“Nothing can go wrong…until it does.”
“You don’t see the lightning bolt that hits you.”
If you know me or have read a few of my blogs, you may have heard these phrases before. They are two of my favorites when talking about commercial real estate. Here is why.
Economic Forecasts: Cause for Concern?
January was filled with economists touting their forecasts. It was interesting that these prognosticators were all saying the same thing. In my experience, when they are lined up like that, there tends to be a blind spot. Or they minimize a factor that turns out to be significant. Hence, my phrases above.
The consensus is this: after a slow start in Q1 (and maybe Q2), the economy is going to roar back. The cause? Acceleration in vaccines which will help control COVID-19, pent up demand (mostly for travel and entertainment), unusually high savings and Federal stimulus.
In my opinion, there are several bogies in the room:
- First is efficacy of the vaccine and how we adapt to living with this virus, which likely will not be eradicated.
- Second is the lingering impact on low-wage workers who have been out of work even after their jobs return. They might never catch up.
- Third is looming inflation and how the Fed will respond to it.
- Last are the high valuations in the equity and real estate markets, which look more and more like a “bubble,” ready to burst with a pinprick.
What’s Happening in the CRE Sectors?
Further proving the truth of my “lightning bolt” theory is one of my early 2020 blogs, “CRE 2020: What to Expect.” A quick re-read clearly indicates that neither NREI nor myself had any idea what was about to rock the world one month following that post.
So, let us look at a snapshot of the CRE sectors right now. See if you can spot the red flags.
- Industrial: By now, it is no surprise to you that industrial is scorching hot, being driven by e-commerce. Buildings cannot be built fast enough. Developers might have to move farther from central locations with a dwindling supply of close-in industrial land.
- Rental Housing: This sector is 2nd hottest. People are still renting apartments, but with people wanting more space and prices for single-family houses now “off-the-chart,” single-family rentals grow in popularity. Traditionally for investors only, we now see new single-family homes for rent developed on spec basis.
- Office: Consensus indicates most people want to return to the office, but a significant percentage will work from home several days per week. In addition, future office space design will allow for “social distancing.” In my opinion, the net result of these trends will be a stagnant office leasing market in the next one to two years followed by slower growth than would have occurred without the pandemic’s impact.
- Retail: This sector is in turmoil with all but the top malls being distressed, restaurants closing, and small retailers hurt by e-commerce. Those that emerge will do well, but it could take a while for the industry to recover.
- Hospitality: Arguably the hardest hit sector. It will be three to five years minimum before this sector returns to pre-COVID-19 levels.
Where Are We in the CRE Cycle?
As mentioned in previous blogs, many of the current trends were already happening—COVID-19 just accelerated them. Market disruptions always weed out the weak players, allowing those who are better prepared, armed with capital and less debt, and anticipating the trends to thrive. This time the same holds true.
However, two differences are emerging. The first is the extraordinary amount of capital on the sidelines looking for deals. This has not only pushed up the price of all assets to record levels (with no end in sight), but also will cushion the downward price pressure on distressed assets. Many people are anticipating a buying opportunity greater than the Great Recession, but I do not see it, except maybe for hospitality. Even now, the pace of transactions has slowed as buyers resist those sellers who seek to buy at distressed levels.
Also, this is not just a market disruption where there will be a rebalancing of supply and demand as the economy recovers. Instead, the demand drivers will be different this time, which results in space being used differently and in old technology companies falling by the wayside.
In addition, government policies, particularly in states like New York and California, have resulted in their residents’ migration to Texas, Florida, Arizona and even Georgia. So where will you want to invest?
With a value-add based platform, I find the market for new deals challenging right now. If you still feel the need to invest in this market or any market based on future growth, I advise you to be patient and invest for the long-term. Low interest rates today and future inflation will support this strategy.
I would also advise conservative use of debt even though it will lower the current yield slightly. This will protect you from the possibility of loss from a short-term correction because like I said at the beginning:
Nothing can go wrong…until it does.