Not all real estate was created equal. Which sectors are positioned to perform better than others? Below is an opinion piece by Jay Rollins, Portfolio Manager of JCR Funds, that addresses this question with a specific look at office, multi-family, industrial, retail, and hotels.
A Mid-Winter’s Night
By Jay Rollins
The following is an opinion piece for JCR Fund investors authored by Jay Rollins.
Dear JCR Fund Investors:
It was a dark night. It was hard to see. There were lights in the distance, and we could not see what was happening around us. We knew there was damage, but we could not see it. The enemy was invisible, and we were scared. Some stayed deep in their foxholes and would not venture out. Others pushed forward but did not get far. In the depths of the night, we all worried. The darkness made it worse. Was everything lost? Would this ever end? What would it look like when it was over?
As the dawn broke over the landscape, the world became clearer. Yes, there was damage, but it was not as bad as our middle of the night thoughts. The daylight was providing clarity. Now we are starting to see what has really happened . . .
A war story? No, a real estate COVID-19 story.
As the vaccine flows, and as we return to our lives, we now see what has happened—and what might happen next.
It’s been a year since COVID-19 rocked the financial community. A two week flatten the curve act of patriotism, led to a year of moratoriums and lockdowns. COVID-19 has stopped travel, office work, conventions, and the ability to transact with many retail merchants.
As I write this, the real estate industry and the US economy is closer to getting “back” and there is collateral damage, but the bigger question is “what’s next”? What is going to happen to the real estate market we knew only 12 months ago.
Well, it’s getting clearer now. This update will explore those questions and hopefully offer some investment insight.
Office and work at home
It is becoming clear to me that office will be divided into various factions:
a) Urban vs. suburban
b) Large companies vs. small companies
It is not that complicated.
Urban office is typically made up of larger companies like insurance, banks, accounting, and consulting firms. Employees of these companies will continue to be the primary constituents of the “work from home” society.
Suburban office is typically made up of smaller businesses, entrepreneurs doing all sorts of work. This segment finds it extremely difficult to work from home, does not want, or in many cases will not allow work from home. These are gritty entrepreneurs, who are building cultures with collaborative ideas, and they need people and teams on-site. Many are already back in-person and these numbers will continue to grow.
Punchline: Suburban office is emerging as a survivor, while urban office will take longer as many of these people will come back, but not right away.
The “work from home” movement
This will be fascinating to watch over 2021 and into 2022. There is a narrative that everything has changed but I’m not so sure. Over the coming months look for the following:
Everyone who wants a vaccine will have one by summer.
Many CEO’s want their people back in the office.
Some firms will mandate returning to the office, others will encourage it.
There will be hybrid models, primarily from larger firms, but this will divide the work force and will bring its own set of issues.
The fear of being “left out” will play a role. As decisions get made by people in the office, work from home people will feel left out.
If the majority are back in the office, some work from home people will be seen as slackers.
Younger people who value their careers may feel “left behind” and less likely to advance.
Most young people will want to be in the office so they can interact with others and mentors.
Only the bigger companies will offer hybrid models, but they may be confusing, and workers may want to shift over time.
Big companies will struggle with their office footprint as employer desires and employee desires may be different.
In short, this will take 12-24 months to work itself out, and what happens now may not be what ultimately happens.
So, who will be those who work from home?
The younger work-life balance cohort: Over time (short period of time) they may find they are falling behind in their career vs. the in-office worker. I believe this cohort will shrink over time.
The older cohort who just prefer not going into the office: This cohort is less concerned about their career future at this later stage.
The unintended consequences: The older cohort that is left working from home will, for the most, be part of the economic 1%. This cohort may see a backlash over time of undue privilege and even a tax burden (work at home tax), as the majority of the country will begin to resent rich people working at home while others must go to the office.
I have written in prior letters that I believe COVID-19 will accelerate Baby Boomers leaving the workforce.
Older workers being outhustled by younger people, as the younger people travel and build relationships
Unwillingness of older work-at-home employees to reengage in person
So how does all of this affect real estate?
Punchline: Don’t give up on office just yet. Yes, there will be shrinkage, and there will be headlines of large firms not renewing leases, but it’s not over until it’s over – and it’s not over.
Multifamily
Multifamily, especially Class B, has become the “real estate bond.”
The market is looking past eviction restrictions. It’s also looking at rising interest rates to slow home ownership.
The Class B market will continue to outperform due to:
Continued and growing need for affordable places to live
A growing populations base that fits that demographic
The inability to replace this infill housing at its current cost basis
The massive financial support the federal government provides to multifamily assets
Again, I put these in two categories – suburban and urban.
Suburban:
It’s back and with a vengeance. It has everything going for it.
Less dense properties
Close in, but away from the city center
Affordable rents that fit the needs of most renters
Urban:
Typically, Class A normally has more affluent renters. These renters more easily convert to home buyers. These tenants usually want to be near their urban office spaces.
The future of this asset class is less clear. What is clear is that these are great assets, which will be desirable for years to come, but at what rents? When constructed, these assets pushed the limit of what renters could/would pay.
Filling these assets at pre-COVID-19 rents will be a challenge. Some will, some won’t. So, in the short term, the future of these assets will depend on the ownership structure, financial strength, the debt structure, and the ability to “hold on” and see how urban office actually performs.
There is more risk here, but good real estate investors will do just fine in this asset class.
Punchline: Class B Multifamily will continue to provide income. Class A will be more opportunistic investments.
Industrial
This asset class has been the darling of the business the last few years. Values have increased more in this asset class than any other.
Investors need to take more notice that all industrial is not created equal. Industrial trades on the following:
Ceiling height
Access to transportation hubs
Number and type of bays
Pricing (very price sensitive asset)
Punchline: While there is more room to run, don’t expect everything to work and for this strategy will not work forever.
Retail
Grocery-anchored
These will be fine, especially in lower demographic areas. Most people still want to see what they are buying at the point-of-sale. In-line stores will transition to more service-oriented retail. Cap rates are higher now, but I would expect them to compress. I think this is one of the best opportunities coming out of the pandemic, as long as there is a long-term grocer lease.
Punchline: There is opportunity now for the right centers in the right market, but a strong grocer with term on their lease is the anchor to the deal.
Big Box
No man’s land – like everything else, it is nuanced but it’s the poster child for the pandemic. Much of what they sell can be found on Amazon. There will be some adaptive reuse of the assets, and some will come down and the land will be converted to suburban multifamily. This asset class is not for the faint of heart.
Malls
Everyone knows this story. A few “fortress malls” will survive, but a large percentage of older and Class B malls will not. Malls were dead men walking before the pandemic. This just accelerated it. The key to mall redevelopment is the developer and city working together. Typically, they require zoning changes and possible tax incentives. These are capital intensive projects with a long duration. Some conversions will work, others will not.
Punchline: This is a specialty investment that will take years to play out.
Hotels
Again, I separate hotels into two categories:
Leisure Hotels: These will be fine. People want to resume vacations, etc. I would expect this hotel class to recover in 2021.
Business Hotels: This is a different story. Business travel will suffer into the foreseeable future. Older executives will want to travel less, younger workers don’t have the expense accounts, and larger firms will limit the travel budget. It will take time and we may not see 2019 performance for years, if ever. Of course, there will be case-by-case exceptions.
Summary
The COVID-19 storm was not as bad as we thought. But it did bring new things to think about:
Massive spending and deficit spending.
Fed policy of buying everything to keep rates low (how long can that last?)
What happens with massive spending deficits, and a very accommodating monetary policy?
Higher taxes around the corner as the economy struggles to come back.
New human behavior patterns that we do not fully understand yet.
All that said, I am confident that as real estate investors, we will manage through this just like we have managed through various “crises” over the last 30 years. We will be cautious but look for opportunities within asset classes, broken capital structures, and the poor decision making made by others. (That does not sound nice, but that’s what good investors do.)
We appreciate your continued trust in us. We recognize trust is built on transparency and results. We continue to provide both.
____________________
Jay Rollins
Portfolio Manager
JCR Funds
All investments have risk of loss; there is no guarantee any investment will perform as expected. The opinions expressed herein are those of the author and may not take into account all relevant available market information.