Our outlook for commercial real estate investing
How we’re navigating the current market and finding opportunities amidst uncertainty
After a 10+ year bull run–the longest on record–the U.S. is officially in a recession. During a recession, demand for real estate supply typically decreases, which leads to higher vacancies. Rent growth is either negative or below the rate of inflation. And operators and owners often offer more concessions and rent reductions to entice and retain tenants.
However, unlike 2008-09, this recession was not caused by anything that happened inside the financial markets, but rather, something that happened to the markets with the spread of COVID-19.
Officially declared a global pandemic on March 11, 2020, COVID-19 effectively brought the world’s economies to a screeching halt overnight. As of early July, the unemployment rate in the U.S. stood at 11.1% (17.8 million), daily U.S. coronavirus cases hit a record of 50,000+ and states everywhere struggled with balancing safety with reopening. To help support a struggling economy, the U.S. federal government has passed several relief packages including the Paycheck Protection Program, HEROES Act, and CARES Act. We expect that states and the federal government will do everything in their power to support workers, small business owners, American institutions, and more. However, we are still many months, if not years, away from a full recovery.
Our current market outlook
On a macro level, COVID-19 has forced us all to re-evaluate our priorities–including how we use and navigate physical places–and we believe that people across the country are thinking about where and how they want to spend the next phase of their lives. Commercial real estate will need to evolve to meet changing demands for space, amenities, and logistics. And investors prepared to take advantage of the opportunities these changes will present may see significant returns in the years ahead.
Even in the face of economic uncertainty, we remain confident in the long-term prospects of 18-hour cities like Austin, Nashville, Charlotte, and more. Prior to COVID-19, their job and population growth were above national averages, and they were supported by a diverse employment base. Compared to metros that have a strong reliance on the service industry, these markets stand a better chance of bouncing back quickly, once the health concerns of COVID-19 are under control.
As markets regain their footing, we believe there will be an acceleration of the trends in place pre-COVID; namely, the growth of secondary markets that were already attracting people due to the quality of life and good employment opportunities, outpacing many primary markets.
However, we recognize that we must continually analyze the state of the commercial real estate market and adapt our deal flow accordingly. As always, we’re reviewing deals on a case-by-case basis. As we evaluate any potential deals over the next few quarters, we’re assuming:
- Noticeable pricing discounts
- Flat rent growth for at least the next year
- Minimal distributions as sponsors look to hold cash in reserve
As the economic environment changes, so too will our market outlook and, ultimately, the attributes of the deals we look to bring to the Marketplace.
How we’re evaluating each asset class
Although the entire economy is impacted by a recession, each asset class responds differently. Our team is monitoring the potential opportunity of each asset class under the current economic conditions to help guide our deal review and Investment Committee decisions.
The hospitality industry was hit the hardest and fastest in the wake of COVID-19. According to STR, the nation’s leading hotel research group, U.S. hotel occupancy rates dropped to 22%, the lowest level ever recorded in STR’s 35-year history. Many luxury class hotels hit well below 10%. As we look ahead, STR projects a 50% year-over-year decline in revenue per available room (RevPAR) for 2020.
However, we are cautiously optimistic about the future of hospitality. As of the end of June, we’ve seen 12 successive weeks of recovery with nationwide occupancy levels back up into the mid-40% range. Some weekend destination markets are hitting as high as 90+%. Airline travel is beginning to rebound as well.
STR projects a 60% increase in RevPAR for 2021 and a full recovery on the national level by 2024. We view hospitality as one of the asset classes that will present numerous opportunities to acquire distressed assets at deep discounts to replacement cost, providing investors with strong prospects for opportunistic investments.
The key to hotel investing in 2020 is a prudent capitalization strategy that bridges acquisitions from a cash flow perspective through mid-2021. When we find opportunities with particularly astute sponsorship, we will seek to bring them to the Marketplace.
Industrial Last updated – July 2020
Last-mile industrial properties are more valuable today than ever, thanks to the dramatic increase in online shopping we’ve experienced this year. While e-commerce accounted for 11% of all retail sales in 2019, it doubled to 22% for April and May of this year (according to a June 2020 Mastercard study). We have witnessed e-commerce steadily gain market share each year over the past decade, but the pandemic has greatly accelerated its rate of adoption.
Despite the rosy outlook for the industrial sector, we do have some concerns about major distribution centers–particularly those near major ports. Trade tensions with China and decreased international trade could also negatively affect demand, impacting the value of those properties. In addition, industrial properties seem priced to perfection, so finding value in this segment is more challenging.
Odds are that heightened demand for last-mile distribution spaces will continue for years to come, likely in growing metro areas, as companies strive to ensure they are well-positioned for the future. As such, we are keeping an eye out for smaller industrial deals (typically sub-300K square feet) that cater to last-mile demand where we can find the appropriate risk/reward characteristics. As most stabilized industrial properties trade at prices that are above replacement cost, this means we are increasingly seeking ground-up development opportunities in locations where demand looks to outstrip supply for the foreseeable future.
We’re also keeping an eye on niche industrial projects, such as data centers. Forbes reported that, amongst REITs, data centers were the only industry segment to “show a positive gain for the first quarter of 2020, growing by 8.8%.”
Medical Office Last updated – July 2020
At the moment, the difference between critical medical tenants and non-critical tenants is highly pronounced. Some procedures–including dialysis and chemotherapy–can’t be postponed, while other services like teeth cleanings and ACL reconstruction surgery were canceled to protect both patients and healthcare employees. These non-elective procedures are often a large source of revenue for many medical offices, so the wave of cancellations has exposed a potential weakness in what was historically perceived as a highly resilient asset class.
Due to the high cost of moving, the highly specific and expensive build-outs often required to open a new medical office, and the relative financial health of practices heading into the pandemic, we suspect that most medical tenants will not break their leases. Instead, they are more likely to renew when the time comes. Medical office can still be a highly attractive asset class, but investors should consider the types of uses on-premises. We will seek medical office investment opportunities that cater to critical types of care and, where valuations justify, non-critical uses, particularly when those properties are located within specified healthcare districts.
Multifamily Last updated – July 2020
The ability of a landlord to collect rents is heavily dependent upon the employment status of the tenants. Now more than ever, it’s important to understand the employment and economic drivers associated with the renter population of a property. The landlords of Class A and Class B units, whose tenants are primarily professional workers that have been able to work from home and remained employed, have been able to continue collecting rent on-time and in-full.
Overall, rent collections remain strong nationwide. According to the National Multifamily Housing Council, June collections were almost identical to the same month last year. With that said, we know that lower quality properties are more likely to be occupied by lower-earning service-oriented workers, who have been the hardest hit during the pandemic. Their unemployment rate remains much higher than the already high 11.1% national unemployment rate (as of July 6th). If our current economic stimulus expires before we see a meaningful drop in the unemployment rate, lower Class B and Class C properties could experience a precipitous drop off in collections later this year.
We like the prospects of ground-up multifamily development projects already in progress in key markets, especially those projects that will deliver late in 2021 or 2022. Further entitlements for new developments will be greatly muted over the next 12 months, meaning fewer competitors when those projects that are already-in-motion hit the market.
We also like higher Class B to Class A assets in strong locations within vibrant submarkets. These properties, while possibly seeing low to no rent growth over the short term, will likely continue to perform well and should see a rebound in rent growth as the economy moves into recovery.
Finally, we are strong proponents of a relatively new model within the multifamily sector called “Build-to-Rent.” As millennials age into their 30’s, they are now starting to place greater value on space and amenities such as a backyard instead of a rooftop deck. In generations past, we would typically expect to see this demographic begin purchasing homes in droves, yet this generation finds itself with greater liabilities, mostly in the form of student debt, that is preventing this transition at scale. Build-to-Rent communities are primely positioned to capture demand from this demographic. As a result, we are actively seeking investment opportunities with this strategy.
Office Last updated – July 2020
Right now, offices in any downtown central business district are practically empty. Almost all tenants are paying rent, but very few are looking to expand their footprint until they have a better sense of what their post-COVID offices will look like. Office buildings with credit tenants and longer-term leases in place should fare well through the pandemic. Unfortunately, those with higher vacancy rates and lower quality tenants may suffer.
We see mixed effects on office space demand moving forward. First, we are already seeing companies announce that some office workers can work remotely indefinitely, reducing the need for space. However, those that do come back will likely demand more space around them to feel safe. The days of the most densely occupied open offices, those with as little as 125 square feet per employee, are gone for now and it’s uncertain if they will ever return.
Since office occupancy cost is a real consideration, one path to making more square feet per employee work is for companies to seek cheaper office space. Suburban office space is cheaper than urban office space. It’s also available all over the U.S. It’s mostly low-rise (i.e. you can use the stairs) and it offers employees abundant and, usually, free parking. As a result, we see a shift coming towards suburban office markets, particularly in the largest metros with the most expensive urban office space.
Finally, there is little doubt that office will come under short-term pressure as a result of the current environment. Some markets may have knee-jerk reactions in the valuation of these assets and we would view those scenarios as buying opportunities, although such scenarios are likely still months away.
Retail Last updated – July 2020
After hospitality, retail has been the second hardest-hit asset class so far during the pandemic. Within the retail sector, malls have suffered the most followed by any type of experiential retail, particularly those with a heavy food and beverage component.
However, certain types of “essential” retail are still faring relatively well, such as power centers anchored by Home Depot or Walmart, as well as grocery-anchored centers. We’ve seen per square foot sale numbers for grocery stores instantly double during the pandemic, which demonstrates that this type of retail is still important to our daily lives.
We view grocery-anchored shopping centers as the best investment opportunities within retail right now. According to a study published by the Hartman Group, grocery stores’ share of food spending rose from 50% in February to 63% in March and then 68% in April. Food consumption purchased at grocery stores is still up in the mid-60% range, a level not seen since the mid-1990s. Even with some expected regression towards the mean whenever we exit the pandemic, we anticipate grocery store sales will remain strong for a number of years.
We’ll be looking for retail deals with a combination of strong grocery sales, high traffic counts, and a mix of inline tenants that we believe can mostly bounce back post-pandemic and at a compelling price that offer strong prospects for attractive risk-adjusted returns.
Self Storage Last updated – July 2020
For the self-storage industry, there are four commonly cited life events that tend to drive demand for units: death, divorce, dislocation, and downsizing. The frequency of all four of these life events is likely to increase during a recession, particularly one sparked by a global pandemic.
As a result, we view the space favorably. This asset class proved resilient during the Great Recession and, given the greater adoption of self-storage over the last decade, we believe it will again prove resilient. So far, public markets agree. Throughout the pandemic, publicly-traded storage REITs have been among the best performing of all asset classes. According to multiple reports from Green Street Advisors, public storage REITs experienced only single-digit percentage drops, roughly in line with industrial and manufactured housing REITs while office, retail, and hospitality REITs all experienced drops of 30-50% over the same time period.
Due to the abnormally large spread between a typical stabilized yield on cost to develop (or redevelop) self-storage properties (ranging from 8% to over 9%), versus the typical exit cap of a stabilized self-storage property (roughly 5 – 5.5%), we prefer new development and redevelopment opportunities. This means a sponsor can often sell a stabilized self-storage property for 40-45% more than the cost to build it, while a stabilized apartment community would fetch only 20-25% over its total development cost.
While self-storage properties do typically take longer to stabilize than other properties, we believe this outsized spread is largely attributable to the insatiable demand from the public REITs, most notably Cube Smart and Extra Space, to acquire stabilized assets for their portfolios with their relatively cheap cost of capital. When we seek new development or redevelopment opportunities, we look for growing metros with a relative dearth of supply, namely five square feet or less of self-storage space per capita within the primary market area.
Senior Housing Last updated – July 2020
Senior housing entered 2020 already facing headwinds attributable to oversupply. The onset of the pandemic added yet another obstacle in the path of this struggling asset class. As expected, we have seen the rates at which new residents move into senior housing facilities slow dramatically since March, something we expect to continue in the months ahead. However, almost surprisingly, many properties have still been able to take on new residents during the pandemic, so new resident growth for the sector may not be as bleak as one might assume.
Despite a challenging market, there are a few bright spots for the sector. One benefit of the pandemic has been a reduction in resident turnover. While it might be difficult to attract new residents during the pandemic, it also means that residents you already have are more likely to stay in place. Senior housing properties that were already stabilized heading into the pandemic are performing relatively well.
The brightest light at the end of the tunnel for senior housing is the fact that we are now less than four years away from the first wave of Baby Boomers turning 80 years old. As we transition from the Silent Generation to the Baby Boomer generation as the primary target demographic, the senior housing sector will likely see a massive influx of demand. This sector will thrive again one day, especially as our population ages.
The current state of the senior housing industry may provide an optimal window to acquire assets at significant discounts to replacement cost. While we don’t necessarily expect an immediate rebound to occur for the industry, if you can acquire assets at compelling prices in 2020-2021, you can set yourself up to perform remarkably well by 2024-2025 when we expect the eligible resident population to begin to balloon. As a result, we are eyeing opportunities to partner with best-in-class operators on deals that are priced at a compelling discount to pre-pandemic trades.
Student Housing Last updated – Sept 2020
Anchored by the institution it serves, student housing is sensitive to micro-market trends. Properties near universities with consistent total enrollment growth–and muted supply growth–can enjoy long periods of high occupancy and steady upward pressure in rents. However, if student enrollment dips and/or excess new supply is added, a student housing market can experience turbulence. So while U.S macro university enrollment trends matter to some degree, the success of a student housing asset really boils down to the continued growth of the particular university it is attached to paired with a relatively muted level of new supply.
As an asset class, student housing has consistently demonstrated that it is resilient, proving to be recession resistant in 2008. And even through the pandemic, it continues to perform better than most expected at many universities across the country. Looking ahead, the 2021/2022 school year should show continued enrollment growth due to continued high unemployment, as well as 2020/21 deferrals.
COVID has brought dislocation to segments of the student housing market. Certain smaller, second-tier colleges and universities have suffered tremendous revenue declines. In some instances, these schools were also under capitalized heading into the pandemic, and it has led to their complete failure. Conversely, we have seen many large, top-tier, major conference schools open this fall and offer either in-person classes or a blend of online and in-person classes.
Further, many larger universities have experienced strong enrollment numbers for 2020, even record enrollment for some schools. Part of this phenomenon we attribute to larger schools picking up students from smaller and/or weaker schools. We also see larger schools benefiting from an increase in graduate students–a behavior you would typically expect in a recessionary environment. Add to that the fact that a large portion of campuses have lowered their capacity for on campus housing and the result has been an immediate increase in off-campus housing demand.
As a result, we are seeking top tier, major conference, student housing offerings for the Marketplace with a select eye towards certain types of opportunities. We particularly look for projects near or adjacent to campus– location is hyper critical for this asset class. As we exit the pandemic, we believe that larger, well-capitalized and higher profile universities will continue to distance themselves from their smaller, weaker and lesser known competition.
Outlook by geography
We entered 2020 with a focus on investment opportunities in growing, secondary markets, also known as “18-hour cities.” We’re still confident in the long-term value of these metros for several reasons.
First, we’re seeing a spike in population migration out of some of the largest metros towards secondary and tertiary markets. The pandemic is hitting some of the largest U.S. cities the hardest, and numerous employers in those metros are offering workers the flexibility to work remotely indefinitely. On a less fortunate note, for those who have lost their jobs, the cost of the living in a major metro quickly becomes unsustainable. Whether it’s out of necessity or a desire to seek a more affordable lifestyle, dislocation associated with the pandemic has spurred a wave of net-migration out of certain major metros to less-expensive metros with a high quality of life.
On the East Coast, people are leaving NYC and the primary beneficiaries appear to be multiple metros in Florida, as well as Charlotte, NC, and Nashville, TN. On the West Coast, there is migration out of California, particularly the Bay Area, as people relocate to Texas, particularly Austin, as well as smaller western metros such as Boise, ID and Salt Lake City, UT. Green Street Advisors recently published a report that discusses the cities best positioned to thrive post-pandemic, benefitting from an increased work from home environment. These include Raleigh-Durham, NC, Denver, CO, Charlotte, NC, Austin, TX, and Phoenix, AZ.
However, instead of prices increasing 3-8% this year (as we expected), we are now able to obtain price discounts of roughly the same amount relative to 2019 prices. Any time we can find a roughly 10% year-over-year price swing on a great deal with a great sponsor located in our most favored markets, we aim to bring that deal to our Marketplace.
The current recession is unique in both its cause and how it will unfold, with the impacts on commercial real estate highly varied based on asset class and geography. We believe that high-growth, 18-hour metros, particularly those with diversified economies, are best-positioned to survive the damaging effects of COVID-19 and survive over the next few years until we eventually enter the recovery phase of the current market cycle.
Certain asset classes will perform incredibly well in spite of, or even because of, the recession. We’ll continue to source deals from experienced sponsors who we believe understand how to win in the current market. Other asset classes will likely suffer in the short-term but, ultimately, provide investors with access to distressed investment opportunities that could prove profitable in the mid-term. The common denominator between both types of investment opportunities will be that they present a compelling answer to the question, “Why this deal right now?”
The markets are currently under enormous pressure and may remain so for some time, but with great change comes the potential opportunity for investors who are prepared to act on burgeoning trends to reap benefits in the long-term. As a reminder, most people make commercial real estate investments today with hopes of earning attractive returns over the next three to seven years.
We will continue to bring institutional-quality commercial real estate deals to the Marketplace, adapting our deal flow to meet the times and investor demand. As the market evolves, as it inevitably will do, we will constantly re-examine and test our investment thesis and update it accordingly.