The longer we endure lockdown, the more habits will likely shift, having profound consequences for markets, businesses and consumers. Nowhere is this perceived shift more evident right now than in the real estate market across all sectors.
Real estate investors have enjoyed a good run over the past 50 or so years. The FTSE NAREIT Index has returned 9.77% annually since 1971 and the REIT structure has offered access to professionally managed real estate assets for the masses as opposed to being an asset class reserved for the ultra wealthy. There have been many downturns before. Besides the obvious example of the housing crisis of 2007-2009, there have been severe commercial property downturns in the early 90’s as well as during the 70’s. The fundamental makeup of the market has remained relatively the same though. Sub sectors have had tough times but have remained viable. There are office REITs, Mall REITs, Hospital REITs and Residential Mortgage REITs. Around 2015 though, with the shift towards online shopping and delivery, both malls and retail stores started to come under pressure.
The pandemic has just accelerated these forces that were already at play. Malls are in severe decline, important anchor tenants such as JC Penny, Nordstrom, Sears etc. are either bankrupt or struggling. Hospitals are vital but some may have trouble paying the bills with the loss of elective surgeries as focus has shifted to treating the virus. The one shock that no one saw coming though, was the shift to working from home that was a side effect of the pandemic. Companies that can rely on a high percentage of staff working from home have found that productivity has not dropped significantly and that they actually don’t need all those people into the office at once. These sectors include the tech sector, finance and consulting.
On the flip side, workers have found that their commute was actually a inefficient time void that they had to dedicate their day to and if not going into the office, other residential opportunities become more viable, especially those further away from large cities. If these habits start to become entrenched there is a good chance it could have profound effects on the residential and commercial property markets at the same time and in addition to the already ongoing shifts in retail and malls mentioned above. These scenarios will produce both winners and losers in the new real estate landscape but it isn’t as easy to profit from for novice investors as you would think. Below I am going to lay out who those winners and losers will be in more detail and a contrarian argument via the REIT sector as to why these phenomena may not play out cut and dry via the capital markets as some may be hoping.
The Losers
Retail – There is good reason to assume that the retail sector will remain in decline and continue to accelerate. Those firms that have not successfully pivoted to an online model will quickly die out. Essentially stores are now becoming logistics and software companies. Their job will be to source the products the market wants and make sure they get it to the local or domestic market to meet customers needs at an efficient and reasonable price. The last leg of the job of getting it to your doorstep is outsourced to the packaging companies, although Amazon has moved into this space as well. So expect retail store and mall REITs to continue their decline and be net losers as this force accelerated.
Office – The other potential losers may be those REITs which own large office buildings, especially those which have tenants in particular industries such as software and finance where a high percentage of workers can work from home. These tenants will likely come under cost pressure themselves as the economy weakens and will start to reduce their footprint and renegotiate leases to pay less for the space they do use. In addition, less well off workers using the facilities around the building will put further pressure on the landlords as some of these tenants may try to reduce costs or leave altogether.
Homeowners – That segment of well off homeowners that purchased expensive housing in large urban centers close to work may see some steep declines in the value of their properties. Take for example midtown Manhattan. Prices are sky high to live in places near this area, which is the largest commercial district in the United States. If most of the white collar workers do not need to show up most of the time, they would be less willing to pay a high premium to live closer to the office.
The above factors are one reason office and mall REITs have sold off so much in comparison to residential real estate which would only have a portion of the market affected as opposed to the residential sector as a whole.
The Winners
Corporate Tenants – Those thats rent their office space will have the advantage of having a stronger negotiating hand with owners and benefit in a big way from the reduced cost due to more people working from home. For those that own their own buildings it may be a mixed back. Real estate valuations may have to be marked down but that may open up more space to rent to other tenants, how this plays out for each individual company will depend on how they tackle this challenge.
Home Builders – Home builders were rocked during the last crisis and had only regained their pre-crisis highs as of last year. Further restrictions, more expensive workers and tariffs have all worked to increase costs and actually slow the building of new homes. As consumers shift to further out and more suburban areas though, demand may be able to overcome these costs and spur a new boom for builders.
Home Owners (Again) – The opposite of those in expensive urban centers, those in cheaper suburban settings could see their home prices rise as the phenomenon of more space for working from home takes hold. A wild card is how the Trump tax cuts affect this factor. Deductions were capped for property taxes which favors cities and states where property taxes are low, you get more house for the taxes you pay. It may be easier to live in Georgia, Florida or Alabama in terms of having a large home as opposed to New Jersey. The only difference is logistics when you do have to go into the office.
Urban homeowners have seen bigger upside in the past in large global centers like New York but could cheaper regional centers start to see an uptick? Bloomberg compared past appreciation in New York compres to Atlanta to show the past growth disparities.
How the Market May Adjust
Despite all this, there is a contrarian argument to be made for each of these sectors that look to be in decline and may prove to be the salvation for some REITs.
Mall REITs – Owners can get creative with their spaces, turning old malls into residential complexes or even storage centers. Some of these would require a large investment to convert the property and some would not. There is nothing to say that a mall REIT cannot pivot its strategy towards storage or multi family to not have to sell a property. This will all depend on the skill and vision of management though but some may make the successful transition.
Office – Large tenants may shrink their footprint and leave but this will just drop prices which could attract new tenants. Following the same model they will use less space but if the price is right more of them will come. There may be good reason for smaller companies to want to do this as well. Lower office space prices could make prestigious corporate locations such as Manhattan or London viable for some companies that hasn’t even considered those locations before due to costs. It could actually swing the opposite way and further consolidate even more companies into large urban centers which would balance out the smaller footprint per company.
Home Owners – Urban homeowners may benefit from price declines to upgrade in terms of space. Rather than sell at a loss, they may want to double down, buy the cheap apartment next door and knock down a wall to expand their current dwelling. Although their equity has taken a hit, they could then see the benefits in more space rather than more equity in their original home.
Takeaways
So the outcome of this is not cut and dry and the contrarian arguments end up leaving some room for upside in those segments of the REIT market that have been battered by online shopping as well as the pandemic. We often tend to underestimate the surprise to the upside as we are so focused on the downside. It’s just another reason to stay diversified. The future is tougher to predict than we think sometimes.
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