It’s undeniable: The commercial real estate (CRE) market has fallen on hard times these past four years. But despite all the challenges, there are signs of improving health in the sector as evidenced by the prices of certain real estate investment trusts (REITs), a type of security allowing individuals and commercial real estate investors to invest in income-producing real estate.

RELATED N EWS: Here are the finalists for the 2024 RED Awards

A confluence of recent factors has led to greater market optimism, setting the stage for future stabilization within the CRE market. With the need to balance current economic complexities and enthusiasm about possibilities for long-term growth, how can REITs help savvy investors in Arizona best navigate this next economic frontier?

Impact of interest and inflation on commercial real estate investors

After a discouraging decline throughout 2023, diversified and certain sector REITs have seen a resurgence in value since late last year. Several factors underpin this latest flurry of activity, including:

  • Rate Stabilization: The Federal Reserve has indicated its tightening cycle has come to a close, signaling that further increases in short-term interest rates are unlikely. While that doesn’t mean rates are coming down anytime soon, it does mean current rates are near the highest we’ll see for the time being.
  • Inflation Cooldown: Also encouraging are indications of inflation stabilization. While the U.S. Consumer Price Index saw a small jump upward during January 2024, the national inflation growth rate is continuing to steadily slow when compared to early 2023. Naturally, decreases in this area will contribute to Federal Reserve timing for anticipated future rate decreases. Longer-term rates take their cue, in part, from inflation expectations, and lower inflation expectations should help put a ceiling on further rate increases.

Given REITs exhibit the greatest sensitivity to long-term interest rates and economic activity, the cautiously optimistic environment we’re in calls for investors to look beyond short-term rate fluctuations to the bigger picture painted by inflation expectations and economic growth forecasts.

Balancing Office Challenges with Industrial Success

A closer examination of REIT performance offers a more nuanced perspective of ongoing office space woes. Struggles in this sector are still particularly persistent in downtowns and major metropolitan areas; that said, foreign banks have seen the greatest exposure to this trend in top-tier U.S. markets.

While there is no doubt that office real estate is and will continue to be embattled, this sector represents just a small fraction – about 8% – of the total CRE market, according to 2023 data from Evercore ISI Research and BMO Wealth Management. Fortunately, many REIT indices have low exposure to office spaces, and industry-specific REITs can offer investors a more targeted approach while mitigating risks. This specificity can allow them to selectively steer clear of higher-risk CRE sectors.

A strong counterbalance to office vacancies, Arizona has seen great harmony in the industrial real estate sector, which will likely serve as the state’s greatest advantage on the road to economic recovery. The increasing need for central shipping locations, distribution centers, data warehousing and industrial space has accelerated CRE opportunities in the state – Arizona answers these needs readily with its highly compatible infrastructure and business friendliness as well as the economically sensible inclination to have third-party owners of properties such as these.

All told, one of the greatest tools commercial real estate investors can leverage is consistent evaluation of lender and sector exposure to current economic strains. Add to that some due diligence and digging into REIT indices to ensure they align with priority niches and areas of opportunity, and you have a foundation for possible long-term, CRE-driven portfolio growth.

Impact of REITs on Residential & Retail

The increasing involvement of REITs in single-family and multi-family dwellings and neighborhoods has sparked discussions about their role in housing market dynamics. Creators of these types of REITs are particularly sensitive to property prices. Naturally, today’s inflated valuations, which have only continued to tick upward since 2020, have contributed to significantly lower formation of these types of REITs and lessened their overall impact on prices in the residential sector.

Ultimately, investors should exercise caution when evaluating residential REITs, as density and regional factors create additional, varied nuance in an already complex real estate market. While opportunities certainly exist, such as in multi-family properties, a thorough evaluation of risk is essential to ensure sustainable growth and portfolio longevity.

Meanwhile, the brick-and-mortar retail sector, undergoing rationalization since the advent of e-commerce, has seen a transformative shift. Malls, once considered liabilities, are now being repurposed into multi-use facilities, marking a potentially positive (and clever) turn of events for REITs that include these spaces. Contrary to previous headwinds, this transformation is not a detractor but an opportunity for diversification within a REIT portfolio.

A Brighter CRE Future in Arizona

As investors navigate the intricate landscape of commercial real estate, REITs can play a specialized role in indicating areas of opportunity. This nuanced approach can not only help investors better understand continued challenges and emerging trends, but also help keep them one step ahead as a new, more resilient economic landscape unfolds.

Author: Jason Lattin is a Director and Senior Portfolio Manager for BMO Wealth Management in Scottsdale. Dedicated to assisting business owners at every step of their journey, BMO Wealth Management has a significant Arizona presence that offers the resources and local market understanding needed to advise clients at various levels of wealth. Learn more at uswealth.bmo.com.