Economy
Ethan Roberts covers the weakness in office REITs over the past couple years in a Benzinga article and whether there is any opportunity to buy the dip. To recap, the sector’s struggles began due to the pandemic with remote work gaining in popularity, leading many companies to downsize or abandon their offices.
Not surprisingly, office REITs were crushed and their struggles were exacerbated by high interest rates. Many of these REITs dropped more than 50% and are trading below their March 2020 levels, despite the broader market being substantially higher.
However, some contrarians are turning more optimistic on the sector. They believe that valuations have become very compelling especially given that public market valuations are much cheaper than private markets. Additionally, there are increasing signs that corporations are pushing back against remote work culture by insisting that workers must go to the office at least a couple of times per week.
In addition to this, real-time metrics like metro ridership and miles driven also seem to confirm that more workers are returning to the office. Finally, with increasing cracks in the labor market and expectations that the unemployment rate will increase over the next year, workers have less leverage and may be forced to return to the office.
Finsum: Office REITs have been crushed over the past couple of years due to the pandemic and high rates. Now, there are some reasons for optimism.
In an article for Seeking Alpha, Jussi Askola covered the aggressive buying of REITs by the Blackstone group and bullish comments from Steve Schwartzman and John Gray, who are the CEO and COOs of the Blackstone group, respectively. Their investment decisions are monitored due to their leadership of the private equity giant, and its successful long-term investing track record. Additionally, private equity groups are large owners of real estate, so they could have particular insight into the sector.
This is evident in public filings of REITs whose shares fell precipitously last year due to the rise in rates and weakness in real estate. The company has built up a portfolio of REIT assets, totaling nearly $30 billion. Essentially, the company sees a discrepancy between real estate assets in private and public markets with public markets offering more favorable valuations.
And, it signaled on a recent conference call that it says more upside in other types of liquid real estate securities as other investors pull back from the asset class. And, they note that these opportunities present themselves in REITs that are exposed to strong sectors with no distress. One factor that may appeal to Blackstone is that many REITs currently have a nearly 30% discount to their market value.
Finsum: Blackstone is being contrarian with its aggressive buying of REITs while most investors flee the sector.
Jonathan Brasse discussed a recent white paper from Swiss alternatives group, Partners Group, about why private markets are poised to grow faster than public ones over the next decade in an article for PEREnews.
In essence, Partners Group notes the changing landscape for private markets, and how they are playing a larger role in financing the ‘real economy’. Since 2016, funding on private markets has exceeded that of public markets. Last year, about $400 billion was raised on public markets, while more than $1 trillion was raised in private markets.
Another change is that companies raising on private markets are generally healthier and more profitable than ones listing on public exchanges. These trends are also evident in the real estate market.
Fundraising for real estate in private markets has been steadily growing, while the number of real estate IPOs has dwindled. In terms of future returns, real estate listed on private markets has a better chance to be renewed, repurposed, and transformed, while such expenditures are less common on the public side given the pressures of quarterly earnings and shorter time horizons of public investors.
Finsum: Private markets have been overtaking public markets in terms of funding. This trend is also happening in real estate markets.
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According to research from the Indiana University Kelley School of Business, the current strength in real estate may prove to be transitory. Currently, the housing market has remained resilient despite higher rates due to a demographic bulge and low inventory of available homes.
However, Indiana University’s research indicates that demographic-driven demand is at a peak. Coupled with low supply, this is likely to drive prices higher in the near-term. However, there is likely to be long-term slowing in demand due to slower population growth and an aging population, barring an unforeseen surge in immigration or household formation.
Additionally, baby boomers are likely to start downsizing, while lower fertility rates also mean that demand for housing will be structurally less. Due to the pandemic and increase in remote work, there was a surge in household formation that exceeded population growth over the last couple of years. This trend is also unsustainable given demographic realities.
The rise in mortgage rates has also artificially constrained supply as many would-be sellers are not selling due to locking in low rates. Yet, this is simply ‘pent-up’ supply that will be released into the market once rates decline or through the passage of time.
Finsum: Real estate has continued to hold up well despite deceleration in economic growth and higher rates. However, this state of affairs looks unsustainable in the longer-term.
Commercial real estate was facing serious issues at the end of 2021 due to the increase in remote work and changes brought about by the pandemic. This resulted in a situation of excess inventories amid declining demand. However, these issues have been exacerbated by recent bank failures.
In a MarketWatch article by Joy Wiltermuth, she covered a research piece by Lisa Shalett, the Chief Investment Officer (CIO) at Morgan Stanley Wealth Management, who warned that commercial property prices could drop by as much as 40% and even have negative effects for other parts of the economy.
Shalett’s concern centers around the trillions of dollars of commercial mortgage debt set to mature over the next decade. And, the pressure is more acute in the current environment especially given high rates.
In terms of the broader economy, Shalett sees collateral damage from offices at depressed occupancy levels in terms of the businesses and municipalities that rely on people working in the cities. In her opinion, the stock market’s performance in Q1 reveals that investors are being ignorant of these risks.
Finsum: Morgan Stanley’s Lisa Shalett lays out some concerns over the commercial real estate market, why it could get worse, and its potential broader impacts on the economy.
While the entire real estate market is struggling amid a backdrop of rising rates, stubbornly high inflation, and a banking crisis, there is no area feeling more pain than commercial real estate (CRE). This segment never fully recovered from the pandemic as many businesses and employees seem to have permanently adopted a remote or hybrid work scheme.
Thus, commercial real estate was already struggling before the past year when these pains intensified due to a slowing economy and a hawkish Fed. However, some Wall Street analysts are seeing a contrarian opportunity in the sector despite these headwinds according to an article by Phillip van Doorn of Marketwatch.
Overall, the analyst community remains negative on the sector especially among office buildings. According to Adam Posen, President of the Peteron Institute for International Economics, office occupancy remains 30 to 40% lower than from before the pandemic. Many REITs with exposure to office buildings have already endured severe corrections.
Another risk is the potential of spillover pain into the financial system given that there is about $400 billion of annual CRE loan maturities. Current models estimate losses in the range of 1 to 3%.
Despite these headwinds, analysts see opportunities in the REITs with top-quartile properties and successful management teams.
Finsum: The weakest part of the real estate market is commercial real estate. It was already struggling due to the increase in remote and hybrid work, but these pains have been compounded by rising rates and a slowing economy.