Since the end of the global financial crisis, US GDP has grown by roughly $5 trillion, interest rates remain low, and unemployment has fallen below 4%. As a result, commercial real estate has done well. But now the US is approaching the longest economic recovery in history. Some investors are worried that an economic slowdown is on the horizon and the commercial real estate cycle is nearing an end. We agree that an economic slowdown will happen at some point, but we think that matters less for long-term investors in private commercial real estate. Here’s why:
Windows of Opportunity
Investors in private real estate expect their capital to be tied up for extended periods—10 years, in fact, is the typical term for a private fund. Over any 10 years, even over the prolonged expansion of the last decade, opportunities to take advantage of market dislocations occur. At the end of 2018, for example, when the equity markets fell amid uncertainty that caused extreme volatility, long-term investors were able to capitalize on attractive commercial real estate values. We expect this trend to continue. In the meantime, yields on commercial real estate compare favorably to other fixed income investments. So, not only should private investors be less concerned about a cycle as they earn a nice income stream, patient investors should almost welcome down markets because they could offer windows of opportunity to find mispriced assets. Those opportunities, together with solid market fundamentals, paint an optimistic picture for private commercial real estate.
Commercial real estate contains several sectors—notably multifamily, offices, industrial, hotels, and retail. Each has unique drivers of return—urbanization, e-commerce, home ownership rates, and a strong economy, for example— but they also have one common key determinant of a healthy market—the balance between supply and demand. When supply and demand are balanced, the market is said to be in equilibrium; but if there is an imbalance, prices react—if demand is more significant than supply, prices tend to rise, and if supply is greater than demand, prices fall. Take multifamily housing, for example.
Today, many Americans prefer to rent, not buy, a home. Homeownership rates have fallen dramatically since the 2004 highs and are now below 1997 levels (Display 1). Part of this stems from millennials who are delaying homeownership, but it’s also an outgrowth of an urbanization trend.
This propensity to rent leads to a favorable rental demand picture. At the same time, supply has been generally in check in most markets and rental vacancy rates are still below 1997 levels. This aggregate demand and supply imbalance favors increasing rental rates (Display 2, left side).
Offices have a similar dynamic. Several forces are changing the office landscape—open floor plans with smaller work areas per employee, more amenities, a move away from suburban areas, following the urbanization trend, and a reversal of full-time teleworking arrangements. There are also new arrangements—co-working businesses that share space. More and more companies are moving locations or desiring updated facilities to follow these trends. The result of this growing demand, with relatively flat vacancy rates—consistent supply—has increased rental rates over the last eight years.
Industrial spaces, such as warehouses, fulfillment centers, and logistics properties, are experiencing a new type of demand resulting from e-commerce. E-commerce requires three times more distribution space per dollar spent than traditional retail because distribution is more complicated and decentralized to go to individual homes instead of a centralized store. Additionally, to accommodate faster shipping times, fulfillment centers tend to be smaller than warehouses, but located near urban centers. The result: declining vacancies with growing rents per square foot (Display 2, right side).
Hotels, on the other hand, have some positive drivers but are also contending with new competitive threats from technology. Technology companies, like Airbnb, that connect homeowners with potential short-term renters on their platform, are threatening both room and occupancy rates. At the same time, hotels are being gouged by online travel agents, who don’t get commissions from airline companies, so they try to take them from hotels. Despite this, positive trends stemming from a focus on the consumer experience and a healthy economy are still benefiting hotel demand. Average daily rates have steadily climbed since the financial crisis in spite of occupancy rates remaining at mid-60% levels.
The one negative sector is retail. We’ve all heard about the problems facing retailers—competition from e-commerce and an overstored landscape, high legacy debt, and millennials desire to spend money on experiences rather than goods. But this “100-year storm,” we think, may ultimately provide opportunities as “brick and mortar” retail isn’t going away but is instead being reconfigured to appeal to shoppers’ preferences. So by having a long investment time horizon, private real estate can profit from changes sweeping through the retail landscape.
Making Money Throughout the Cycle
Markets are fluid, especially long-cycled ones like commercial real estate. That means that opportunities will present themselves to those who invest over a prolonged time frame. Private real estate doesn’t come with the discomfiting daily ups and downs of the stock market but tying funds up in illiquid investments can still worry investors. However, appropriately diversified real estate exposure can help mitigate risk and position patient investors to benefit from this enduring asset class.
- Greg Young, CFA
- Senior Investment Strategist—Investment Strategies