Finding Value in Post-Pandemic Commercial Real Estate

After a year when terms like “work from home” and “social distancing” were introduced into the popular lexicon and almost all leisure travel was canceled, looking for private commercial real estate opportunities may seem counterintuitive. We believe, however, that disruption drives opportunity, and many sectors of real estate (i.e., urban office, retail, and hotel) will undergo a transformation in the coming years as utilization needs change. While the asset class has suffered throughout the pandemic, several of real estate’s enduring advantages make it especially compelling right now.

Timeless Appeal Meets Timely Opportunity

Investors have long been allocating to real estate, though several aspects of today’s landscape make it particularly attractive. First, the return prospects for traditional asset classes like stocks and bonds over the next decade remain muted. Bernstein’s capital markets forecasts call for global equities to return nearly 5% annualized and global investment grade bonds to deliver roughly 1%. And we expect real returns—after taking inflation into account—to come in even lower. The search for greater return potential has prompted investors who are comfortable with illiquidity to consider a wide range of alternative investments, including real estate.

But modest returns aren’t the only challenge for investors. The chances of an elevated inflationary path emerging in the US over the next decade appear higher today than at any point in recent history. That means hard assets like real estate are coming into greater focus as a potential inflation hedge. Historically, real estate has outperformed other asset classes during periods of higher inflation, in part due to the ability to increase rents. Consider the May 2021 spike in inflation to 3.8%—one of eight sharp spikes over the past 50 years. During those flare-ups, average total returns for REITs (publicly traded real estate stocks) were 24%, outpacing S&P returns (15%).

Interest rates are also playing a key role. Given today’s low prevailing rates, investors can expect to earn a paltry 1.25% on the 10-year US Treasury. By comparison, commercial real estate offers the potential for outsized yields. Just consider the gap between major real estate sector cap rates—or the rate of return you can expect to earn before factoring in any price appreciation—and interest rates. Currently, that spread sits at a historically wide 3.5% (Display). Real estate strategies that employ leverage can take advantage of today’s low borrowing costs to push those yields even higher.

 

Has COVID Changed the Game?

Many astute investors expect real estate returns to outperform equities and bonds as the economic malaise from the pandemic recedes. But others remain less certain, voicing concerns that tend to coalesce around key themes:

• Retail Is Dead: Retail was undergoing a secular shift prior to the pandemic, and its challenges were further amplified by COVID-19. Consequentially, many overbuilt retail locations could be ripe for transformation. For example, certain locations may be transitioned into industrial building space. E-commerce accounts for 14% of total US retail sales and is expected to account for 21% by 2024 and 29% by 2030, supporting strong industrial rent growth and declining vacancy rates (Display).

 

• Hotels Are Empty: Hospitality was impacted the fastest, as travel (domestic and international, leisure and business, group and transient) ground to a halt instantly and has just begun to recover. Because it may take many years for business travel and conferences to reach their pre-pandemic heights, hotels that rely on convention and large group business are still struggling. On the other hand, those that cater to the vacation crowd are starting to see encouraging signs.
• Offices Are Obsolete: While commercial real estate transaction activity dropped to its lowest level in seven years in 2020, much of corporate America is slowly returning to the office. Still, a firm’s footprint is not directly correlated with the share of staff physically present on any given day. In other words, even with three days in the office, businesses will still need conference rooms, reception areas, and other places to gather, so the decline in leased space may not prove as steep as some predict. Additionally, the idea of desk “surfing”—or having an open environment where employees rotate workspaces—no longer makes sense in a COVID world. With this footprint reduction method off the table, fewer employees may return to the office, but those who do will require more space.

Several Opportunities to Find Value

For interested investors, real estate businesses—like other enterprises—offer both equity and debt return streams. Each has distinctive characteristics, leading some to put their money in more than one property basket.

Generally, equity offers greater opportunity for capital appreciation but comes with greater risk. In some cases, ongoing cash flows can help smooth some of the potential volatility. Meanwhile, the debt return streams are safer, in exchange for slightly more modest returns. Real estate debt also typically offers greater income potential. Then there’s a hybrid approach, which combines an equity investment in stabilized properties designed to generate steady, attractive income streams.

The macroeconomic backdrop matters, too. Certain environments—such as stable to declining interest rates with positive economic growth—benefit real estate equities because of lower cost of capital combined with rising demand for property. On the other hand, rising interest rate environments generally are accompanied by strong economic growth and rising inflation, circumstances under which real estate debt issued with floating rates has historically been a beneficiary. In either case, commercial real estate exposure tends to have different return drivers compared to traditional asset classes, making it an excellent portfolio diversifier.

Key Questions to Ask Your Investment Manager

No matter which direction you choose, asking key questions of the portfolio team overseeing your real estate strategy can increase your odds of success:

• What are the supply and demand dynamics for a particular real estate sector? Are there opportunities to take advantage of dislocations? For instance, demand for alternative sources of real estate lending capital in commercial real estate remains high, as traditional lenders such as banks, insurance companies, and CMBS lenders pull back due to regulatory restrictions and compartmentalization of risk.
• What other conditions—such as the ability to capitalize on arbitrage in the financing market—offer a potential tailwind?
• Does the team have a proprietary platform to source and identify attractive off-market opportunities?
• Do they have a proven record structuring and negotiating creative financing solutions, and proactively addressing issues that may arise with an underperforming investment to maximize value for investors?
• What is the underwriting and approval process? Will leverage be employed? How is risk monitored and managed (for instance, are there protective covenant structures for lending)?  

Cashing In on Commercial Real Estate

The timeless case for real estate is that much stronger in today’s environment of low prevailing interest rates, rising inflation prospects, and muted traditional returns. And while COVID has introduced some unique challenges to certain commercial real estate sectors, it has also created opportunities. Real estate equity and debt both offer advantages, and tend to complement one another, along with traditional stock and bond exposure. With the right due diligence and guidance from your financial advisor, you can increase your odds of success.