We’re bullish on barber shops!
A few investors have asked me what the commercial real estate world looks like post virus. This is obviously uncharted territory, so no one truly knows what’s next. Those that claim certainty are amateurs (i.e. economists).
However, it’s useful to start thinking through first and second order consequences so we can identify opportunities quickly.
There should be plenty of targets. The V shaped recovery argument feels like a pipe dream to me. The economy is a giant ship, it can’t turn on a dime.
Pain comes swiftly, recovery takes time.
Under that premise, below are some top-down thoughts on the next 12-24 months for various real estate asset classes. Unlike the Great Financial Crisis, I suspect not all asset classes will suffer deep losses. There will be some clear winners that come out of this relatively unscathed.
Here we go:
(shocker – I started with one of my and probably your favorites)
- Transactions have slowed, but the private equity love fest continues. Plenty of new entrants hungry for scale. The consolidation (from mom & pops to professional operators) phase accelerates
- 100+ pad parks and portfolios in reasonable size markets will continue to command top of market pricing as long as interest rates say near record lows
- Occupancy and net operating income can still grow (albeit more slowly) in recessions – we’re seeing the defensive nature of manufactured housing playing out in real time
- Large owners are reporting April collections of around 97%, which is unreal given the circumstances. Its early, but May collections look strong as well
- No long-term structural changes to the industry due to virus. Business as usual
Single Family Rentals (Bulk Owners)
- Near term collection concerns due to job losses, but once country “re-opens”, this emerging asset class could benefit from crisis. There will be – at least temporarily – additional net migration away from dense cities that were hit hardest by the virus
- We didn’t overbuild homes this cycle – supply / demand story for large rentals is strong
- Freddie Mac research survey found that 84% of renters still believe renting is more affordable than owning, an all-time high for the survey
- Still difficult for the average American to qualify for a mortgage – lenders overcorrected from the credit crisis. This leads to more demand for rentals
- Millennials are still human beings….I think. As soon as that second / or third kid arrives, they too will want another room to escape the crazy – if only for a brief, but glorious ten minutes. Bye, bye Sunday brunch, hello Home Depot. Or perhaps I’m wrong and this is me justifying my life choices
- Online shopping Tsunami counterbalances short term demand loss
- Asset class is unphased thus far; April collections were 95%+
- Some markets are definitely frothy and overbuilt, but growth should bail most owners that can hold long term
- Class A properties (cross dock, 25+ clear heights, in major distribution markets with direct access to major highway or railway infrastructure) feel defensive given the circumstances
The Pretty Good
- Showing resilience (at least for April rents – 93%+ rent collections), Class A (nicest assets) are outperforming. Growing job markets with tight zoning laws are ports in the storm
- Buyer beware of markets where new construction has spiked – construction has finally outpaced demand in many cities
- Underwriting projections (rent & occupancy) that looked modest two months are probably wildly aggressive today – expect lower near-term growth
- Short term – less impacted by COVID due to longer term leases from credit tenants (this excludes those landlords that thought it was smart to lease half their building to WeWork
- Long term – more problematic. A subset of companies will downsize space or non-renew their leases. However, there are plenty of parents that once fantasied about working from home but are now taking conference calls from the car in the garage
- The vast majority of large firms are going to keep their headquarter offices. However, plenty of satellite offices will be on the chopping block
- In other words, the “death of office” calls from the cheap seats are exaggerated, but I still wouldn’t want to own a lot of office product in tertiary markets right now
- Has performed well in prior recessions
- Businesses and homes will be downsizing to save money – all that stuff needs to go somewhere (why that somewhere is not the dumpster is beyond me, but Americans love their junk)
- However, most 24 hour city / major markets are still overbuilt. There will be some distress opportunities (from builders that overleveraged late in the cycle) – will be interesting to see if increased demand (downsizing) outweighs these supply issues in high supply markets
- Luxury malls and outdoor entertainment centers will recover (we all have to get out of the house and do something Friday night). People don’t impulse buy as much online, they are much more likely to blow some cash after a couple salty margs at The Grove (insert your local trendy outdoor mall). Plus, if shelter in place has taught us anything, it’s that home is boring. The crowds will return
- However, the remaining small market, Sears / JC Penny anchored malls built in the 1980s are now on suicide watch
Freaky, post-apocalyptic mall coming to small city near you
Strip Malls (Retail)
- Ouch. Do not pass go, do not collect $200
- April rent collections were between 20-50%
- High percentage of poorly located strip centers without a via grocery store or “essential business” anchor are TOAST – many of these will be converted to alternative uses. Get ready for more trampoline parks!
- On life support until therapeutic solution or vaccine arrives. However, last time I checked, gambling is still addictive and being the house is a legal way to steal.
- The firms that make it to the other side will gobble up competitors and have a bright future.
- Woof. Going to be a rough 12 months. Triple whammy of virus reducing travel coupled with lower economic demand (recession) and too much supply
- The messy middle: top-tier hotels locations backed by big investors will survive. Budget road hotels should see occupancy gains soon as more families opt to fire up the van vs. crowded flights. But middle tier hotels in small markets???
- We’re all Zoom wizards now. Businesses will reduce travel budgets, but conferences will eventually return. For some strange reason Americans can’t get enough conferences.
- Hotel Brands will matter more than ever. Temperature scanning, sanitation stickers everywhere, virus free wristbands. Traveling is about to get weird.
- However, well located hotels don’t have a structural problem (looking at you retail). Don’t get me wrong, plenty of small market, middle-tier hotels are going to zero – but Americans are not going to stop traveling permanently. Pretty sure my wife is still going to opt for the beach hotel over the RV.If there is life, there is travel.
Bottom Line: I don’t suspect this is going to be another 2008 real estate crisis where every asset class tanks. The Fed’s money printer won’t allow that to happen as the world is still starved for yield. Real estate provides a healthy spread over sub 1% bon
Therefore, this feels like sharpshooter opportunity to target specific real estate sectors that are facing near term demand shocks. But buyers will need to be patient – unlike stockholders, distressed real estate owners don’t capitulate overnight.
Just be careful in the sectors that are also facing longer term existential issues. As always, there are exceptions and the specific deal / location trumps sector, but why fight the tide?