Commercial Real Estate in a COVID World. Notes from Podcast Interview

Ian Formigle is the Chief Investment Officer at Crowdstreet. Crowdstreet is an online marketplace that allow the individual to review, compare, and choose the deals that meet your investment criteria.

Ian comes has 24 years of experience in real estate private equity, trading, and start-up. In this interview with the Investor’s Podcast, Ian shares with the listeners what he is seeing on the ground and his perspective on how the market has been shaping up.

Here are my short notes taken from the podcast. It covers how the various commercial real estate sector is doing, the impact of the fiscal measures, office and retail landscape.

The More Important Take-aways

Out of all the stuff, here is a summary of what I learn the most:

1. A lot of what affects real estate prices are current and perceived real estate demand.

2. Ultimate driver of value in real estate is demand relative to its supply.

3. One way to get a good deal is based on price. The other way is to secure a good deal based on structure. Because capital is hard to come by, investors may be pitched more advantageous splits in private equity deals.

4. There is going to be some moderation in certain markets. People are calling for the death of the CBD in Manhattan. However, if prices drop to a certain level, we might want to buy it. The lower asset value creates an opportunity for buyers to come in and profitably operate them at lower rents. This is only valid if the market is attractive. 

5. This recession is different from before. Different sectors are affected differently. If you wait for a performing sector to go down, then it might be a futile wait.

6. When looking at distressed deals, look at the discount to replacement costs. You do not know when they will come back but you must use certain assumptions about how these properties will look like when they return to some forms of normalcy.

7. Right idea wrong execution. Pay attention to the strength of sponsorship. We do not know how long this down cycle will run its way through, so it will need people with strong reserves to run through.

Ranking the Sectors from Worst to Thriving

1. Hospitality. 22% occupancy
2. Retail Malls. Follow by those heavy on food and beverage. If you have a mall anchored by a grocery or home repair, you are doing well.
3. Office: Downtown location looks weak but too early to tell. Not a lot of trades so the jury is still out. We can look at what the public traded REITs are telling us, and the REITs are telling us there is a fair amount of uncertainty. Ian thinks we will know more about the office market by the end of the year
4. Multifamily. Hanging in well. Year over year collections has been strong. Property transacted value Is 2-8% lower than pre-COVID. To see when a $600/week stimulus is off. Without stimulus, researchers predict that 1 in 5 tenants are at risk of eviction. Class B and Class A Multifamily would do better as it is populated by people working from home.
5. Last-mile Industrial Properties. Record demand.
6. Needs-based medical office and Data Centers

Indicators for Observing the Health of the Industry

1. The debt markets. For a lot of commercial real estate deals, without debt, you cannot buy it. A high correlation between the number of lenders making deals and how many deals are transacting. Got commercial trades to give you the latest market prices.
2. Ending occupancy data for hotels provided by SDR. The data shows that they have 12 weeks of successful improvement in occupancy from a low of 22% occupancy to 46% occupancy. This tells us that the market is recovering but is still weak. The owners need a lot of operating reserves still.

The stimulus that we should pay attention to:

1. Economic injury disaster loans by SPA. $2 million max amortized over 30 years.
2. Funds from Paycheck protection program.  Hotels and senior housing facilities are supported by this. They have allowed them to support the employees there and Ian expects these loans to be fully forgiven.
3. $600/week additional unemployment benefit. Supporting those lower-Class B and Class C properties.

If no second package passed, things could unravel.

$600 billion Mainstreet lending was announced but not yet seen, but we may be seeing initial signs of it.

The Office Sector: Too Much Conflicting Views

1. Companies are likely to retool their space to reduce density. Companies are going to use this increased spatial divide to recruit employees. Free food and ping pong tables will fade to the background. Office space has dropped from 250 square feet per employee to 100 square feet per employee in dense space. Possibly a 46% reduction in space due to reduced density. May create demand for more space
2. Companies not going to look for more space. Most of their workers working at home. Bad.
3. Companies not looking to hire more people. Bad.
4. More companies comfortable with remote working. Drag on demand
5. Shifts in demand based on location. Due to #1 to #4, companies may re-locate employees from higher cost to lower cost metros. If a company is thinking of opening an office in Austin versus expanding in San Francisco, the pandemic might have pushed the decision. Austin rent is half of San Francisco.
6. The resurgence in demand for suburban office space. Even before the pandemic, in 2019, 69% of Class A net absorption (increase in demand filled) occur in suburban, up from the long-term average of 60%. Suburban has appeal. Plentiful. Free parking. Vacancy 2% higher than average. Low-rise. Closer to employee home. 38% cheaper on the Class A level. Major users are asking brokers to look for 50,000 to 100,000 square feet of suburban space when they currently occupy 1 million square feet of space in the city core.

The Retail Space: Challenging

Grocery anchor shopping centres are hot. Store sales have doubled. The space isn’t dead.

The amount of food they purchase from grocery stores is up to mid-60%. It was not this high since the mid-1990s. This could moderate down.

If you can find a retail strip that is anchor by this kind of tenants, that are valued at below replacement costs, it is very attractive.

Key number: US$100 psf.

The Rising Popularity of the “18-Hour Cities”

In previous podcast interview, Ian have mentioned about the attractiveness of these mid-size cities with attractive amenities, higher-than-average population growth, and a lower cost of living and doing business than the biggest urban areas.

Pandemic have accelerated trend. Population migration from major cities to secondary and tertiary cities.

With companies allowing remote working will benefit this trend.

People are leaving New York but Ian feels that New York is damn resilient.

Changes in flow based on Marcus & Millichap research of Migration:

Outflow: LA, Bay Area, New York City

Inflow: Florida, Nashville, Charlotte, Texas, Austin, Boise, Salt Lake City.

In-demand cities based on Greenstreet Advisers research on cities that will thrive post-pandemic:

1. Denver
2. Charlotte
3. Phoenix
4. Austin
5. Raleigh-Durham

Commercial Mortgage-Backed Securities (CMBS) Market – Why is This Market So Important?

Usually, we will take out Multifamily because agency debt is dominated mainly by Fannie Mae and Freddie Mac.

CMBS accounts for 23% of outstanding debts issued last year.

CMBS is important as the canary in the coal mine for the commercial real estate market.

CMBS are typically placed on riskier asset. This is the first sign of weakness.

Today, we are seeing delinquencies skyrocketing in the retail and hospitality space.  The delinquencies are up 20% and 25% respectively when before the delinquency rates is less than 5% in March 2020.

For other asset classes such as industrial, the rats are still less than 5%.

This recession is not finance lead like 2008 and should be viewed differently.

When CMBS dry up, the transactions will dry up. No signals. Market participants become skittish about everything.

CMBS is also a leading indicator of recovery (as we are seeing recently). Price may not immediately rise, but it gives indication people are more comfortable.

Timing the Market

Ian thinks getting the right time is difficult. We know that currently this is a new cycle and it is a down cycle. Somewhere things will bottom out. And then prices will go upwards.

Layer into opportunities.

Commercial markets behave differently from residential markets and one of the drives is debt maturity.

The difference is residential loans are amortizing and you make decisions on them. For commercial loans, if your loan matures at a down market, you get exposed.

The best deals is timed based on debt maturities.

Institution owners can be fatigued. They may be aggressive to shed properties at crazy prices.

There is no magic moment. Just evaluate and buy good deals.

There are more articles like this in my Learning about REITs section

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