A commercial real estate primer for newbies
With Goldman Sachs, Cohen & Steers, and other prominent firms starting to raise billions of dollars to gobble up distressed properties, it appears as though beleaguered property owners are finally capitulating to the high interest rate environment rather than continuing to hold out hope for an eventual recovery.
Before you decide to get in the game by investing in a REIT, private real estate fund, or directly in a property, keep in mind that commercial real estate (CRE) is not the monolithic entity it’s often made out to be.
Professional investors generally break out CRE into distinct asset classes, and each has its own set of drivers and idiosyncrasic risks. CRE investment vehicles will vary significantly in terms of: 1) their targeted risk/reward profile 2) their geographic focus, and 3) the exposure they’ll provide to the different asset classes.
If you’re thinking it may be an opportune time to “buy low” but you don’t have much experience investing in CRE, here’s a short primer for you on the seven components of a highly heterogeneous market:
· Senior housing
· Hotels
· Self-storage
· Office
· Industrial
· Retail
· Multifamily
Senior Housing
Outlook
Occupancy levels have recovered from pandemic-related lows but have continued to underperform for two reasons: 1) labor shortages, and 2) improvements in medical technology which have increased opportunities for seniors to remain in their own homes. High operational costs remain a big concern for the sector.
Fundamentals
Driven by an aging population
The baby boomer population is fueling the expansion of senior housing. It’s estimated that, by 2050, 22% of the US population will be over the age of 65, compared to 17% today. Many seniors choose to live in 55+ communities for the social benefits, convenience of meals and other amenities, along with relatively lower maintenance costs. Others will have less of a choice as their physical and mental health decline.
Both the underlying real estate and the manager matter
By analyzing a senior housing deal in the context of local demographics and with attention to things like modern design and a progressive operating strategy, you can better understand how well a particular investment might perform.
Owners get paid in different ways
Investors must consider the various payment options in senior housing, including private pay, long-term care insurance, Medicare, Medicaid, and veteran’s benefits. Some public programs can be more sensitive to limits on reimbursement or legislation that may affect billing processes and payments. Properties with business models oriented towards private pay are naturally less vulnerable to regulatory risk.
A broad-based shift away from institutional-style facilities
Seniors and their families now have higher expectations for the quality of their living situtation. Operators are re-imagining facilities to keep seniors happy and engaged, and are placing more focus on preventative care, wellness, and amenities such as chef-run restaurants, nature trails, spas, and fitness rooms. Technological investments are allowing facilities to provide improved health and safety monitoring and better communication between residents and their families.
Hotels
Outlook
The post-pandemic recovery in the hospitality sector has been strong thanks to a notable uptick in business travel and leisure travel. While the pent-up demand for hotels is pushing up occupancy and revenue rates nationwide, labor shortages and high interest rates are hampering the pace of recovery.
Fundamentals
The Ace Effect
Millennials by and large want affordable and hip hotels in urban locations, as demonstrated by the success of the Ace Hotel franchise. Major hotel brands have been rapidly evolving to emulate this model. More and more hotels are offering smaller rooms that eschew traditional fixtures like closets and desks, opting instead to invest heavily in technology and vibrant common areas.
New tech is the name of the game
Most of the developments in the hotel industry are rooted in the adoption of new technologies. Online travel agencies (OTAs), such as Expedia and Priceline, drive significant traffic to hotels and help operators fill last-minute vacancies. At the same time, OTAs come with steep commissions, and operators can risk becoming dependent on them. Other online services enable guests to redefine the period of the traditional-night stay. Various apps allow guests to book hotel rooms by the hour, filling intraday vacancies that would otherwise go unused.
It helps to have a good eye
Hotels across all categories and price points have their own market segments, competitive sets, and corresponding metrics. Successful hotel investing requires a rigorous comparative analysis to determine whether the property is positioned to capture its fair share of market demand. Much of that analysis is a logical application of things that, from a guest's perspective, provide a compelling hotel experience.
Self-storage
Outlook
Work-from-home culture and relocation trends are driving demand for self-storage higher. Pandemic-induced migratory patterns are creating attractive opportunities in non-coastal markets. A large number of older self-storage facilities that lack amenities such as climate control, security systems, etc., are also presenting opportunities for further development of this asset class.
Fundamentals
More stuff!
Population growth and consumerism are key drivers of demand for self-storage facilities. This might suggest self-storage demand is highly economically-sensitive, but demand also comes from people in transition who are in need of a temporary or long-term storage solution. The self-storage sector actually benefited from both the 2008 recession, as many were displaced from their homes or forced to relocate to seek new work, and also from the pandemic, as people moved from urban to suburban locations.
The sector is institutionalizing
Major storage REITs, including Extra Space, Cube Smart, Public Storage, and Life Storage, are acquiring properties and consolidating this fragmented asset class.
Competition is elevating design and technology standards
No-frills storage properties are being replaced with a new generation of facilities with upscale designs and landscaping. As storage operators have pushed harder for retail locations that get them closer to customers, they are finding that they have to upgrade their image to attract customers and satisfy city building and zoning requirements. Operators are embracing surveillance, security and communication technology in response to growing competitive pressure to offer facilities that are clean, safe, and secure.
Solid and stable cash flows with a lean operating strategy
The low costs associated with tenant turnover and the immediate reusability of storage space is unmatched among other CRE asset classes. Self-storage facilities typically rely on relatively low occupancy levels: the break-even occupancy rate to service debt for a self-storage facility is usually 40% to 45%, compared to 65% or more for apartments, retail, and office. Consequently, once delivered and stabilized, self-storage facilities tend to hold value better and recover faster than other assets when real estate markets sour.
Office
Outlook
The looming possibility of a recession and frozen capital markets are slowing the recovery of the office sector, exacerbated by the hybrid-work model that gained traction during the pandemic. Before the pandemic, roughly 1 out of 67 jobs was remote, according to LinkedIn, and that number climbed to 1 out of every 6 jobs in 2022. The major unknown is to what extent the pendulum will swing back towards greater physical presence in offices, as we’ve started to see. For now, metro markets in the Sunbelt seem to be leading the way towards a recovery in occupancy rates.
Fundamentals
Employment levels don’t seem to matter as much anymore
Over the long-term there’s been a strong, positive correlation between employment growth and the absorption of office space. That has clearly not been the case in the current cycle.
The new criteria
The credit quality of the tenants, the level of employee occupancy, the quality of the asset, the experience level of the sponsor behind the deal, and the resiliency of the submarket should be central to an analysis.
Catering to the next generation
Prior to the pandemic, companies looking to hire young talent were focused on making their offices more appealing with amenities such as bike parking, locker rooms and coffee bars. Modern offices were starting to look more like professional living rooms than the cube farms of decades past.
Relevancy matters
Office real estate is highly heterogeneous. No matter the type or location of any office asset, the bottom line is that it must be able to maintain its relevance over the course of the holding period. Understanding which trends have staying power, and which will be short-lived, are the key to long-term success.
Industrial
Outlook
The 2021 frenzy for industrial space has been fading on the heels of a slow-down in e-commerce sales, but the sector is still characterized by undersupply, low vacancies, and relatively high demand for industrial projects. Demand for industrial space is perhaps the highest among all CRE property types and relative to projected demand, many believe the sector still appears undersupplied. Tertiary markets with burgeoning institutional presence are driving demand, and so are niche strategies such as industrial storage facilities, which are essentially fenced yards leased out to companies who can park their vehicles, trailers, containers, and the like to accommodate their supply chain and logistical demands.
Fundamentals
A laundry list of factors to consider
Location, proximity to customers and workers, transportation, access to land, and financial incentives that can offset building costs all come into play when analyzing industrial real estate opportunities. The sector depends on easy access to major highways and interstates, intermodal rail, ports, and air freight.
Government comes into play in a big way
Developing large industrial facilities usually involves working closely with local, city, or state agencies to negotiate incentives that can influence location decisions. Large industrial properties can have big tax benefits, and cities and states compete aggressively for projects that will boost their tax base with jobs and property taxes. Those bidding wars include offers of tax rebates, low-cost loans and even free land, all of which have a big impact on a project’s overall cost and ROI for investors.
E-commerce is changing the landscape
The shift in consumer behavior due to e-commerce is changing the use of certain types of industrial real estate as fulfillment has different locational requirements and functional needs than distribution, which involves the storage and shipment of goods to stores in large batches.
Retail
Outlook
The pandemic forced weaker retailers to exit centers around the US and resulted in a consolidation in rent rolls. Grocery-anchored centers and neighborhood shopping centers, as opposed to traditional shopping malls and second-tier big-box stores, appear more likely to maintain long-term viability. Retailers are increasingly “rightsizing” their space at the end of their leases, meaning they are letting go of square footage that drags on their profits, or entire stores that aren’t growing revenues.
Fundamentals
Consumer spending fuels retail sales and strategic expansion
Consumer spending is a macro demand driver and provides no guidance for competitiveness from a real estate perspective, within the industry. The key points of analysis at the submarket level are foot traffic, population density, demographics, parking access, and tenant mix.
E-commerce dominates conversations about retail
Although e-commerce continues to grow its share of total retail sales, it still only represents approximately 15% of total retail sales. It’s easy for casual observers to predict that e-commerce will completely destroy brick-and-mortar retail, but it’s more realistic to believe that hybrid models will evolve over time. Some retailers are effectively using stores as showrooms to drive online sales, while others are offering in-store pick-up of online orders as a means to draw customers into their stores and capture additional sales through in-store consumer discovery.
The experience matters
Retail properties are designed and constructed expressly for the purpose of selling consumer goods and services. The success of the asset class is highly dependent on the experience it offers. Retail properties vary greatly in format and size, and their valuations depend on the metro, location within the metro, age and quality of construction, and tenant base.
Multifamily
Outlook
The multifamily sector includes townhouses, condominiums, apartments, and all other buildings containing at least two housing units that are adjacent vertically or horizontally. Due to a nationwide shortfall in housing supply, the fundamentals of the group look decent despite higher interest rates that are making many owners look more vulnerable.
Fundamentals
A macro-driven asset class
The key contributors to multifamily demand are population growth, renter household growth, job growth, and changes in the cost of homeownership. Demographic trends are significantly contributing to the growing popularity of renting. Millennials, as a whole, are delaying marriage, having children, and moving to the suburbs to buy a home until later in life. They’re also carrying mountains of student debt, which makes it more challenging to finance a first-time home purchase. Meanwhile, many empty nesters are downsizing and opting for low-maintenance rental townhomes and apartments.
A shift in preferences
In the past it was common to see multifamily properties tucked away in a secure and private setting. That trend has given way to more accessible properties with amenities such as bike parking, rooftop lounges, soundproof walls, balconies, etc. As commuting via public transportation has become more popular with renters, apartment buildings are increasingly clustered along transit lines.
One of the most defensive sectors
From a risk perspective, multifamily is generally regarded as one of the most defensive commercial real estate asset classes. Fundamentally, people need a place to live regardless of the prevailing economic conditions.
