar feels that several long-term trends will impact the sector positively. It states in report:
…We believe that the CRE service companies in our coverage benefit from various secular tailwinds, such as consolidation, outsourcing, and increasing real estate allocations. These tailwinds should result in decent top- and bottom-line growth over the upcoming decade.
As for consolidation, the report notes that the CRE service industry has been rapidly consolidating over the past 20 years, with the largest companies gaining the most market share due to this trend. Morningstar expects this advantage to strengthen:
…The larger and globally diversified players in the [CRE] services industry will continue to benefit from consolidation and the increased global nature of operations…we believe that there is still a long runway of talent consolidation for global full-service brokerage firms.
…The consolidation in the industry has disproportionately benefited larger service firms as they have increased their market share and developed scale advantages. As an example, CBRE Group has increased its global market share of property sales from 18% in 2007 to approximately 24% in 2021.
Additionally, Morningstar emphasizes that the growth in corporate outsourcing “should also benefit the sector for many years to come.” As more corporations outsource their real estate-related functions to CRE service companies through multiyear contracts, more firms in the sector are improving their service offerings to capture these growth opportunities. Once again, Morningstar feels that this secular trend will mostly benefit the large, established players in the CRE service industry:
…[We] expect that large CRE service firms with established capabilities and adequate scale will grow their market share disproportionately in this business…we are confident about our mid- to high-single-digit revenue growth projection for the outsourcing businesses of CRE service firms in our coverage over the next decade.
Finally, the report notes that institutional investors have increased their allocations to CRE over recent decades, viewing the asset class as attractive for yield and inflation protection. “We think that the increased capital flows from institutional investors should benefit the industry irrespective of the yield environment,” Morningstar states, noting in the report that this tailwind comes with an inherent bonus for CRE service companies: these allocating REITs, private equity firms, and other large investors also make handy clients:
…The institutionalization and increasing asset allocation toward CRE is advantageous for service companies as institutional owners tend to use [outsourcing services provided by the industry] more frequently and they also tend to turn over their properties more quickly than traditional owners.
What’s the risk from tech?
Bearish analysts commonly point to advancing technology as major disruption threat to the CRE service sector, and the proliferation of online marketplaces and listing services in the CRE brokerage space may seem support to this concern. While Morningstar agrees that such disruption is certainly possible, it argues that it’s likely not coming within this decade. The report states:
……We believe that advances in technology, data, and artificial intelligence have a very real potential to disrupt the traditional [CRE] brokerage model in the long run...[However,] we have not seen any material signs of widespread adoption of alternative transaction platforms. Currently, an overwhelming majority of CRE transactions taking place on digital platforms are facilitated by brokers.
…[Additionally,] we think that the pace of any such disruption will be quite slow given the unique aspects of [CRE] transactions. It can possibly take a couple of decades for digital CRE property transactions to eliminate the need for a broker and gain a substantial market share.
…[To date, the CRE] brokerage business has been relatively unscathed by the technological disruption impacting various other traditional businesses. The general market perception is that [CRE] deals require property-specific analysis, local real estate market expertise, and personal connections for a successful execution which makes the business less susceptible to disruptions.
Just hold on through 2023…
Morningstar makes it clear that there’s no sugarcoating the short-term pain that CRE service industry is likely to endure in this climate of high inflation, rising interest rates, and lingering investor pessimism (rational or not) about CRE’s growth prospects. The combined dynamics of these factors could lead to a reduction real estate transactions and leasing volumes (in both office and industrial sites) several quarters down the road, the report notes. “We expect things to get worse in the upcoming quarters before they get any better,” Morningstar states.
But this shouldn’t scare off institutional investors with long-term strategies and a tolerance for volatility. “[CRE] service industry investors should look beyond the expected near-term slowdown,” Morningstar argues, advising investors to consider the benefits of purchasing shares at discount courtesy of depressed valuations. “We agree that the share price of CRE service firms can come under significant pressure in 2023 due to near-term weakness,” Morningstar states, “but the long-term outlook for the industry looks bright.”