Investors are pondering hard on COVID-19’s impact on private real estate, what actions are advisable now and what their portfolio positioning should be going forward. We recommend the multifamily and industrial sectors as core assets in an institutional investor’s portfolio. These asset classes have lower ongoing capital needs, are well-positioned to provide rental growth and typically have bounced back quickly following downturns.
Direct real estate is an important part of most institutional portfolios as it offers strong long-term returns, current income, inflation protection, diversification from equity returns and lower beta compared with publicly traded real estate investment trusts (REIT). A typical US endowment or pension has approximately 5%-10% of its portfolio allocated to private real estate. 1
While many publicly traded REITs have declined by more than 20%, 2 the impact of the current environment on direct real estate is less transparent given a lack of direct properties that have traded since the beginning of the pandemic. However, now that April rents have been largely collected, we can begin to better understand how various property types are performing. Figure 1 summarizes the relative severity of COVID-19’s impact on each of the major real estate sectors. Obviously, there will be significant variances based on location, tenant quality and the specific characteristics of each property.
Hotel: Limit to Small, Opportunistic Exposures
The shutdown of businesses and travel has predictably caused a catastrophic collapse in the hotel industry with Revenue per Available Room (RevPar) falling by approximately 80% across the United States. 3 Hotel performance is highly correlated to the health of the economy. We believe that the economic recovery will be gradual and uneven across geographies and would be dependent on unemployment levels. Further, business travel may see a lower recovery trajectory given the growing acceptance of video technology. Although, longer term, consumer travel and vacationing will boost hotel usage from today’s levels, a return to pre-COVID 19 levels will likely take many years. Accordingly, we see hospitality as having a limited role except for investors who desire a small, opportunistic exposure.
Retail: Avoid, Except for Properties with “Necessity” Tenants
The outlook for retail assets prior to COVID-19 was already challenged due to e-commerce, declining in-store sales and an oversupply of retail space. The COVID-19 mandated closures and shutdowns further cloud the long-term return profile for most retail assets. Not surprisingly, a significant number of retail tenants failed to pay their April rents, and many could be forced into liquidation.
The bright spots for retail have been grocery stores, pharmacies and certain specialty retail such as auto dealerships. Outside these “necessity” retail environments, the short- and long-term outlook for conventional retail (regional malls, power centers and factory outlets) remains bleak and should be largely avoided by most institutional investors in our opinion.
Office: Selectively Acquire Newer Core Assets
The outlook for office properties is mixed. We have been pleasantly surprised by the high rate of rental collections in our own office properties. The office market entered the downturn in comparatively good shape with a vacancy rate below 10% and a low amount of new supply being added in most markets. The need to create greater social distancing for employees may result in businesses leasing more office space to decrease the density of their floor plans (one tenant in our portfolio has already made such a request). We also believe medical-office, life-science and lab buildings will see an increase in tenant demand over the long term.
However, office tenants in businesses impacted by the economic shutdown are beginning to request rent deferrals to control company expenses. We also expect the success of work-from-home programs initiated by many companies to reduce demand for conventional office space. Additionally, persistent unemployment will depress the demand for office space, and we remain concerned about the health of co-working tenants that have absorbed considerable space in recent years. Finally, property owners are likely to see an increase in both operating and capital costs owing to a demand for continued enhanced cleaning protocols as well as larger tenant improvement allowances that enhance social distancing by building traditional offices rather than open, collaborative spaces.
Overall, office will remain a key asset class for investors but will require a high degree of selectivity. We would continue to selectively acquire newer vintage (more recent) core and core-plus office assets, favoring high-growth urban cities as well as infill suburban markets where public transportation is not heavily relied on. We also favor energy-efficient, LEED-certified properties with sustainable characteristics. Older properties that would likely need heavy capital improvements or have exposure to tenant sectors that have been especially impacted by the downturn should be avoided.
Multifamily: Continues to be a Preferred Asset
Multifamily properties have traditionally been one of the best performing assets during an economic downturn as more people rent housing rather than buy. While the spike in unemployment certainly bears watching, the significant levels of new federal stimulus should buffer the risk to rents. Investors should monitor trends for tenant-favorable legislation that might limit rent growth in markets such as New York, Oregon and California, but we believe that the long-term demographic and business trends will remain tailwinds for well-located multifamily properties. With new construction slowed by tighter lending standards, we believe that multifamily will continue to be a preferred asset class.
Our multifamily portfolio primarily consists of higher-quality assets in markets with stronger employment trends, resulting in rent collection of well over 90% in April. We have avoided lower-quality and workforce housing assets as these sectors are more exposed to economic downturns.
Industrial: A Must-Have Asset as E-Commerce Grows
The increased growth in e-commerce had already transformed the industrial sector, particularly last-mile warehouse properties, and the COVID-19 pandemic has further increased the speed of this trend and created a stronger economic reliance on this asset class. While certain supply chain disruptions may hurt near-term leasing, the long-term trends for industrial are stronger than ever and make this a must-have asset class for institutional investors.
Three Considerations for All Sectors
Several tenets are important considerations across real estate sectors. First, we favor buying Class-A, higher-quality assets, especially at a time when they can be purchased at a discount to replacement cost. Such properties retain their value in downturns, rebound more quickly in recoveries and offer greater liquidity in all markets. In dislocations, we favor not lowering the standards but sticking with top-quality assets.
Second, investors should take note of niche strategies that offer above-trend rental growth. Currently, we highlight three such niche sectors: data centers, medical and life science office properties and cold-storage assets. These assets can add diversification and returns to complement an investor’s core multifamily, industrial and office assets.
Third, we would leverage experienced partners and external managers for distressed investments in credit, hotels and retail. We believe institutional investors should not attempt to buy such assets directly but rather partner with opportunistic investors that have a demonstrated track record of investing in these sectors.
COVID-19 is likely to have significant short-term effects on real estate investing, but the long-term outlook for direct properties remains strong. Indeed, with interest rates likely persisting at historical lows, we anticipate that the capitalization rates for stable real estate properties will continue to decline, fueling further gains. The current market environment provides opportunistic long-term investors with an attractive entry point to make real estate investments. Through careful upfront property selection and diligent, proactive asset management, we believe that real estate is likely to deliver strong risk-adjusted returns.
Strong Hands-on Management Adds Value
Successful real estate investing requires both good initial selection of assets and strong asset management of individual properties. In times of disruptions such as the current pandemic, investors should think of the critical steps that are required to maintain value in an existing portfolio. Here are five steps that we have been employing to drive greater value at our direct properties:
Maintain or increase occupancy at properties by using virtual leasing tours and offering competitive rental rates to attract new tenants while retaining existing tenants. All properties will likely experience some level of credit loss during a downturn, so it becomes more critical to have a higher occupancy rate to maximize current cash flow and better position the property for an economic recovery.
Increase communication with tenants about enhanced cleaning protocols, social distancing guidelines and other safety measures. Tenants prefer engaged landlords and owners who are proactively addressing key concerns.
Identify expense-reduction opportunities, especially in commercial properties where daily occupancy has been greatly reduced.
Address any upcoming financing needs by engaging lenders early to extend or refinance debt well in advance of loan maturity dates.
Where possible, complete planned value-add upgrades to common areas while tenant traffic is reduced to avoid inconveniencing tenants and lock in more favorable contractor pricing.
1 National Association of State Retirement Administrators, Public Fund Survey December 2019 and National Association of College and University Business Officers, Public NTSE Tables, 4 February 2020. 2 FTSE NAREIT Composite, year-to-date through 1 May 2020. 3 STR data for the last week of March 2020.
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