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Has Commercial Real Estate Bottomed?

U.S. office space isn’t a very sexy economic indicator, but it’s an important one. We live in a service-driven economy, and commercial real estate vacancies are a very good indicator of whether employers are growing and businesses are starting up … or conversely, whether they are closing up shop.

Unfortunately, the latest numbers show office vacancies remain stubbornly high.

According to fourth-quarter numbers from Reis, a commercial real estate research firm, the vacancy rate remains stubbornly high at 17.1%. That’s down from a peak of 17.6% in Q3 and Q4 of 2010, but hardly much improved — especially considering the 12.6% rate in 2007 before the financial crisis.

Here’s the recent rundown:

  • Q4 2012: 17.1% vacancy rate
  • Q3 2012: 17.1% vacancy rate
  • Q2 2012:17.2% vacancy rate
  • Q1 2012: 17.2% vacancy rate

The details of the Reis report show tenants leased 3.7 million square feet of additional office space in the quarter. While that’s better than a contraction, it’s still down from the 4.8 million square feet of growth in Q3.

Why? Well Reuters hits it on the head with this key quote:

“Without a robust labor market recovery there will be no robust office market recovery,” said Ryan Severino, senior economist for Reis.

Employers did add 155,000 jobs in December, but that’s just enough to tread water, and the unemployment rate persists at a high 7.8%.

It’s no surprise that jobs are clearly tied to office space trends. But commercial real estate also is, in turn, tied to jobs. Who would build a new office park when almost one in six offices are empty? Construction of commercial real estate is a bad idea because it will depress rents and risks creating a building that can’t be filled enough to cover the cost.

In fact, Reis notes that the average rental rates grew a measly 0.8% in the quarter.

So while employment naturally affects commercial real estate, keep an eye on rent rates and vacancy rates as a bellwether of construction. Though residential real estate and related stocks like Home Depot (NYSE:HD), PulteGroup (NYSE:PHM), Toll Brothers (NYSE:TOL) and others seem to be recovering nicely, commercial real estate is lagging and not creating many jobs.

What’s the Investment Play?

If you think bluer skies are ahead in 2013 based on slow but steady improvement in the labor market, then now might be a decent time to invest in commercial real estate. Yes, vacancies and rents are stagnant … but they’re not getting worse. That could signal a time to buy.

For those seeking growth and yield, look at some commercial real estate REITs like Simon Property Group (NYSE:SPG). Simon Property is up 25% in the last 12 months vs. 15% for the S&P and boasts a 2.8% dividend yield. The company mainly owns malls and outlet properties.

A more conventional play on true office space is Vornado (NYSE:VNO), which leases not just retail space but office properties in D.C. and New York. Vornado has had a tougher go of it, up just 7% in the last 12 months, but it does have a 3.3% yield.

If you don’t want to pick individual REITs, then consider a diversified ETF. There are some that contain both commercial and residential real estate like the Schwab U.S. REIT ETF (NYSE:SCHH). This fund is benchmarked to the Dow Jones U.S. Select REIT Index, and as a passively indexed ETF, it has a rock-bottom expense of just 0.07%. Top holdings include commercial real estate firm Boston Properties (NYSE:BXP) as well as residential REIT AvalonBay Communities (NYSE:AVB) and a host of healthcare REITs. Another good low-cost option is the Vanguard REIT ETF (NYSE:VNQ), with a similarly diverse group of holdings benchmarked to the MSCI US REIT Index instead.

If you want to focus wholly on commercial real estate, consider the SPDR DJ Wilshire REIT ETF (NYSE:RWR), which is designed to avoid exposure to residential REITs.

Of course, if commercial real estate remains a tough market, then the REITs and related ETFs will continue to underperform. So bear that in mind.

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Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at editor@investorplace.com or follow him on Twitter via @JeffReevesIP. As of this writing, he did not own a position in any of the stocks named here.

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