Written by: Samira Fatehyar
Introduction
Before I talk about anything in this blog, I just want to say that with everything going on in the country right now, it’s hard to just focus on the economy when everything else seems to be in chaos. Apologies for sending this blog post out later than usual. A lot of this was written before we started seeing protests and riots erupting around the nation. I did add a section at the end to talk about where I think we could be going with the current social unrest we are witnessing.
With everything going on in the economy, I thought it would be a great time to step back and look at the real estate market and see if there are any trends in sight. The rule of thumb is that the real estate market usually lags behind economic shocks by about 3-6 months. I thought I’d take a stab at it and see what could be found right now in terms of trends or data that suggests we are moving a certain direction. My thoughts are that we are probably going to see prices decline and cap rates increase. For my many real estate colleagues, I think this will be pretty redundant in what you already know, but I feel like others would benefit from the knowledge of all of this.
Real Estate Market
Commercial Real Estate
I will start with the commercial real estate market and then talk about residential later on. I think it would be helpful to those not in the real estate industry to get a sense of what commercial real estate is. Commercial real estate is essentially made up of retail, office, industrial, multifamily, as well as mixed use. I will separate each sector and talk about them in terms of their REIT returns because that is the most easily available data to analyze the current state of the commercial real estate market.
Retail Sector
Over the past several years, due to the online business model, retail had already taken a big hit. The Millennial generation is in search of more of an experiential way of life. In general, they prefer experiences to accumulating things. Granted, they still buy consumer goods, but not in the same way previous generations have. Because of this, millennials have the desire to have an experiential retail experience. Why go out somewhere to buy something when it can all be done online nowadays? There is something that needs to entice them to go out and that is the experiential aspect. So, even before Covid-19 days, the retail sector was struggling because of this growing trend. Adding Covid-19 into the mix, we see a sector that is absolutely struggling. Many have called this the retail apocalypse. Table 1-A, below illustrates this point.
Before I get into the table, I think I should first explain what REITs are as well as Nareit. REITs, or real estate investment trusts, are companies that own, manage, and/or finance income producing properties. These companies have shares that are publicly traded so investors can buy these and receive a dividend without having to actually buy physical property. There are certain requirements to become a REIT, two important criteria include investing at least 75% of total assets into real estate, US treasuries, or cash as well as paying a minimum of 90% of taxable income through shareholder dividends every year. There are also three types of REITs: equity, mortgage, and a hybrid of both.
Nareit is the National Association of Real Estate Investment Trusts. The importance of Nareit is that it publicly provides REIT performance data.
Table 1-A
FTSE Nareit U.S. Real Estate Index Series Daily Returns as of May 28th, 2020, highlighting Retail
https://www.reit.com/sites/default/files/returns/DomesticReturns.pdf
Now, looking at Table 1-A, we see quite a bit of data. I’ve highlighted the retail sector to illustrate how much the retail sector has been struggling.
Looking at the year to date (YTD) return for retail as a whole, it is down -42.62% which is reasonable considering all the temporary closures brought on by the Covid-19 pandemic. The importance of this table is also found in the compound annual total returns which has seen a 10 year total return of 2.93%, 5 year total return of -9.44%, 3 year total return of -12.75%, and a 1 year total return of -42.12%. What this shows us is that the trend in retail space has become worse in recent years. Many believe it will continue to get worse unless retailers can figure out a way to adapt to the experiential atmosphere that millennials desire.
It should be noted many analysts predict that big corporation names are going to weather this storm pretty well, but unfortunately this isn’t the case for many. Starbucks recently sent letters to landlords asking for 12 months worth of rent concessions starting June 1st. This is a bit of a shock to landlords because Starbucks, at least those with a drive thru option, remained opened during the lockdowns put in place due to Covid-19. Looking at Starbucks stock prices number in Graph 1 below, we see that their year to date return was -9.03%. A terrible return but to ask for a years worth of concessions shows just how bad it must be internally financially.
Graph 1
YTD Return for Starbucks Stock
https://finance.yahoo.com/chart/SBUX
As more and more retailers declare bankruptcy and find other cost saving strategies, retail landlords will have to figure out another way to market their space. As of May 29th, 2020, retailers have announced 3,600 stores closing this year and we are only about half way through the year. According to Business Insider, the list includes Walgreens, Victoria Secret, Tuesday Morning, Forever 21, Sears, Bath & Body Works, Pier 1, Game Stop, Nordstrom, and many others. In that article, it stated that Cushman & Wakefield predicted last year (before the Covid-19 pandemic) that as many as 12,000 stores could close in 2020. It’s no surprise that retail stores as we know it will soon be a thing of the past.
Office Sector
The office sector has undergone a quite dramatic change, similar to that of the retail sector. Many millennials are opting for remote work as they care to travel more and spend less time in a traditional office and clocking in the traditional hours of 9am to 5pm. Again, this all comes back to the emphasis of experiences as opposed to the more traditional lifestyle. With that being said, many tech start ups are either going remote or embracing the co-working spaces. Now, Covid-19 has thrown a curve ball since even co-working spaces could prove hazardous because of the proximity of everyone as well as shared resources. This could be mitigated through daily cleanings and other safety measures, but it would prove to be more cost effective to remain or become remote for many small to medium size businesses.
Looking at the same table that we looked at for retail REITs, we see that the office sector is also listed on there. I’ve highlighted the office numbers to help emphasis how negative the numbers are in Table 1-B below.
Table 1-B
FTSE Nareit U.S. Real Estate Index Series Daily Returns, as of May 28th, 2020, highlighting Office
https://www.reit.com/sites/default/files/returns/DomesticReturns.pdf
Looking at Table 1-B above, it’s obvious that office has also followed a very similar trend to retail but not as severe. Looking at the YTD returns, we see a -26.14% return. Not as severe as retail, but still not a very good sign. Looking at the trend of compound annual total returns we see that over a 10 year return of 5.05%,a 5 year return of -0.22%, a 3 year return of -4.48%, and a 1 year period return of -18.39%. Again, not as bad as retail, but in more recent years a more major decline trend becoming prevalent.
I don’t foresee office undergoing as radical a change as the retail sector, but I do foresee a massive reduction of companies wanting to use office space. Of course, there are some industries that need office space, like healthcare, government, as well as big corporations to house their headquarters, but I think many will be minimizing the space they once occupied. This will definitely be the case as businesses experienced their overhead expenses decline during the lockdown brought on by the Covid-19 pandemic. Major changes are around the corner for this sector and many of these changes are again due to millennials desiring a different lifestyle.
Many people have asked me about WeWork and the future of co-working space. I was never a fan of WeWork’s business model because of the increased liability they had by leasing out spaces from landlords as opposed to acquiring it themselves. That ended up causing problems for them in the long-run. But, I do believe there is a future for co-working spaces, especially as many companies reduce the space needed for their offices. Many employees will want to work from home, but I know many others will want to feel as if they are in an office environment and this will help with that need. Startups are even getting into the co-working space, so there is definitely a space in the industry for it.
Industrial Sector
The industrial sector seems to be the strongest sector in the commercial real estate industry. I tend to group industrial by these groups: warehouse space, flex R&D, data centers, and self storage. There’s been a growing trend towards industrial for a multitude of reasons; aesthetics, cost, and durability to name a few. Aesthetics because we live in an era that desires a modern minimalistic industrial look to things. Cost because the cost to build industrial space is far less than any other type of space in commercial real estate as well as leasing the space (in most cases). Durability because if it’s done right with concrete tilt up walls it can last far longer than the normal wood based structures other commercial real estate sectors use. I may be biased to this sector as I grew up in a commercial real estate investment firm that solely invests in it, but I see the many advantages to it.
Now looking at the REIT data available, the same table we’ve looked at before, we focus in on the industrial sector. I’ve also included self storage as well as data centers into this. Table 1-C is provided below.
Table 1-C
FTSE Nareit U.S. Real Estate Index Series Daily Returns, as of May 28th, 2020, highlighting Industrial, Self Storage, and Data Centers
https://www.reit.com/sites/default/files/returns/DomesticReturns.pdf
As we can see in the highlight portions of Table 1-C, Industrial and Data Centers are the only ones with positive YTD, even self storage took a negative hit of 6.07%. A trend to highlight is Industrial’s compound annual total returns which had a positive 10 year return of 16.93%, a 5 year return of 20.16%, a 3 year return of 17.6%, and a1 year return of 20.07%. This is something very interesting because it shows that there is a positive trend in the industrial sector.
Self-storage in Table 1-C shows a bit of a different story but it is still fairly strong compared to other sectors. It did take a YTD return hit of -6.07%, and a compound annual total returns hit of -7.75% for 1 year, but over the 3, 5, and 10 year returns it was still positive. Though, it should be noted that there has been a decreasing trend over the 10, 5, 3, and 1 year returns. I suspect this has to do with people not needed self-storage as much. I also suspect that in economic downturns more people tend to rent units these self-storage facilities because of downsizing their living quarters to bare any financial burdens.
Data centers in Table 1-C shows just how strong that sector is. It has had a YTD return of 19.49%, the highest of any sector listed in this table. The compound annual total returns only shows a small history but even within the 3 and 1 year returns, we see an increasing trend of 15.51% and 34.76%, respectively.
So to recap, industrial has remained somewhat steady in their returns, self-storage has declined (I suspect an increase as the economic downfall worsens), and data centers have increased over the past 3 years. Industrial seems like a pretty safe asset based on this data. Although, I do believe the prices on these assets are still too high, they will probably decline in price but they will continue to be the leading asset in terms of returns in the short and long term.
Multifamily Sector
A lot of people confuse multifamily with being part of the residential sector. In the industry, we group multifamily, of more than 4 units, to be part of commercial. Residential is considered to be single family homes and 4-plexes or less. That being said, the multifamily sector has had its share of difficulties due to the Covid-19 pandemic as well as the rising rent prices and slow growth of wages. Many colleagues have pointed out that due to the lockdowns, many people will be more focused on getting a the right type of place to live and work remotely. They assume growth in multifamily. I don’t think they are wrong, but that they are currently valuing multifamily assets too high. As more people turn to remote work, it’s no surprise that many will be focused on finding the right place for themselves. But again, with the slow growth of wages as compared to the cost of living, the cap rates on these buildings will have to rise to make it attractive and sustainable in the long run. By this I mean, rent rates will have to decrease which in turn will decrease the value of the entire asset.
Now let’s look at the same table we have been looking at Table 1-D. below, which highlights the multifamily sector.
Table 1-D
FTSE Nareit U.S. Real Estate Index Series Daily Returns, as of May 28th, 2020, highlighting Apartments
https://www.reit.com/sites/default/files/returns/DomesticReturns.pdf
Looking at the numbers highlighted in yellow, we see apartments which is essentially multifamily. Looking at YTD returns we see a -19.83%, which is substantially negative but not as negative as office or retail. Again, a same trend can be seen when looking at the compound total annual returns where we see a 10 year return of 9.58%, a 5 year return of 4.37%, a 3 year return of 1.45%, and a 1 year return of -13.84%. It’s an ever decreasing trend in returns and I believe this is caused by assets be overvalued and not as many people being able to pay rent at high rates.
Residential Real Estate
I’ve seen a lot of articles saying how new home sales are up or that mortgage applications are up. This has taken me by surprise for many reasons. I will say that it’s currently a very strange time in the residential real estate market. We can take a look at the REIT data pertaining to both manufactured and single family homes as well as home financing REITS, found in Table 1-E below.
Table 1-E
FTSE Nareit U.S. Real Estate Index Series Daily Returns, as of May 28th, 2020, highlighting Manufactured and Single Family Homes as well as Home Financing
https://www.reit.com/sites/default/files/returns/DomesticReturns.pdf
Looking at the manufactured home data we see YTD returns at -9.56% rate as well as a decreasing trend from 10 year compound annual total returns all the way to 1 year returns. This should be a signal that manufactured homes are starting to decline as well.
Now, looking at single family home data, we also see YTD returns at -9.76%. There is also a decreasing trend over years shown but because single family home REITs haven’t been around for more than 3 years we can only see 3 years worth of returns. It should be pointed out that quarter to date returns are pretty strong, with an increase of 16.82% returns, but looking at the negative YTD return helps put it in perspective.
Home financing REITs have had some turbulent times with similar returns seen in the retail sector. A YTD return is observed at a rate of -47.77%. And a very negative trend over the last 10 years in compound annual total returns. This means that these REITs are not making any money and are not doing well on the home financing front.
I wanted to make sense of these headlines seen in the news, though. So I went off to see Fannie Mae’s data. Overall Fannie Mae has predicted that home sales will decline but they still foresee home prices to remain either steady or even increase. Tables 2 and 3 below shows Fannie Mae housing forecasts from April 2020 and May 2020, respectively.
Table 2
Fannie Mae Housing Forecast: April 2020
https://www.fanniemae.com/resources/file/research/emma/pdf/Housing_Forecast_041520.pdf
Table 3
Fannie Mae Housing Forecast: May 2020
https://www.fanniemae.com/resources/file/research/emma/pdf/Housing_Forecast_051320.pdf
I’ve attached both because I wanted to show how Fannie Mae’s forecasts changed to become more negative from April to May. Predictions for Total Housing Starts, or new home (single family or multifamily) construction, year on year percentage change, for 2020 decreased from -9.3% to -10.2%. Fannie Mae’s prediction for Total Home Sales (including newly built and existing dwellings) declined from -14.7% to -14.8%. Not a big difference, but for the new homes being sold, their prediction declined from -11.9% to -14.6%.
Like I mentioned before, Fannie Mae is predicting that the median price for both new and existing homes will increase by $4,000 and $5,000, respectively from the year before. They are also expecting mortgage rates to continue to decrease in 2020 and 2021. Another important note to highlight is the single family mortgage origination figures. Between those that are for purchase vs. refinancing, 58% is for refinancing while the remaining 42% is purchases. Quite a high figure for refinancing. I suspect that because of the overall origination figures increasing, it has led many to believe people are buying homes when they are in fact just refinancing.
Consumer Spending, Confidence, and Personal Income
It’s always important to look at consumer spending and confidence as leading indicators for where the economy is headed. Behavioral economics and finance is becoming a popular subset of each field. Looking at these three measures we see a lot of different stories coming from each. The BEA (Bureau of Economic Analysis) released the numbers on May 29th, 2020 and can be found in Table 4 below.
Table 4
Personal Income and Outlays
https://www.bea.gov/news/2020/personal-income-and-outlays-april-2020
Looking at Table 4, we see changes in personal income and personal consumption. Looking at personal income, we see an increase of 10.5% which was mostly due to the government aid distributed in forms of $1,200 checks to people as well as unemployment benefits. It’s a figure that can be misleading since we are still seeing record level unemployments across the US.
If we go down and look at personal consumption expenditures or PCE, we see a growth of -13.6%. Let me highlight this because this is the biggest drop ever recorded. If consumer’s income increase, why did we see a major consumption decrease? This could be for a multitude of reasons. Many of these people used their stimulus check to pay for essentials such as, rent, medical expenses, and food. We are a consumer based economy, meaning we are heavily reliant upon people spending on non-essential goods and services. We are in a dire economic crisis at the moment so people are saving their money as well as spending only on essentials. Because of this we are expected to see second quarter GDP numbers to show a drastic negative growth rate. This will reaffirm that we are indeed in a recession if not entering a period of an economic depression.
Another measure I wanted to highlight was that of consumer confidence. Although this measure is solely based on the psychology of consumers, it is extremely important to focus on because at the end of the day, many consumer’s spending habits are influence by behavior. Graph 2 below illustrates the level of consumer confidence, dating back to June 1st, 2007 to present day (June 1st, 2020).
Graph 2
Consumer Confidence from June 1st, 2007 to June 1st, 2020
https://tradingeconomics.com/united-states/consumer-confidence
As we can see in Graph 2, the drop in consumer confidence has not reached the levels seen during the Great Recession. It should be pointed out that the sudden drop we saw from March to April was very large as it’s compared to monthly drops seen in the last 13 years. It did recover in May marginally, but is still way down compared to previous months. If consumer confidence continues to decline, it will get harder to restart the economy as it very well may become a self-fulfilling prophecy.
Social Unrest
This is an economic and real estate current events blog and with that being said, I want to touch on the social unrest currently being witnessed in the US. Social unrest, for any reason, causes chaos to financial markets. In the financial markets, we look at risk a lot and political risk is one that we look as well, but never in the US because we see the US has being stable, politically speaking. With the unrest and riots we are witnessing across the US, it’s hard to not wonder what other countries are thinking about all of this in terms of their financial assets. Buildings are being torched and that should definitely concern real estate owners, because it’s a real risk.
It’s also important to note the many other problems we are currently facing in the US. Depression level unemployment rates, the Covid-19 pandemic, cost of living rising while wages are not rising at a level to sustain the cost of living growth, the Federal Reserve acting recklessly, the impending homeless crisis, and so much more. The deepening political division in the US certainly does not help the situation either. Adding in the warm weather, many call this a recipe for social unrest. I had many colleagues talking about the potential for social unrest weeks ago and how they were all waiting for a trigger. There isn’t a historical precedent for what is going on in the US and my guess at what will happen next is as good as anyones.
Concluding Remarks
We might very well be at a turning point in the US. Like I mentioned above, with all these variables in an equation that we obviously has never seen before, I don’t know what we have to look forward next. It feels as if 2020 is a year of loss. Normal is no longer normal and we are getting used to a new normal. We just faced lockdowns lasting weeks and now we are facing curfews in cities due to the unrest.
I hope we will get through these challenges and I truly hope we come out of this as a better country. We cannot deny the problems we have, we need to look at ourselves in the mirror and see what we can all do together and as well as on an individual level.
Stay safe everyone and I’ll write you in two weeks!