Investment real estate — not just offices

Investment real estate consists of more than office buildings. We know this, so why say it? Because headlines about office market risk are crowding out discussion about the other types of investment real estate and their opportunity set. Consider this: A recent Google search on “US office real estate market” generated more than one billion results — four times more than for industrial and retail, five times more than for apartments, 10 times more than for self-storage, and hundreds more than for other property sectors, such as medical office, data centers, life science, student housing, senior housing, and single-family rental.¹ They’re all investment real estate! While the media focus on office is understandable given its risks, it’s disproportional to its role in the broader real estate market.

Opportunity set far beyond offices

Only focusing on office may mean missing investing opportunities. The real estate opportunity set spans far beyond office buildings. About 80% of US private institutional real estate market value and 90% of private institutional real estate property counts are sectors other than traditional office.² Also, about 96% of US public real estate investment trust (REIT) value is in sectors other than traditional office.³

The role of office shrunk

The office sector has played a larger role in investment real estate than it does today. Traditional office comprised more than 40% of US institutional (private) real estate market value at the end of 2000. That dropped to just below 34% by the end of 2010 and fell further to 20.2% in Q1 2023, only half of the share from the turn of the century. Office share composition among US REITs (public real estate) fell from roughly 22% in 2000 to just over 12% in 2010 and eventually to a mere 4.5% in April 2023.³

Stronger demand driving tighter vacancy in non-office sectors

While office demand continues to adjust to remote and hybrid work trends, stronger demand in non-office sectors has spurred tighter vacancy conditions. (See chart below.) National office vacancy in Q1 2023 averaged 17.8%, which is considerably higher than the past 10-year average of 14.1% and the pre-COVID-19 rate of 12.3% in Q1 2020. It’s also two to seven times higher than the vacancy rates for other sectors. By contrast, most commercial sector vacancy in Q1 2023 was below 10%, and the average residential vacancy was below 5%.

Rates similar to — or lower than — pre-COVID-19

Office vacancy rates have increased by five percentage points since the start of COVID-19 in late Q1 2020. For most sectors, however, rates in Q1 2023 were similar to — or lower than pre-COVID-19. (See chart below.) For example:

• Strip retail, industrial, self storage, and single-family rentals stood below pre-COVID-19 levels, with each sector reaching record low vacancy rates at various times within the past three years.
• Medical office building vacancy only increased mildly during the past three years, demonstrating low volatility during one of the most variable economic periods in US history.
• Current apartment vacancy is moderately higher today than three years ago after reaching all-time lows in early 2022.

Increased vacancy in some sectors, including office

Apartments (up 2.5 percentage points through Q1 2023), self storage (up 1.7 percentage points), and office (up 1.0 percentage point) experienced the sharpest annual rise in vacancy rates since the Federal Reserve started raising the fed funds rate in March 2023 (see chart above). Some important takeaways:

• Increased vacancy rates for apartments and storage were due to a reduced leasing pace, elevated levels of new supply deliveries, and exposure to shorter-term leases that accelerated changes in supply and demand trends. (Typically, leases for apartments are annual and monthly for self storage.)
• The rise in office vacancy demonstrates tenant sensitivity to higher interest rates and the ongoing impact of remote and hybrid work models despite the office sector benefiting from the stability of longer-term leases (typically 10 years for higher credit tenants).

Some sectors have been resilient

Certain sectors experienced either nominal increases in vacancy rates or tightening for the year ending Q1 2023. Medical office buildings and single-family rental vacancies mildly increased. Strip retail vacancy rates fell to record lows. Each benefited from limited levels of new supply and steady demand growth, which reduced the impact of higher interest rates on sector vacancies. Industrial experienced a moderate vacancy rate rise in the year ending Q1 2023 with record levels of new construction delivered against moderating demand. 

Non-office real estate: Larger and healthier

The next time you read something about the commercial real estate market, see if it addresses the broad, multi-sector real estate market — or just the office market. Remember, the non-office segment is much larger than the traditional office sector.  Several of the non-office property sectors are posting tight vacancy rates, even in a rising interest rate environment. Assuming interest rates and inflation eventually moderate, a recovery in tenant demand is expected to follow. Most sectors, other than office, should begin their resurgence in demand from a favorable position of low- to moderate- vacancy rates.