By: Jenna Morr, CFA, CAIA
As markets are unsettled with heightened concerns over rising costs and a slowing economy, we believe that commercial real estate can play a critical role towards diversification and stability in client portfolios.
An unmatched run in equity markets, and generally across risk assets, that was driven by low interest rates and easy monetary policy since the Global Financial Crisis, has seemingly come to an end in 2022. Since the beginning of the year, a convergence of factors has challenged the global economy and financial markets alike: inflation moved beyond transitory, heightened by high energy and food prices due to the Russia-Ukraine war. This has further exacerbated the already tight labor market, thus prompting the Federal Reserve to raise interest rates to slow demand and consumption. Once the Fed made the decision to act, they did so swiftly, leading to five hikes in the federal fund rate since the beginning of the year to 3.25% (at the time of this writing). Additional hikes are expected in 2022 and through 2023. Central banks around the world have followed suit as the general tone has pivoted toward monetary tightening. These measures and the Fed’s posture of maintaining rates higher for longer have stoked fears of a recession.
In this environment, we believe commercial real estate will be accretive to portfolios due to its defensive attributes and its ability to protect against inflation. We expect the asset class to benefit from a limited supply of quality assets, rental rates aligned with inflation (as can be seen in Exhibit 1), and generally low costs for maintenance. Still, it is important to be thoughtful with respect to purchase price, asset types and geographies as the elevated risks in the market may create wider dispersion across properties. As such, we have partnered with high quality real estate investors who have experience navigating through business cycles and deep sourcing networks in still rapidly growing markets when building out portfolios of assets.
Exhibit 1: Real Estate as Inflation Hedge
Source: Federal Reserve Bank of St. Louis
Exhibit 2 shows commercial real estate returns compared to other asset classes. It examines how the inclusion of commercial real estate in a client portfolio historically delivers diversification benefits and downside protection relative to a traditional 60/40 allocation.
Exhibit 2: 20 Year Risk/Return – Stocks, Bonds & Private Commercial Real Estate
Source: Cadre, as of 9/30/21
Not all real estate is created equal. Afterall, in difficult economies consumers typically spend and travel less, impacting retail and hospitality sectors. There is often a higher number of business closures and layoffs affecting office buildings. Although we will continue to allocate across commercial real estate, our managers emphasize the value of rented residential properties, including conventional apartments, student housing and single-family rentals. We believe the asset class is best positioned for the current environment as everyone needs a place to sleep, and so the sector is often viewed as non-discretionary. As such, it is more predictable in both economic expansions and recessions compared to other asset classes.
Rented residential is a highly resilient asset class. It outperformed other commercial real estate during both the 2001, 2008 and 2020 recessions. But more importantly, as can be seen in Exhibit 3, it did so with lower volatility.
Exhibit 3: Commercial Real Estate Asset Types – Return & Volatility
Source: Manager Research
Furthermore, the market fundamentals described below support a highly attractive longer-term opportunity despite a weakening consumer.
1. According to a study completed by the National Association of REALTORS ® the United States is facing a housing shortage of 5.5 million homes. The U.S. Census found that 12.3 million households were formed from January 2012 to June 2021 but only 7 million new single-family homes were built during the same period. In fact, single family home construction is running at its slowest pace since 1995. The shortage has been worsening in urban areas across the country over the last decade. The gap may take another decade-plus to close. In Exhibit 4 you will see that housing starts continue to remain low.
Exhibit 4: Supply vs. Demand
Source: Manager Research
2. Apartment vacancies have dropped across the country. Please see Exhibit 5. We expect this trend to continue as the United States needs an estimated 4.3 million new apartment units between now and 2035 to meet the increasing demand according to research commissioned by the National Multi-family Housing Council and National Apartment Association.
Exhibit 5: Rental Vacancy Rate in the United States, Quarterly, Not Seasonally Adjusted
Source: Federal Reserve Bank of St. Louis
3. The affordability of home ownership has declined dramatically. The financial health of millennials does not help the situation. Millennials as well as Gen Z are more likely to be living paycheck to paycheck and are more concerned about their money lasting. Young adults are living home with parents longer and/or are seeking rental options more frequently rather than looking to purchase their first homes. The below charts illustrate this phenomenon. In Exhibit 6 we’ve outlined home prices relative to median income over the last 70 years. Today, we are at an all-time high.
Exhibit 6: Home Price/Median Income Ratio
4. Real estate investors seek to pass through cost increases to their tenants via adjustments to rental prices. Multi-family operators primarily utilize shorter term lease agreements which generally turnover annually and therefore allow for timely adjustments to ensure valuations keep up with the broader economic environment. Moreover, although wage inflation is a factor, operating costs of multi-family properties tend to be low, especially within stabilized buildings.
Although we are excited about the various opportunities, we are not insensitive to current market conditions of rising interest rates and concern of an impending recession. All else equal, higher interest rates result in a lower ability to borrow against real estate assets due to higher debt service coverage requirements by lenders as well as a greater degree of scrutiny by underwriters. As a result, investors will require a higher rate of return. We’ve received feedback that in 2022 loan proceeds across commercial real estate are lower by about 10-15% and interest cost has increased by about 250bps+. The change in mortgage rates is highlighted in Exhibit 7.
Increasing interest rates also generally put an upward pressure on cap rates, or the profitability of a property, which in turn impact asset values. In many cases cap rates have already expanded 50bps+. Experts in the field suggest that cap rates will need to move in entirety 125-150bps compared to where they started the year to account for borrowing costs. It is important to recognize that although inflation has hit levels not seen in nearly four decades, interest rates are not yet close to the historical average let alone the historical highs. Cap rates tend to lag interest rate hikes and will undeniably influence the price an investor is willing to pay. Pricing is down 10%+ relative to broker guidance in early Q2 2022. However, in many cases prices are still higher over last year as can be seen in Exhibit 8. Many investors and lenders have paused new activity as they wait for everything to settle. Fortunately, real estate fundamentals are much stronger relative to prior challenging economic environments such as the Great Recession which was characterized by a massive oversupply in markets and loose lending practices. On the contrary, no major markets in the US are experiencing oversupply today according to CoStar.
Exhibit 7: Mortgage Rates
Source: Federal Reserve Bank of St. Louis
Exhibit 8: U.S. Primary Property Type – Quarterly Indices Value-Weighted
Source: CoStar Commercial Repeat-Sales Indices TM
Where we are seeing the most challenges in real estate today is in development projects that were acquired at tight cap rates last year and still hadn’t finalized budgets and secured financing ahead of the current market. To avoid such risks, while valuations try to find its footing and as the inflation picture remains uncertain, we are favoring core plus, stabilized real estate while being selective and opportunistic in value-add and development projects.
Compared to value-add real estate or development, core plus is a conservative allocation with more predictable cash flow generation. Investors typically seek an 8%-12% return profile through a combination of income and growth. Core plus real estate is typically high quality and well-occupied. It generates income upon investment but has growth potential through light renovations and extracting property management efficiencies. While we acknowledge the equity risk-associated with this strategy, we do believe a core plus allocation has the ability to enhance income generation within portfolios, especially as we remain unenthusiastic about traditional fixed income.
In contrast, value-add investors expect total return to be driven by growth as they seek to drive higher occupancy and rents through capital improvements. Development projects are highest on the risk/return spectrum as it may take months to build, stabilize and lease up a property.
While value-add and development have greater execution risk relative to core plus, recent price declines and new underwritings incorporating higher cost projections and greater cap rate expansion, are creating new, high-returning opportunities. Historically, real estate funds that are investing and developing during an economic slowdown generate strong results for investors. We are cautiously, and slowly adding exposure here, but to a lesser degree than core plus assets.
Regardless of the broader opportunity or cycle, property selection is paramount. We are focused on well-placed assets in thriving markets benefiting from qualities such as strong job and population growth, diversified economies and a depth of institutional ownership. These are typically primary and secondary markets throughout the United States but particularly within the Sunbelt and Midwest. They include cities such as Salt Lake City, Phoenix, Columbus, Austin, Denver and Charlotte. Exhibit 9 illustrates the markets in the United States that are expected to drive US economic growth through 2027.
Exhibit 9: Markets Expected to Drive US Economic Growth
Source: Manager Research
Each property type has its own challenges but with that, comes opportunity. We’ve summarized the case for rented residential and as noted previously, we will maintain an overweight positioning to that asset type. However, there are select pockets of attractive opportunities within industrial, office and even retail. Some of these areas include:
- Industrial: Infill light industrial in supply-constrained markets
- Office: High quality, amenitized buildings with non-remote worker tenancy; close to dining and retail
- Retail: Top locations; eCommerce resistant tenant mix; lifestyle centers
As we finish out 2022, there seems to be limited signs that the volatility experienced year-to-date is decelerating. The challenging environment has created a tremendous amount of uncertainty and fear, and market participants are responding accordingly. Asset allocation is as important now as it ever has been. We believe the addition of commercial real estate will enhance the risk-adjusted returns in client portfolios through this downturn and subsequent recovery.
About Jenna Morr
Ms. Morr joined Simon Quick in 2013 as a member of the Investments Team based in Morristown, NJ. Her primary responsibilities include conducting due diligence on prospective investment managers as well as monitoring existing investments on an ongoing basis. Jenna is responsible for sourcing new investment opportunities and conducting research presentations at client and prospect meetings. Jenna graduated from The Pennsylvania State University in May of 2013 with a B.S in Mathematics and a Minor in Economics. To learn more about Jenna visit her LinkedIn.
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