Our outlook for real estate investing

Despite all the tumult of 2022 thus far, recovery in the hospitality sector has continued thanks to a notable uptick in business travel and growth in leisure travel. Although a complete business travel recovery is still likely a year away, according to STR, businesses now have “the least negative sentiment” for business travel (globally) since the pandemic began. 

Overall, hotels are now operating above pre-pandemic performance, with total U.S. hotel occupancy above 70% as of July 2022. Revenue Per Available Room (RevPAR) is expected to surpass 2019 levels on an annual basis by 2024 on a real level after accounting for inflation, with central business district recovery expected to lag suburban recovery. However, hotels are somewhat more susceptible to inflation given their larger operating budgets. While the pent-up demand for hotels is pushing up occupancy and revenue rates nationwide, we still see labor shortages, high inflation, and a rise in interest rates collectively hampering the pace of recovery.

Given the outlook for this property type, 2022 may be the final window to bargain shop for hospitality deals. In the immediate aftermath of the pandemic, our team saw asset pricing discounted by as much as 20%* relative to 2019 trades. For the most part, hotels are no longer priced at a discount and are entering an expansionary phase. While discounted pricing for hospitality assets compared to 2019 values is still possible, it’s much more likely to occur as a one-off or unique situation. By sifting through and discarding marginally priced deal flow, we aim to focus on those situations where pricing disparities continue to exist. We are also seeing specific property types bounce back, particularly leisure, high-tier/luxury, and extended-stay hotels, especially in drivable, leisure-oriented destinations or vacation markets with pent-up travel demand.

Conversely, urban-located hotels may present the most compelling mispriced opportunities. As a result, we are tuning into some urban-located hotels, provided the going-in basis is attractive, and the deal is adequately capitalized to see it through to 2023 and beyond. Urban districts and STR’s “Top 25 Markets” are not expected to reach full RevPAR recovery until after 2024. Yet, in the “age of the new traveler,” remote work has given many people the flexibility to extend vacations and work from their destination. As business travel is recovering, the blending of remote work into leisure travel or, as STR calls it, “work-cation,” may provide opportunities in upcoming years for urban, leisure, and extended-stay hotels.

*Based on CrowdStreet data as of March 3, 2022

The healthcare industry is poised to benefit from strong demand, which will drive growth for the medical office sector over the next decade. According to the 2020 Profile of Older Americans, the average U.S. population is aging. U.S. Census data estimates that one in five Americans will be 65 or older by 2030, which increases to one in four by 2060. Furthermore, population projections from the census show that by 2034, older adults will outnumber children for the first time in U.S. history. Americans in the 65+ cohort visit their physicians more frequently than younger people, increasing the demand for medical office facilities.

The COVID-19 pandemic was turbulent for the economics of the healthcare system. Hospitals canceled elective procedures and postponed non-urgent treatments, while urgent care facilities operated at maximum capacity. There is pent-up demand for postponed procedures from the last two years, which will likely manifest in increased in-patient visits.

A consistent and ever-growing need for healthcare bodes well for the medical office sector. We see strong opportunity, especially in areas where population projection for older Americans is expected to rise. According to the Population Reference Bureau, most of the older population is concentrated in markets like California, Florida, and Texas. 

We also expect increased demand for medical offices located further out and away from Central Business Districts as hybrid workers are relatively less tied to medical offices that are solely near their office. We continue to like small-to-mid-sized medical offices which are located near hospital campuses rather than inside large hospitals. Such facilities offer patients greater accessibility and they lower operating costs for practices. As a result, health professionals have been migrating from hospital campus locations to purpose-built outpatient facilities, a trend we previously pursued for the Marketplace and see continuing in the years ahead.

Medical offices near well-performing retail locations like power centers and strip centers also tend to do well as people often schedule their appointments around running other errands due to convenience. Overall, we expect continued recovery for the medical office sector in 2022 as healthcare employment recovers and patients return for in-patient visits.

Our previous speculation was that we may have witnessed the bottom of the office market in 2021, but the looming possibility of a recession could further delay the recovery of the office sector. Even with the assumption of a delayed recovery baked in, however, we continue to believe that the office market, on the whole, will look better by 2025 than it looks today. With higher-quality office projects in demand, obsolescence is a serious issue for this market segment, and data suggests that offices will lose at least if not more than 28% of their market value within the next decade as compared to 2019 levels. Most major asset classes experienced cap rate compression during the last two years (particularly for multifamily and industrial property types), while office is the only property type that has been experiencing cap rate expansion continuously since after the pandemic.

Although the future of office is still uncertain, it is undeniable that the hybrid-work model has gained more traction since the pandemic's beginning. Before the pandemic, roughly 1 out of 67 jobs were remote, according to data provided by LinkedIn. That number climbed to 1 out of every six jobs in 2022. The major question that remains to be answered for the hybrid work model is whether it will continue to gain traction or if we see the pendulum swing back towards greater physical presence in offices. As business market volatility increases, as one would expect in a tumultuous business environment, we may see more companies call employees back to the office to better navigate the choppy waters ahead. While uncertainty remains, an environment where the office currently trades in a similar range to retail cap rates suggests that a considerable amount of risk has already been priced in for this sector.

With increased caution for this sector, we are tuning into the flight-to-quality trend in the office market and chasing high-quality, newer construction projects and/or properties in strategic locations. Tenants are increasingly disqualifying older projects and relocating or moving into new construction projects that offer modern amenities to uplift the office experience. 

The credit quality of the tenant is always a requirement for a good investment, but now more than ever, we are paying close attention to the entire tenant mix when considering office deals. While we still like stabilized, cash-flowing office deals (as these types of properties currently offer relatively high annual operating yields when compared to multifamily and industrial property types),  we are taking a cautious approach and tuning into particular value-add and opportunistic deals with attractive going-in basis, high asset quality, an experienced sponsor behind the deal, and a location in a resilient submarket with high employee occupancy.

While people are increasingly returning to the office, the volume of reentry varies across markets. According to Kastle Systems, Houston, Austin, and Dallas are among the top metros in terms of bringing people back to the office. These Texas markets are currently hovering at an average occupancy level of ~55%. On average, looking across the top 10 metros tracked by Kastle Systems, office re-utilization rates are currently around 44% (as of 8/12/2022); this discrepancy in occupancy rates among submarkets is part of what makes us more bullish on Sunbelt office locations in 2022, as office occupancy is strongest in these markets.

The self-storage sector boomed in the last two decades but saw decelerating market fundamentals in the three years prior to the COVID-19 pandemic. Fast-forward to 2020, demand for self-storage space spiked again, bolstered by pandemic-related migration as people moved across states, as well as intrastate, from urban to more suburban locations.

The sector is institutionalizing with major storage REITs, including Extra Space, Cube Smart, Public Storage, and Life Storage, acquiring properties and consolidating this fragmented asset class.

The self-storage pricing shot skyward, up 66% in 2021, according to Green Street Advisors*. A few factors drive this rampant appreciation. Double-digit rent growth and occupancy rates of 95% (a record high nationwide) translated into a 16.5% increase in NOI in 2021, contributing to strong pricing. At the same time, cap rates have compressed close to 100 basis points since the beginning of the pandemic, down to 4.6%** nationally. All told, self-storage ranks right at the top, alongside industrial, as one of the better performing of all property types over the past two years with a strong outlook for growth.

*Green Street Advisors - U.S. Self-Storage Outlook, 2022
**Green Street Advisors - Cap Rate Observer, July 2022

There is an increasing need for self-storage due to work-from-home and relocation trends, which will likely create more opportunities in non-coastal markets due to pandemic-induced migratory patterns. We also expect major university towns to see strong demand for storage space. Older self-storage facilities often lack amenities such as climate control, security systems, etc., which continues to create opportunities for further development of this asset class. We seek 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. 

We are also bullish on adaptive reuse projects as oftentimes they are situated in great in-fill locations, which are development sites in an urban area that is mostly built out, such as a retail center on a busy thoroughfare. In our experience, both development and adaptive reuse projects benefit from an unusually large spread between a typical stabilized yield on cost at stabilization (typically ranging from 7.5–8%) versus the typical exit cap of a fully stabilized self-storage property (roughly 3.5–4.5%). This outsized spread means a sponsor can often sell a stabilized self-storage property for 40–45% more than the cost to build it.

According to Green Street Advisors*, there will be a downtick in new self-storage deliveries in 2022, predicted to last until 2024, due to labor shortages and supply chain issues. However, construction deliveries are expected to climb in 2025 and beyond due to the ever-increasing demand for self-storage. This suggests that the next two years may provide an extended window of opportunity to invest in the self-storage sector and re-evaluate our strategy to get ahead of opportunities as we approach 2024.

*Green Street Advisors - U.S. Self-Storage Outlook, 2022

In an effort to stop the spread of the virus, COVID-19 vaccinations were mandated for close to 1,000 colleges and universities in late 2021, according to The Chronicle of Higher Education. As a result of these precautionary measures, students were allowed to return to campuses for the 2021 fall semester, and pre-leasing was up 5.2% from the year prior.

Fannie Mae reported uninterrupted new supply by bed deliveries for 2020 and 2021, which translated into level supply year-over-year. However, due to supply chain issues that are impacting most asset classes, new student housing project completions are expected to be sluggish, with a relatively low new supply of bed deliveries forecasted for 2022, according to RealPage Inc.

Although the student housing sector is normalizing faster than was previously anticipated, we do not view the current state of the sector as a rising tide that will lift all boats, because overall reduced enrollment in colleges and universities and declining birth rates may pose future challenges to several schools. According to the National Student Clearinghouse Research Center, enrollment in colleges and universities has not yet caught up to pre-pandemic levels and is actually declining, with undergraduate enrollment accounting for most of the decline, down 4.7% from Spring of 2021 to Spring of 2022.

The opportunity in the student housing sector is dichotomous, and location plays a key role in choosing the right investment. The most desirable and best-capitalized flagship universities will exploit their competitive advantage to attract students in record numbers, which will propel the student housing markets in areas with large universities at the expense of markets with smaller institutions and community colleges. This leads us to be generally bullish on Tier I universities (schools that are expected to bring in at least $100 million per year in research grants, plus have selective admissions and high-quality faculty), particularly those with large student populations and affiliated with major conferences.

According to the Yardi Matrix Student Housing report, the outlook for student housing is positive, especially for off-campus properties and in highly selective universities. The report also mentions that rents are at above pre-pandemic levels. Low vacancies in the student housing sector are pushing rents up in areas where student enrollment is anticipated to be high and where supply is strict. 

We fully expect more educational institutions to adopt a blended learning approach with both in-person and online courses. However, there is little evidence as of now to support that blending virtual classrooms into the traditional university settings will negatively affect the student populations that are local to campuses, considering that the in-person college experience is still important to students.

Overall, we see an opportunity for the sector and will focus on areas surrounding top-tier universities with a prudent supply of new housing relative to forecasted demand.