Real estate has had a very good run during the past several years. In fact, values in most major markets are now at or above pre-crisis peaks. This comeback should give investors a warm fuzzy feeling — real estate took the worst the universe could throw at it and bounced back stronger than ever. Instead, investors and industry pundits are nervous and forecasting that it is only a matter of time, maybe a very short time, before real estate falls again.
Doomsday predictions have a tendency of turning into self-fulfilling prophecies. Indeed, investment activity for the first half of the year was down about 15 percent year over year, according to Real Capital Analytics. More specifically, transaction volume in the multifamily sector, which was the largest and most liquid investment market for most of 2015 and 2016, was down 25 percent. Office is down 5 percent for the first half of 2017 when compared to first half 2016.
In addition, equity REIT returns year to date have fallen to just 2.86 percent, compared to gains of 8.66 percent for the S&P 500 and 7.47 percent for the Dow Jones Industrial Average.
But looking at real estate through a wide-angle lens at 30,000 feet runs the risk of missing the advantages still found when looking at real estate from ground level. Except for the retail sector, for example, prices are not falling, despite lower transaction volume. Some markets and sectors might be seeing values flattening, but many are still increasing and look to continue that way.
And, maybe most importantly, investors typically add real estate to their portfolios for its income potential. In that respect, real estate is still outperforming other asset classes. Dividends for NAREIT equity REITs currently average 3.87 percent compared to 1.99 percent for the S&P 500 and 2.21 percent for 10-year Treasuries.
Real estate has always been a nuanced investment, and today’s climate is no different. If you look beneath the surface, there are still plenty of sectors, markets and investment structures that are hot, as well as plenty that are not. Figuring out which is which is the key to success.
FINDING VALUE
“What’s hot is the real estate that has value in today’s economy,” says Scott Crowe, chief investment strategist at CenterSquare Investment Management. “It is the stuff we need more of because that’s the direction the economy is heading. What’s not hot is the stuff we need less of.”
So, what direction is the economy heading? Simply, hot sectors and asset classes are being driven by the needs and wants of the millennial cohort, and by the needs and wants of e-commerce and the tech industry.
In general, the millennial workforce prefers urban settings to suburban. It looks for amenities such as retail in the building and proximity to transportation hubs. Energy-efficient and LEED certified buildings have an advantage over older, less environmentally friendly assets. Choosing assets that fit this profile will provide a better chance of future success than relying on less-preferred asset types.
Investors would also do well to look beneath the surface when it comes to choosing markets because the tech and e-commerce industries are revitalizing some currently overlooked Rust Belt cities. Pittsburgh, for example, is the epicenter for driverless cars, thanks to the research being done at Carnegie Mellon University and the city’s embrace of technology. Harrisburg, Pa., is within an hour’s drive of an enormous percentage of the country’s population, making it one of the two largest distribution centers in the country. Greenville, S.C., is experiencing a growth boom as global manufacturing firms, such as BMW and Michelin, open North American headquarters in the area. Other non-gateway cities that have keyed into the needs of the evolving economy are finding the same sort of growth.
“Areas where younger people want to live will be the growth centers of the future,” says Tim Lee, vice president corporate development and legal affairs at Olive Hill Group. “These will likely include some of today’s secondary markets, such as Seattle, Austin and Denver.”
SPECIFIC SECTORS
Getting down to specifics, what looks hot and will continue to look hot are real estate types such as data centers, distribution facilities, creative office and single-family homes for rent. These sectors are all connected by the demands of e-commerce and the millennial workforce. What’s not hot is retail and healthcare.
E-commerce is taking the blame for the death of brick-and-mortar retail, but it is, at the same time, driving the best brick-and-mortar opportunities in other sectors. Data centers, for example, are the physical infrastructure for e-commerce and the digital economy. The “cloud” is simply a data center network.
“Data centers are up 23 percent this year,” says Eric Flett, CEO of Concentric Wealth Management. “Industrial space is also surging. It was up 30 percent in 2016 and another 8 percent so far this year.”
The growth of industrial is no surprise, given the reliance of e-commerce on both large-scale 200,000 to 300,000 square-foot warehouses and small, last-mile distribution centers.
“The growth of e-retailing has necessitated the reconstruction of the supply chain,” says Crowe. “This creates a hot market for real estate investors because we are the ones who are creating that chain through real estate assets.”
The overall office sector might be past its peak, but the creative office subset is doing very well. Creative office is easier to describe than define. It is the flexible office space that allows open floor plans, shared office space, mixed-use office and research or warehouse, and other permutations on the standard office layout. It often involves a campus feel with lots of outdoor space.
“We are no longer tied to a desk the way we used to be,” says Lee. “To meet the needs of modern workers — particularly tech, visual media and services professionals — we look for assets that combine outdoor work space with modern build-out space. We are not looking for standalone buildings in an office park, but for creative office space near multifamily developments. Employees like walking to work.”
OPPORTUNITIES AMONG THE STRUGGLERS
Everyone agrees there are a few investment sectors to avoid. Mid-sector grocery and department stores do not seem to have anything going for them. Obsolete suburban office buildings will find it hard to attract tenants. Values of luxury condominiums in overbuilt locations, particularly New York City and Miami, are nearing crash levels. Even the darling of many investors — multifamily — is finding its fortunes turning as too many developers saw the opportunity over the past couple of years and ended up oversupplying the demand. And healthcare has simply never taken off the way everyone expected it to.
“Healthcare is a sector that should be doing well, given demographics, but is not and probably will not,” says Crowe. “The U.S. spends about $10,000 per person per year on healthcare, which is more than twice the average of other developed countries. But if you look at outcomes, it’s far below most other countries. That means we are probably going to be spending less on healthcare, and that will put pressure on the industry.”
But even sectors that fall in the “not hot” column have spots of glowing embers. For example, we are probably not going to see a large number of new hospitals or nursing homes being built. But we are seeing an upswing in medical office buildings. These are assets, built near a large medical center, that handle outpatient care. Historically, patients left the hospital and went to a skilled nursing facility, where all the rehabilitative services came to them. Now patients are sent home, and they access services themselves.
For investors willing to rake through multiple levels of ash to find a warm ember or two, the retail sector might just satisfy their need for long shots.
“There is enough dislocation happening in the retail sector, and especially in malls, that there should be some opportunities there,” says Nina Streeter, director of asset management at Abbot Downing. “Investors should consider whether the best approach is to buy assets directly, purchase the debt, short specific REITs, take contrarian views and go long certain REITs, or arbitrage the stocks/indexes. However you approach it, there should be an opportunity either in the physical assets or in the financial ones.”
All retail is not alike. Despite the challenges facing mid-quality retail, high-quality retail is still extremely valuable.
“The death of retail real estate is greatly exaggerated,” says Flett. “The fact that Amazon is willing to pay $13.7 billion for a grocery store with 450 retail locations tells me that there is value in having high-quality dirt in the right places.”
Multifamily is another sector that might be looking at its best days in the rear-view mirror, but it still has investors finding warm spots, particularly in the value-added space in supply-constrained markets.
“Multifamily still has a long runway,” says Max Sharkansky, managing partner at Trion Properties. “For example, by targeting ‘diamond-in-the-rough’ multifamily communities in urban infill locations, investors can source attractive deals below replacement cost. These assets often have rents well-below market, allowing investors to capitalize on rent appreciation and generate strong risk-
adjusted returns to investors. By acquiring and repositioning undermanaged assets, investors can deliver a value-oriented alternative to new construction, ensuring that their properties stay competitive with new luxury product being delivered to the market.”
In addition to focusing on undermanaged and underutilized multifamily properties, investors should target emerging gateway submarkets where there is plenty of room for rent growth.
“For example, rather than investing in the heart of San Francisco, which is currently experiencing tremendous competition and peak pricing, investors that acquire multifamily in the neighboring East Bay submarkets will find the most long-term value in the years ahead,” continues Sharkansky.
SOMETIMES HEAT BURNS
While no one wants to find themselves in a failing investment, focusing on what is hot in the moment comes with its own perils.
“Following what’s hot and what’s not is constantly chasing your tail,” says Lee. “What’s hot now will not be in the future. Better to dig in and find today’s opportunities. Real estate isn’t rocket science. It’s about understanding people and how they like to live, work or be serviced. Stay focused on fundamentals and don’t invest by headlines.”
One way to avoid competition and rising prices in today’s sellers’ markets is to look at new ways to access standard investments. This might mean looking at different investment structures, or looking at the debt side instead of the equity side of some investments. It might also mean looking at traditional sectors outside the United States.
“European nonperforming loan pools purchased from the European banks have looked attractive for the past several years on a risk/return basis,” says Streeter. “From a global perspective, we believe European assets are a better value than those in the U.S., so this is a way for our clients to gain exposure to the asset class while benefitting from one of the few available areas of distress in the markets today.”
ENJOYING THE WARMTH
Real estate is a cyclical asset class. What is hot today will undoubtedly be cold tomorrow. Instead of trying to time the market to make the perfect investment, investors would be well served to focus on fundamentals and look at real estate as a long-term investment meant to ride out short-term volatility. It is just as painful to be burned by an overheated market as it is to be frostbitten by an ice cold one. Aim for the middle ground. Just enough heat to make perfect s’mores. Not so much that you use up all the firewood before the night is over.
Sheila Hopkins is a freelance writer based in Myrtle Beach, S.C.