Listed real estate investment trusts remain down more than 10% year-to-date, failing to fully participate in the recovery from the market’s March lows. Retail mall REITs have been among the market’s worst performers, with some losing more than 50% for the year. Brick-and-mortar retailers have been crushed by the pandemic, with temporary store closures and acceleration of e-commerce adoption amplifying pressure on stores and mall operators.
Lodging REITs have also performed poorly, as hotel occupancy collapsed amidst drastic reduction in business and personal travel. Offices around the country are largely empty, with employees working from home at an unprecedented rate. Although office vacancy rates have remained stable, major employers may shrink their real estate footprint when leases expire.
High unemployment rates may also hurt the real estate market, as multifamily apartments could face rent delinquencies and rising vacancy rates if the economy remains weak for an extended period.
But despite the many risks, there are compelling reasons to selectively invest in real estate.
Regional malls have been the epicenter of e-commerce’s impact on retailers and, by extension, retail real estate landlords. Not all retail properties face distress, as necessity and convenience-driven retail, such as grocery-anchored shopping centers, convenience stores and gas stations, are experiencing fewer problems with rent delinquencies and defaults.
These tenants provide essential goods and services, making them much more defensive and less vulnerable to e-commerce than tenants in regional malls, whose products tend to be discretionary and more easily ordered online and delivered directly to homes.
Distress among retail malls dominates the headlines, but real estate is far more than the retail segment. Multifamily vacancy rates are typically stable due to inelastic demand, but some investors fear that the pandemic will change household preferences from renting to owning while creating an exodus from densely populated urban areas.
The constrained supply of single-family homes for purchase (or rental) and continued tight lending standards make a major decline in demand for multifamily unlikely. In the multifamily residential segment, pressure may build in the luxury tower market in major cities. “Workforce” housing catering to lower wage workers may also face pressure given the disproportionate impact of the pandemic on lower-wage workers. Upscale suburban garden-level apartments located in highly rated school districts may be “COVID beneficiaries” as more renters seek to move away from densely populated urban areas.
Rent collections in the multifamily segment have averaged in the high 90s despite the pandemic, and tenant turnover has been lower than is normally the case.
Rent collections in the office segment also remain high, but the long-term outlook is less encouraging. Vacancy rates are expected to rise for central business district office properties as working from home becomes the norm in a post-pandemic world. Steps to “de-densify” workplaces may partially offset the trend to have fewer workers in the office every day, though it will be costly to reconfigure offices.
The worst-case scenario for office buildings and downtown cores may be exaggerated. There is a big difference between working from home one or two days per week and working from home five days a week. Most employers have concerns about maintaining productivity, integrating new employees and preserving culture in a work-from-home world. It is likely that workplace flexibility will be of greater importance in a post-pandemic world, but that the need for a physical workplace will continue. There may also be COVID beneficiaries within the office property segment, as suburban office and medical office properties may see gains in demand for office space.
Real Estate Winners
Industrial properties have been the big winners from the explosion in e-commerce. Industrial vacancies were at record lows, and pricing was quite competitive entering the pandemic. The pandemic has accelerated demand for industrial office space, and it may take some time for supply to catch up. Industrial and warehouse assets historically have been highly cyclical, but the e-commerce trend appears to be reducing the segment’s cyclicality.
The public real estate market has evolved dramatically over the past decade. The three largest subsectors of infrastructure (cell towers), data centers and industrial warehouses make up more than 40% of the REIT universe. Two of these categories did not exist 10 years ago; all three benefit from the increase of telecommuting and e-commerce adoption. Retail is now a much smaller part of public real estate market capitalization given long-term secular decline.
Real estate is one asset class in which investors can add value by emphasizing or de-emphasizing real estate segments based on the fundamental analysis of valuations, market outlook, supply and demand.
The pandemic-induced equity market sell-off resulted in indiscriminate selling across the board, which creates opportunities in several of the real estate segments perceived as “COVID losers.” There may even be some opportunities within the hardest-hit segments of the market — retail and lodging properties.
In looking at the highest-risk segments of the market, it is important to examine whether the company’s balance sheets and liquidity provide enough of a “bridge” to get to the other side of the pandemic. It is also important to assess the sustainability of the company’s business model post-pandemic. For example, hotels that cater more to leisure travelers may be better positioned than hotels that rely on business travel that may not recover to pre-pandemic levels.
It appears that high-quality private and public real estate rents have stabilized despite highly uncertain times, which is evidence of the durability of cash flows for the asset class. Relative to stocks and bonds, valuations seem favorable given the market selloff of REITs, historic low interest rates and high valuations of equities. The relative valuations may be a potential tailwind for selective investors.
Daniel S. Kern is chief investment officer of TFC Financial Management, an independent, fee-only financial advisory firm based in Boston.
Prior to joining TFC, Daniel was president and CIO of Advisor Partners. Previously, Daniel was managing director and portfolio manager for Charles Schwab Investment Management, managing asset allocation funds and serving as CFO of the Laudus Funds.
Daniel is a graduate of Brandeis University and earned his MBA in finance from the University of California, Berkeley. He is a CFA charterholder and a former president of the CFA Society of San Francisco. He also sits on the Board of Trustees for the Green Century Funds.