This episode features a discussion around why real estate continues to remain an attractive area of investment, despite higher prices and the pandemic. To discuss this topic and more are Garth Newport, Senior Portfolio Manager, and Joe Bachmann, Senior Research Analyst with the Private Market Value (PMV) Equity Team.
Brandon Brouillard: I’m Brandon Brouillard and you’re listening to On the Trading Desk®.
I’m really excited for today’s conversation around why real estate continues to remain an attractive area of investment, despite higher prices and the pandemic. With this in mind, we’ll be talking about three things that are deserving of investor’s attention right now: The first, housing’s multiple facets—rental, own, senior living, and others; the second, how the pandemic’s creating disruption within office and travel; and the third, why real estate is an attractive investment area looking forward.
And with me to discuss these implications are Garth Newport, Senior Portfolio Manager, and Joe Bachmann, Senior Research Analyst with the Private Market Value Equity Team, otherwise known as the PMV Team. Welcome to On the Trading Desk.
Garth Newport: Hey, Brandon. Thanks for having us today.
Brandon: Thanks for joining. Well, let’s jump in right away at the 30,000 foot level to set the stage for what’s really been driving real estate prices at a broader economic level. Can you share with us how you all have been evaluating macro elements like inflation, jobs, rates, and GDP [gross domestic product] growth as you’re sourcing opportunity within real estate? And Garth, maybe we’ll start this discussion with you.
Garth: Sure, yeah. That’s a great question, Brandon. I mean, these are all key inputs into real estate investing and over the last 18 months, we’ve seen dramatic swings in each of them.
Inflation is running at levels that we’ve not seen in 40 years. Construction costs have risen dramatically, and that’s having a direct impact on real estate values.
There’s been massive fiscal and monetary stimulus that’s driven very strong GDP these last few quarters, and that’s directly helping the health of tenants, which directly impacts real estate landlords.
Also, we’re finally seeing improvement in job growth, and while it’s been somewhat slower than hoped, hopefully it will continue to build over time. Again, that drives demand for real estate.
And when you talk about interest rates, they remain at historic lows, which is keeping financing costs very low. So from your 30,000 foot view, we’re seeing most of the macro indicators be extremely positive for real estate today.
Brandon: That’s great. And so when I think about real estate, I think about office, housing, apartments, and malls. What am I missing and how broad and diverse is the real estate market?
Garth: Yeah, Brandon, those are all key areas within real estate, for sure. But what we find these people often underappreciate how broad real estate really is and how many different verticals there are.
Just to give you a sense, I’ll list some of the key categories that we invest in ourselves. They would include things like single-family rental, multi-family, manufactured housing, senior housing, there’s retail—which includes both malls and strips—towers and data centers, lumber, self-storage, office, hotels, triple nets, and industrial.
Brandon: Wow, that’s a lot more categories than I realized. Thanks for that backdrop. And now I’d like to dig into the aspects of real estate investing that are impacted by some of these macro drivers, specifically housing.
For much of this summer selling season, headlines have really been dominated by references to surging real estate prices around the country. So, wondering if you could provide some perspective around where prices are today relative to long-term averages and if these still offer an attractive entry point for investors today?
Garth: Yeah, I’m sure most of your listeners have either heard similar stories or perhaps are even experiencing it firsthand. I myself have family members that recently bought and sold a home, and listening to the stories of the process that they went through, it’s quite dramatic and very different than what I went to myself when we bought our home a few years ago.
And so with that, you really can’t help but step back and wonder, gee, are we repeating the ‘08, ‘09 housing meltdown? Price increases could and, frankly, hopefully do slow down, but a price collapse is unlikely at this point. There’s several interesting data points that suggest the housing market is on firmer ground.
Now first, construction material inflation and labor inflation is rampant, and this directly impacts the replacement costs in real estate values.
Next, we look at apartment vacancy, and you got to remember, apartments are a substitute good for single-family homes and it is nearly 4% lower today than it was in 2005 to 2007. Another interesting thing that’s happening in apartments is that apartment rents are going up much sooner and much faster in this economic cycle that we’ve see in prior cycles.
Another key indicator that we look at would be the median purchase price of homes to median annual cost to rent one, and this ratio is at roughly two-thirds of the level we saw in 2007.
Wrapping that altogether, it just suggests that there’s strong demand, and the housing market is being driven more by broad-based rise in the cost of shelter than on pure speculation.
In terms of affordability, mortgage rates remain very low. Job growth has resumed. Incomes are growing, and we’ve had a lot of fiscal stimulus over the last 18 months that’s done a lot to restore consumers’ balance sheets and provide dry powder that’s enabling durable purchases, like homes.
Another key factor to consider would be post-financial crisis, there was a lot of bank reforms and legislation that improved banks’ lending and their focus. When we step back, we look at overall lending standards, and they actually remain fairly tight. We’ve seen data showing that 80% to 85% of mortgages originated today are going to borrowers with a FICO score above 720. That would compare to roughly 55% in 2005 to 2007. So all of that’s showing very strong demand kind of across the board for housing.
And then when we look at the supply side, the housing supply is extremely low. There’s roughly 2 to 3 months of housing supply versus over 7 months at the end of the last housing bubble.
So the best that we can tell, wrapping this altogether, is there’s real strong demand that’s driving the cycle versus speculation and froth that drove a lot of the last cycle. We expect pricing to flatten out, but we’d be pretty surprised to see a dramatic fall in price.
Brandon: That’s great perspective and thanks much for sharing that. You mentioned seeing prices rise in many housing categories, not just home prices. Can you expand on the various housing categories and give us a little color on what’s happened post-pandemic and briefly your outlook for each? And maybe Joe, let’s throw this one over to you for your perspective.
Joe Bachmann: Hi, Brandon. Thanks for the question. When our team thinks of housing, we think of it in terms of three main categories: single-family owner-occupied, single-family rental, and multifamily apartments. Technically, there’s a fourth category, senior housing. It’s a little bit different. I’m happy to talk about it later, but as relates to the first three of those, they’re all very interrelated and can act as substitutes for each other.
And all three of them have been getting big increases in either rental income, asset price appreciation, or both. And we think this is a big output of COVID—that the advent of remote work and working from home, meaning people are spending significantly more time where they’re living—and it’s driving up demand.
We’ve also seen remote work/work-from-home trends accelerate some interesting demand patterns, either geographically with Sunbelt winning at the expense of the coast or we’ve also seen shakeups of demand trends, suburban winning at the expense of urban. And so there’s been just a big demand recovery.
And then on the supply side, both for single-family and multifamily, we’ve watched all these construction costs keep inflating. We’ve watched labor shortages and they’re contributing to these bottlenecks in building and it’s left supply unable to meet the sharp demand of recovery.
And so those two things combined have driven the sharp pricing gains we’ve seen. I would say right now we’re positive, echoing what Garth said, on single-family and multifamily. We think this imbalance should continue for some time, particularly in some more favored geographies in the Sunbelt.
That said, we’re also in the camp that economic forces will someday prevail and supply should respond with increased building meeting these pricing gains, but not so good for those who want to buy or rent in the near term. You’re going to have to pay a little bit more until that supply can catch up.
Brandon: That’s interesting and thanks so much for that insight. And I want to circle back to something that you’ve both alluded to in terms of supply and prior experiences in the real estate market. And we know that asset prices can’t rise at this growth rate into perpetuity and we saw this with the Financial Crisis in 2008, as you all alluded to. So at what point does supply exceed demand and we move into a scenario where prices start to come down? And how does work-from-home/remote work impact this outlook? And also if you could share any longer-term thoughts that you have on the space, those would definitely be welcomed, as well.
Garth: Yeah, Brandon. This is Garth. I would agree. Prices can’t rise at these rates forever, but as Joe and I noted earlier, the near-term demand outlook is pretty solid and supply’s going take some time to catch up. Frankly, we’d expect a fairly tight housing market for the next few years.
Your last two questions are areas that we love to debate internally.
In terms of work-from-home/remote work, we simply expect it to be a much bigger percent of how workers work post-pandemic. COVID changed the way many things are done and we think this could be one of the biggest changes. I’ve seen surveys suggest 30% to 40% of office workers would like to be remote post-pandemic, and we’ve increasingly heard companies using it as a recruiting tool.
Another area that doesn’t maybe get as much focus today but I think will have a dramatic impact on work-from-home over the next decade is the focus on climate change. Employees are going to demand less commuting. Why live in one area and work in another when you can live and work in the same and reduce your carbon footprint?
And with work-from-home, it does drive the need for a bit more space so that you can work productively, and this is leading some to potentially move to areas that have more space, a lower cost of living, and an overall better quality of life.
When you wrap that together, this is a pretty dramatic change in real estate. You can’t easily move an apartment building from, say, San Francisco and drop it into Nashville where you need it. There’s going to be an uneven pace of real estate appreciation that will vary across various geographies.
Finally, a topic we debate a lot is really how are Baby Boomers going to impact housing over the next 15 years. It’s something like a quarter of resi real estate is held by those over 70 and over 50% of resi real estate is held by those 55 and older. As they age and can no longer maintain a residence, I think that’s a factor that really could unleash a pretty big amount of supply on the housing market and help rebalance both the supply/demand dynamics that we were discussing earlier. Unfortunately, I just really wouldn’t expect that to happen until mid-decade or perhaps even a little later.
Brandon: Those are great insights and before we move away from housing and since you mentioned the category of Baby Boomers a few times, I wanted to get your perspective on opportunities within the senior housing space. Senior living was definitely an area that experienced volatility from the pandemic, but now we’re nearly a year and a half beyond the onset of this global situation. So what kind of opportunity was created since the onset in March of 2020 and what does this space look like on a post-COVID basis?
Joe: Hey Brandon, this is Joe. That’s a great question. Maybe it’s a little helpful to give some background on what happened last year in senior housing. Senior housing was definitely one of the most challenged of the real estate subgroups throughout the pandemic. As we all know, seniors are particularly vulnerable to severe COVID. Folks were understandably hesitant to move into these group homes and then the outbreak sadly increased the rate of move-outs, and so you saw big drops in occupancy in the space.
At the same time, costs were going up. Operators had to implement all these expensive quarantine and cleaning protocols all while struggling to source effective labor.
And for us, last year, we are able to tactically get in there and find some good opportunities through this disruption, made some investments in strong, well-located senior housing owners at some very attractive prices.
And this year, the vaccine’s been rolling out, thankfully, and really thankful we’ve had very high uptake amongst the elderly. And so we finally started to see occupancy in senior housing and prices start to rise again.
And so post-pandemic, we’re roughly optimistic. We know post-pandemic that the supply picture looks better for senior housing than it did going in. A lot of stuff was put on hold while the pandemic was raging. And then on the demand side, where you’re close to that Baby Boomer cohort that we keep talking. 10,000 people in the U.S. turn 65 each day and this should be a big demand tailwind for senior housing as we move through the decade.
All that said, right now, the labor market’s still tight and it’s driving operating costs higher and we’re watching the delta variant and some uneven vaccine uptake amongst the children of these seniors create visitation restrictions and that could drive softer move-ins into the fall.
So overall, I would say cautiously optimistic for senior housing longer-term, but there’s going to be some bumps here in the near term.
Brandon: So in staying with opportunities created by the pandemic, let’s talk about the lock-down. While everyone was encouraged to avoid traveling and vacations, it seemed like home projects that were once shelved really came back onto the radar for a number of people. At the same time, work-from-home protocols became the norm, as we alluded to previously, and so fewer people were going in offices. What kind of impact has this had on real estate and how has the team capitalized on this situation?
Garth: This is Garth. I’ll take that one. Yeah, work-from-home, as we mentioned, has been one of the biggest impacts on real estate and how we’ll work in a long time. We’ve looked at this over the last year and looked at mainly three different ways of trying to capitalize on the change that this is driving.
The first is we’ve maintained significant weightings in all the housing verticals that we talked about and we skew that towards favored geographies, as we mentioned.
Second, we’ve historically shied away from office and hotels for a variety of concerns and, frankly, those negative views have been more firmly reinforced with this change in behavior post-pandemic and going forward. There recently was an article out highlighting about how corporates are looking to cut their travel budgets once the pandemic is over for a variety of reasons and that’s going to be pretty negative for hotels, in our opinion. And we’ve touched on the office aspects earlier in the podcast.
And finally, we’ve looked at work-from-home winners that we see benefiting the most, which would include things like data centers, towers, and industrial. Now these are all areas that had strong supply and demand fundamentals pre-pandemic but seem to have had their positive positioning and outlooks turbocharged by the pandemic and the associated change in behavior.
Brandon: Well, thank you both for sharing your insights and perspectives. And I want to shift the conversation slightly toward benefits of real estate investing. What role does real estate serve within a portfolio and how should investors think about allocating to it?
Garth: Yeah, that’s a great question, Brandon. We believe an allocation to real estate is very important to overall asset allocation.
And just so we’re speaking the same language, a REIT is a real estate investment trust, and we ourselves are pretty partial to public REITs, given they provide specific benefits, like daily liquidity. They have very strong management teams. They have great access to capital, which enable them to grow over time. And importantly, they provide access to many categories—things like towers, data centers, manufactured housing, and a few others—that are quite hard to get access to in private markets.
In terms of what it provides in an investor’s portfolio, benefits would include the fact that these are real assets that should have broad inflation protections. They do come with current income in the form of a dividend, and there’s long-term asset appreciation.
When we look at real estate versus other assets, it looks especially appealing right now relative to fixed income, given how low fixed-income yields are and the uncertain inflation outlook. Relative to stocks, there’s also some tax benefits to their structure and how their dividends are paid out where they’re not double-taxed on that portion.
Brandon: Well, we can’t talk about opportunities and benefits without addressing the topic of risk while investing in real estate. So how do you all prioritize and manage the various types of risks associated with running a real estate investment trust portfolio?
Joe: Hi, Brandon. This is Joe. I’m happy to talk about risks, and the big one that we focus on a lot is all the different real estate subgroups. It’s very important to remember that they are not created equal. We talked a lot about some of the groups that are on the winning side of secular change, but there are areas that aren’t as well positioned. Hotels, office, and retail are all facing significant long-term challenges behind their supply/demand picture.
And in addition to the secular pressures in some subgroups, as we’ve seen in the last two recessions, a lot of areas of real estate can also be cyclical. I’d like to say during downturns, our companies can generally use those as opportunities to invest and get stronger, come out better positioned. But at the same time, during a recession, a multi-family apartment renter can lose his or her job or an office tenant can go out of business, and this can create choppiness in a REIT’s otherwise consistent cash flow stream.
And so when considering these future unknowns, one area we focus on quite precisely is balance sheet health. We do in-depth reviews of all our holdings’ leverage profiles, maturity schedules, credit ratings, sources of liquidity, mix of secured versus unsecured debt, how much of their debt is variable versus fixed interest rates. And all this is trying to gain an assessment of how much stress this REIT can handle and really optimize our portfolio’s risk-reward.
And it’s all coming from the place of it’s best to be proactive when times are good so we don’t have to be reactive and can avoid problems when times are bad.
Brandon: Thanks for that excellent perspective and we have a minute or so left. So I wondered if you could share a parting thought for our listeners. And I’ll throw this out to either of you.
Garth: Yeah, Brandon, this is Garth. I’d be happy to give you a little summary. And I really appreciate you having us on today.
The main theme today was on housing and that affects a lot of people and it’s a very important real estate category, to be sure. But we’d like to reinforce that real estate is much more diverse than people realize. There are certain areas that are definitely seeing pressure, and we’ve highlighted many of them. But there’s others that are seeing tailwinds right now. The current macroenvironment is extremely positive for real estate fundamentals currently.
Over the long-term, real estate has been an attractive asset class, providing solid returns and diversification. And with that, we think real estate’s earned its place in an investor’s portfolio, in our opinion.
Brandon: Well, thank you again for joining and I really appreciate the opportunity to speak with you both today. This has really been an enjoyable and informative discussion for me and I think our listeners will definitely enjoy it. So thank you again.
That wraps up this episode of the On the Trading Desk podcast. If you’d like to read more market insights and investment perspectives from our investment teams, you can find them at our Advantage Voice® blog. To stay connected to On the Trading Desk and listen to past and future episodes of the program, you may subscribe to the podcast on iTunes, Stitcher, Google Podcasts, Spotify, or Overcast. Thanks for listening. I’m Brandon Brouillard and we’ll catch you next time.