Opportunities in Real Estate

PROSPECTS WERE BRIGHT FOR MANY SECTORS of the investment real estate market a year ago. A growing economy was a strong tailwind for much of the real estate sector. Vacancy was at or near multiyear lows for multifamily residences and office units; hotels were benefiting from high travel demand from both leisure and business segments; and “new economy” sectors such as warehouses were thriving.

Then came the coronavirus, and with it, an upending of the economy in general and real estate in particular. With large swaths of the economy frozen, unprecedented levels of unemployment and offices and stores shuttered, real estate investments suffered. Meanwhile, a deep but temporary lack of liquidity in the real estate market further reduced both transaction speeds and volumes in the capital markets. Investors, understandably, were shaken, and many evaluated their strategic allocations to the asset class.

Fast-forward several months, and savvy investors are finding their way back to certain segments of the real estate market, says Chris Aiello, Managing Director with Bank of America’s Specialty Asset Management, which helps clients manage investments in commercial real estate, farmland, timberland, energy and other private business interests. “In times of economic uncertainty, a lot of people are interested in owning real assets.

With the exception of hotels and some retail, particularly regional malls, “real estate prices overall have been very resilient to the shock delivered by coronavirus,” says David Koletic, Director, real asset investments, with Bank of America’s Specialty Asset Management. Moreover, we believe real estate fundamentals should improve over the course of 2021. Should today’s low interest rates turn out to be a harbinger of inflation, real estate could potentially appreciate at a higher pace, says Koletic, because  rents, land values and commodity prices all typically increase during inflationary cycles.

The outlook

While the long-term impact of the pandemic is still unclear, it has magnified and accelerated a number of trends within various real estate subsectors. Here’s the outlook for the major property groups.

Office property: At the height of the pandemic, as many as three-quarters of office workers were riding things out at home, estimates PwC, instantly upending a decades-long trend toward packing more workers into office spaces.

But now that vaccines have arrived, it’s not clear whether the work-at-home model will last — or in what form offices will exist. While a third of executives in June 2020 said they would likely downsize their office space in the coming years, about half said they would probably increase their footprint to allow for increased social distancing. Though technology offers effective alternatives for some businesses to allow their employees to work remotely, offices are important for teamwork, corporate culture and creativity among other intangibles. It’s a complicated sector, and besides the type of work involved, office space decisions often hinge on several factors including the relative cost in each specific market, says Koletic.

The outlook: Until vaccines are widely in effect, overall demand for office property will be soft. Sector fundamentals will be challenged in coming years, as much is unresolved, including that many large corporate tenants will be reducing their aggregate office footprint while they sort out the work-from- home balance and optimal square footage per employee. Meanwhile, there will likely be a reset on rents and values in many markets, says Koletic.

Multifamily residential: The pandemic hit the brakes on the trend toward urbanization, as singles as well as young families flocked to the suburbs and beyond. While the federal stimulus programhas prevented mass evictions so far, this sector of the market will continue to be challenged in the near term, but the recovery may be rapid, says Koletic.

Going forward, housing, including multifamily, is largely both a demographic and geographic play, says Koletic. “There’s this idea that people exclusively move for jobs.

But low-cost, low-friction cities in good fiscal shape, like many in the Sunbelt, have been magnets for people for a variety of reasons including quality of life. And innovative companies, especially in high-tech, are often going where the people are and want to be.” Besides multi-unit property in the suburbs, the suburbanization trend will also drive demand for single-family housing, says Koletic. The outlook: The multifamily sector may see near-term softness in some markets and sub-classifications. Population trends favoring the Sunbelt and suburbs could drive a relatively quick recovery for those areas. However, the significant amount of new supply in the pipeline in many cities, which hasn’t slowed much during the pandemic, could mute near-term upside in rents and occupancy.

Retail: Unlike other property sectors, retail was challenged even before the pandemic. The United States is rich in retail space, with about 24 square feet of retail space per capita – versus roughly 5 square feet in Europe. Main Street stores were steadily losing market share to e-commerce, while malls mostly in small markets and with functionally obsolete configurations, suffered even more due to excess space. All these dynamics were exacerbated by the coronavirus.

One bright spot: Essential retailers such as grocers and drugstores in the newly hot suburbs saw sales grow during the pandemic and will likely continue to experience robust demand. There may also be location-specific opportunities for retail in densifying suburban locations.

The outlook: Overall, retail will be challenged going forward as a continuing string of brick-and-mortar stores close and retailers fail. Nonessential retail, malls and urban core retail dependent on customer traffic from office workers will continue to see difficult headwinds, says Koletic.

Industrial property: As much as brick-and-mortar retailers struggled during the pandemic, e-commerce thrived. That propelled the growth of an often-ignored property type — warehouses — that must be strategically located near metropolitan areas throughout the country in order to facilitate same-day delivery and other competitive efficiencies. Increasingly, these facilities need to be situated close to large clusters of customers, meaning that there could be opportunities in supply-constrained locations. “Warehouses and data centers benefit from 21st century trends that are being furthered by the pandemic,” says Koletic, “while the underlying demographic drivers won’t be going away.”

The outlook: Industrial has been a top performer leading up to and throughout the pandemic, and it should continue to do  well through 2021, largely driven by strong tenant and investor demand and a relatively balanced supply/demand dynamic. E-commerce penetration, supply chain management considerations and growing demand for same-day delivery will help keep warehouse properties occupied.

Despite some especially hard hit areas, such as hotels and malls and other sectors, which will face near-term challenges, real estate fundamentals are likely to improve going forward. Meanwhile, the central case for long-term investment in real estate remains unchanged, says Koletic: portfolio diversification with high-current income returns that are not entirely correlated to the performance of stocks or bonds; potential for capital appreciation over time; inflation protection as real estate often has pricing power in rent and value during inflationary periods; and attractive relative value in a yield-starved environment with real estate spreads to Treasuries and corporate bonds wide of long-term averages.