Capital IdeasTM

Investment insights from Capital Group

Markets & Economy
Episode 28 – Will commercial real estate sink the U.S. economy?
Xavier Goss
Portfolio Manager

Commercial real estate is in crisis. In this episode, Capital Group portfolio manager Xavier Goss discusses how work-from-home dynamics are casting a shadow on the market for office space, and what this trend could mean for the U.S. economy.

Xavier Goss is a portfolio manager at Capital Group. He has 18 years of investment industry experience and has been with Capital Group for one year. He holds a bachelor's degree in economics from Harvard University. He also holds the Chartered Financial Analyst® designation. Xavier is based in Los Angeles.

Will McKenna - This week on Capital Ideas, we delve into the crisis brewing in commercial real estate and what it means for the U.S. economy.

Capital Group Portfolio Manager Xavier Goss thinks falling values for commercial properties are creating unique opportunities for investors. In this interview with Senior Writer Paunie Samreth, he talks about how work-from-home dynamics have changed office life, the impact of artificial intelligence on the sector, and why his contrarian investment approach is made for these moments.

I’m your host, Will McKenna. Let’s get into it.

Paunie Samreth: Xavier Goss, thank you so much for joining us for this podcast.

Xavier Goss: Thank you for having me.

Paunie Samreth: Commercial real estate has faced some headwinds lately. And you mentioned in a research note that you love to invest during crises. Is commercial real estate in crisis at the moment?

Xavier Goss: Definitely. I think it's still in a crisis. So, I think it’s still in a crisis so going into the COVID era in 2020, I think the entire work from home dynamic really drove CRE in particular office, into a recession or a crisis. It’s worth noting that commercial real estate is pretty broad, so you can't just narrow it down to one sector.

It's just that office during COVID and work from home and the dynamics going on there, office is the area that's been down a fair amount when you look at property values.

And so, if you look at broad commercial real estate, from say the peak of March of 2022, valuations are down roughly 20%, and office is down 35 percent or so. It's definitely been the sector that's been impacted the most.

You can't paint commercial real estate with just one brush. And so, we continue to see opportunity in commercial real estate. But realistically, when you look at the broader sector, I would say that it is going through a pretty significant market correction.

Sitting down and talking on various panels, I always like to ask the audience how many folks are positive on commercial real estate or even neutral on commercial real estate, and literally not one person in the room ever raises their hands.

And so usually when you see that type of dynamic, it means that a decent amount of the downside is being priced in, and it could represent an opportunity. Broadly speaking, I think commercial real estate still has value, but it is in a challenging point, in the cycle, and I think the underlying fundamentals are continuing to be challenged in the near term.

Paunie Samreth: So, I didn't expect to hear that commercial real estate is in a crisis, when you say that it is in crisis, can you define what you mean by that?

Xavier Goss: Yeah, sure. The sector is challenged, but it's very different than a Global Financial Crisis where subprime mortgages, created a decent amount of contagion risk within the world.

A lot of banks held it, a lot of insurance companies held residential mortgages and subprime mortgages, and there was a lot more leverage in the system. This time around, there's been a lot of regulation since the Global Financial Crisis.

The contagion risk within commercial real estate is very different as compared to looking back to 2007 and 2008.

And also, when you think about housing, and housing activity, not just housing itself makes up 10 to 15 percent of GDP within the U. S., coupled that with fraud during the global financial crisis, you can see why it spread quickly. When you look at commercial real estate now, it really only makes up, call it, 5 to 7 percent of GDP.

And so, the risk of contagion just isn't as large as it was, back when we were looking at subprime mortgages. The other thing worth noting is, if you look at commercial real estate, last year was actually kind of interesting. Commercial real estate diverged from the rest of the market. So even though the Fed was hiking rates, 500 some odd basis points, commercial real estate really went through a challenging time, as you would expect. Any time the Fed raises interest rates by that much that quickly, you would expect the sectors that are most levered to rates would be impacted the most, so residential mortgages and also commercial real estate.

It just so happens that on the residential side, there's just a total lack of supply there. And so, you didn't really see downward pressure in home prices, but in commercial real estate, a very different story was coming out of the COVID, experience, office vacancies are down significantly.

I don't think that commercial real estate is going to have contagion risks. We already went through, probably 90%, percent of the repricing in commercial real estate last year, and the rest of the market, performed fine. Equities were up, corporate bond spreads were tighter.

You really saw a divergence in the performance, but you didn't really see contagion risk where commercial real estate was causing other sectors to widen out significantly. If anything, I would make the argument when the Fed raised rates, commercial real estate was one of very few sectors that actually went through a crisis while other sectors performed well.

Paunie Samreth: There's this trend, which is the hybrid work model, where people are coming in two to three times a week. What's the problem?

Xavier Goss: I think it's multi-faceted. So, on one side you have occupancy, so just the usage of property, and office space in the United States.

Work from home, if you just do the rough math in terms of, the average amount of folks that are coming into the office, the amount of space that they need when they come into the office, that basically translates into a 15 to 20 percent reduction in demand for office space, just the working from home dynamic.

Pre-COVID, you had on average folks coming into the office 4.6 days to be exact. And now that's down to 3.6 days on average. And so that gets you to the 15-20 percent decline if not a little bit more in terms of, just the demand for office space. The one good thing is there's not much new supply of office space coming on the market.

On the flip side, the properties that are out there right now, if you think about it, you have to entice people to come into the office now, right? And so, you need to repurpose some of these spaces. You need to make improvements. And so, expenses and costs of, getting people to actually come into the office, having more collaborative space in the office, those costs are going up.

And so, I think it's kind of hard to just look at one factor and say, why is office down a lot? I think it's one, there's just a lot of old office space. So, class A office space, I think that'll continue to do well. So really nice properties, modern fixtures, open architecture, and more collaboration space.

I think those types of properties are continuing to fare well, but now if you're talking a class B or even class C in the middle of nowhere or rural or suburban office, I think that's going to be challenged.

Paunie Samreth: So, you mentioned office space is just one aspect of it. What are some of the other areas of commercial real estate?

Xavier Goss: You have industrial, so one area that's doing really well are data centers. Obviously, you see that in equity valuations and the buzzword is AI. And so, the demand for AI, and computing space, has kept a pretty strong bid for, the industrial space and data centers.

We don't really see that changing anytime soon. If anything, when we look at new deals and the amount of, data centers that are coming online, the amount of demand versus the amount of supply, literally the supply can't keep up with the amount of demand. So new data centers that are being built are, being pre-leased and leased up in a very, very short timeline. Multifamily, that's another area, so given what's going on in residential housing and affordability being at the lows, you've seen a decent amount of, new supply coming online for, multifamily homes, as well, so apartments.

Don't really think the fundamentals of demand will change there. There's a decent amount of supply, but a lot of people just can't afford new homes, and so we think that sector will have a nice little, tailwind to it going forward.

Retail, so malls.

Paunie Samreth: How is the retail space doing?

Xavier Goss: That space is actually it's kind of interesting. Commercial real estate in general, and let's just say there's five major sectors. it's almost like a rolling crisis every three or four years. And so, five, six years ago, everyone was talking about, oh, no one's ever going to go to the mall again.

Basically what you saw there is, a bifurcation in kind of the retail and mall space where, there's not a lot of new supply coming online now just because we're trying to work off some of the existing supply and similar story there, top high quality malls, if you look at Century City Mall right here in, Los Angeles.

Some properties are doing really, really well. and some of the more tertiary, you know, out of major urban area malls are struggling.

The mall and retail space continues to go through challenges. But I feel like it's just a calibration process I think you'll probably see a similar type of story play out in the office space as well, where one of the benefits as a bondholder, but also a negative, is, extension risk.

And so lenders tend to work with borrowers in commercial real estate and extend these loans so that they have time to, come up with better financing and a lifeline for a few more years, and I think it's going to be something similar in office where the top properties I think will do very well, the very modern properties class A will do well, and it's just a recalibration in the space between supply and demand.

Paunie Samreth: Can you give us an overview of how an investor would actually invest in commercial real estate? I imagine one way is you buy a stock of a company that builds and develops commercial real estate. You mentioned as a bondholder, so maybe you can talk a little bit about what areas you focus on.

Xavier Goss: There's a bunch of different ways. So, you mentioned stocks already, you can purchase debt as well, there are a bunch of different originators and issuers that come to market in the corporate bond space. Then you have CMBS, which is, commercial mortgage-backed securities, which are, structured, securities, and that's kind of our focus, on the fixed income side.

The interesting thing about structured products and CMBS bonds is you can actually pick and choose the type of risk that you want to take. And so, unlike buying a corporate bond, where you're just buying the general obligations of, what happens with this company. On the CMBS side, you can actually pick, do you want triple A risk, do you want single A type of risk, do you want to buy triple B type of risk, and so it's a bit more customizable.

So, there are a lot of different venues and ways that you can get commercial real estate exposure, be it equities or debt, and here at Capital Group we look at pretty much everything.

Paunie Samreth: Do they come across your desk, do you get like an email, or how does that work?

Xavier Goss: It kind of comes from everywhere. The beauty of being at a very large asset manager is we just have relationships, be it on the equity side or fixed income side. The dealer community, so the big banks will come to us with different opportunities.

We're not as big in private credit, but we talk to large private equity companies, and at times we can partner with them on different opportunities. I think going forward, especially in commercial real estate, where these types of deals, tend to be much larger, having scale in the context of what we do here at Capital Group, I think that really helps us, and so we have a pretty diversified sourcing function when it comes to being able to get access to these types of transactions.

Paunie Samreth: In terms of your investment style, are you a long-term investor are you looking for more one-off distress type deals or something more liquid?

Xavier Goss: So, my background, I've been in commercial real estate my entire career.

So, call it, roughly 20 years or so. I tend to be a bit of a contrarian.

I tend to wait until the market kind of gets to maximum bearishness, and so that comes back to my comment earlier about sitting down and, asking the audience when I speak on panels about, commercial real estate and who's positive and who's negative. And when you sit in a room and literally every single person, so 100 percent of the people in the room say they're negative on a sector, the fundamentals might continue to get worse, right?

Chances are the valuations are probably priced in a fair amount of negativity going forward. for me, long term investor, I think that's paramount, especially in structured products just because liquidity is something that's fleeting at times. And so, your kind of forced to be a long-term investor.

When things are rallying, I tend to get less excited, and if anything, I try to reduce. And when things look really, really cheap, and market sentiment's really, really negative, those are the times that I sit down and sharpen the pencil and dig in.

Paunie Samreth: I imagine in the work that you do, you have a good line of sight into the consumer. Can you give us a sense of what you're seeing there?

Xavier Goss: From a fundamental standpoint, the U. S. consumer is in a pretty good spot right now.

Very different story than 18 months ago when inflation was rampant and wage growth really wasn't, changing as much, so just the disposable income, and affordability for a lot of different products, auto loans, home mortgages, it was a bit more difficult, for consumers to get access.

Now all those trends are kind of reversing, but at the same time, there are, some warning signs When you look at credit card delinquencies now, they're actually past or higher than pre COVID type of levels.

That being said, unemployment is still an all-time low. And so, if you do begin to see unemployment tick up in the next, 6 to 12 months or so as the Fed's tightening really starts to feed into the general economy. You can definitely see delinquency start to increase a bit more from here. So that's something that we're watching.

Personally, I have a more favourable view of the U. S. consumer as compared to, say, commercial, mortgages and commercial real estate. but again, it's, it's hard to paint any one sector with a broad, brush.

I think the environment right now is actually really, conducive to security selection. When you're looking at deals that are backed by the consumer, there are areas that you have to be very careful, because the consumer is a lever. And same thing in commercial real estate. There are certain areas that look attractive and certain areas that I feel like just haven't repriced enough.

Paunie Samreth: Where do you land when it comes to the recession or no recession debate?

Xavier Goss: So similar to what I mentioned earlier around just the strength of the U.S. consumer the data that we continue to see seems to be trending in the right direction and so the soft landing that the Fed's trying to accomplish, at least as of today, appears to be taking hold.

I think, there are going to be areas that are going to have issues, if we do get some rate cuts, I hope that the Fed's going to be, pre-emptive as opposed to waiting until it's too late and overshooting, where the economy slows more than they want.

But in general, I think it's going to be a soft landing and all the data that I see right now is, is supportive of that thesis.

WBM: OK, there you have it. Special thanks to Xavier and Paunie for coming on the show.

We're always trying to get better, so if you have any feedback, including topics you'd like to see addressed in future episodes, send us an email at

For Capital Ideas, this is Matt Reynolds reminding you that the most valuable asset is a long-term perspective.

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