With the Great Financial Crisis, the e-commerce revolution and the COVID-19 pandemic, the real estate asset class has experienced three major events, touching every one of its sectors, in the space of just over a decade.
In a recent webinar, Erik Knutzen spoke with Matthew Kaplan, Scott Koenig and Dmitry Gasinsky about the state of play in U.S. and European property and real estate lending markets, as we look into the 2020s.
“I haven’t seen fundamentals this promising before in my entire career in Residential Loans.”
– Dmitry Gasinsky
|Erik Knutzen||We've faced a pretty challenging environment over the last 18 to 24 months, not least in real estate has certainly been no exception. After a long period of disruption in bricks-and-mortar retail, in particular, and then the further, widespread impact of the COVID crisis, our Asset Allocation Committee came to a much more constructive view in the fourth quarter of 2020. We saw a combination of value opportunities and interesting secular trends in certain sectors of the market. Scott, from your vantage point looking across the real estate secondaries market, why would you suggest that investors should consider private real estate as we emerge from this challenging period?|
|Scott Koenig||We think real estate always earns a place in a diversified portfolio. It has tended to exhibit relatively low correlation with other asset classes. Historically, especially where there are shorter rental streams and re-setting revenues, it's been considered an inflation hedge—and that risk is on people’s minds right now. But most of all, private real estate markets are generally more inefficient than other asset classes. It's a very localized market. Within regions, the assets are heterogeneous. It’s difficult enough to understand the nuances of both retail and offices within Germany, say, let alone understanding both U.S. residential and German offices. And then transactions themselves are inefficient: they can take months, with multiple diligence, tax, regulatory and legal considerations. In our view, that’s why, if you have the right information advantages, especially those that come with a diverse team and platform, you have the potential to deliver attractive performance.|
|Erik Knutzen||One of the biggest challenges faced by the asset allocators I work with, globally, is how to close the gap between estimated returns and long-term investment objectives. The information advantages, excess-return and inflation-hedging potential of real estate makes it an important contributor to meeting that challenge, in our view. Matt, you’ve been talking about capital returning to the market recently. Why do you think that is?|
|Matthew Kaplan||It’s true, we've been as active as ever in the past 12 months, doing virtually two years’ worth of investments.
I think there are three factors. There are exceptions, like offices, but for the most part fundamentals are strengthening. Back in 2018 and 2019 we were thinking, is this cycle coming to an end? Now it feels like a lot has been reset, the shock of the crisis took some of the weaker tenants out of the market: it’s more like 2011 or 2012.
The second factor is price. Investors can still achieve relatively attractive yields and upside potential in rents and operations, off of low borrowing bases. You can achieve what we've historically achieved in terms of rates of return, echoing Scott's comments about how opaque and inefficient this sector is.
The third factor is the longer-term trend of professionalization and consolidation in the real estate business. Better capital structures, better operating models and better teams are generating more opportunity to deliver attractive performance.
|Erik Knutzen||Dmitry, does the cycle look different from the perspective of residential debt, which has its own dynamics?|
|Dmitry Gasinsky||It’s really interesting that the relationship between net household formations and new unit completions had been fairly steady for decades before the Great Financial Crisis of 2008. That implies that housing supply met housing demand, which makes sense over the long term. But that relationship then began to diverge meaningfully. A lot of private capital, as well as the private lending infrastructure and capacity, exited residential finance, and for more than a decade, now, it has been under-capitalized. This major de-leveraging has made credit conditions tight for both homeowners and homebuilders, leaving housing activity of all kinds very depressed. That meant supply of investment opportunities dwindled, making it suddenly difficult to gain exposure to what is one of the world’s largest asset classes.
Today, the economy is very healthy and we have pent-up demand from home buyers who delayed purchases from a few years back. Supply is now lagging demand to a greater extent than it has for 45 years. In fact, the U.S. is about five million homes short of where it needs to be. That's huge—it would take years to resolve at the current pace of construction. So, purchase prices are rising—and not for speculative, 2008-style reasons, but for pure supply-and-demand reasons. Even before COVID, national home prices were up some 65% from the trough during the 2010s, and they are up another 15 – 20% over the past year and a half. We think this is a major positive for credit. I haven’t seen fundamentals this promising before in my entire career. And for private credit, in particular, it is a very attractive environment, because there is still not nearly enough lending infrastructure and lending capacity to meet this growing demand for credit, leaving us with great opportunities to lend, on a first-lien, senior-secured basis, to high quality borrowers at very attractive rates. Moreover, the current situation of accelerating demand plays very well to the longstanding social-impact objectives of our strategy, which include the provision of debt capital to facilitate home development and acquisition at affordable price points.
|Erik Knutzen||Scott highlighted the heterogeneity of this asset class. Let’s start with a regional view. Matt, how are you seeing different markets in the U.S.?|
|Matthew Kaplan||It has been very fragmented. During COVID, there have clearly been de-urbanization and suburbanization trends, but, nothing has ever managed to completely break the 200-year trend towards urbanization. What does seem clear is that cities will really have to compete, now, based upon local leadership, local government, local regulation, local taxation, local lifestyle, local COVID-safety protocols. Traveling through Texas, you can see that things are wide open: it’s attracting a lot of companies and there's a building boom down there—lifestyle, sports, medical care facilities. There’s a similar vibrancy in New York: some 20,000 people left Manhattan for Miami during the pandemic, but 20,000 came into Brooklyn; people are moving back, it’s hard to get an apartment. Then there are business leaders who want people back in the office, collaborating. There's recognition that government and employers need to work to solve some issues for people, and it’s going to be a long, complex task, but there is a will to do it. The situation in San Francisco is really different, however. That business community has pretty much decamped, partly because it was so technology-oriented and has both experience and a big belief in remote working, but partly because a lot of people in those industries have highly appreciated stock and would be looking at a very big tax bill if they moved back to the city. There are some other cities, more generally, where some of the suburbanization we’ve seen is likely to be structural for those more able to continue working from home.|
Broadly, residential prices are up across all major U.S. regions—with the one notable exception of my home city, Chicago. In some geographies it's really tough to buy a house.
One reason is lower mortgage rates—these are around 75 basis points lower than they were a couple of years ago, which translates to roughly 10% on house prices. And then there’s the de-urbanization and working-from-home trends that Matt highlighted. Downtown areas are up in price by about 10 percentage points less than suburban areas, but the same trend has led people to invest more in their homes. Single family housing is doing better. Smaller metros are doing better than larger. Larger downtown apartments are faring least well. But overall, it’s a very positive fundamental picture.
|Erik Knutzen||Scott, what’s your view on the European markets?|
|Scott Koenig||Europe faces many of the same questions as the U.S. Inflation, rising rates, the move to e-commerce, the working-from-home and suburbanization trend, the general impact of COVID. But as a rule, Europe’s real estate market is even more inefficient than that of the U.S., and even more localized. So, notwithstanding the general working-from-home trend, there are still some markets that are short of office space and present attractive opportunities. The demand for green, environmentally-efficient buildings is growing fast, this desire to move up from B to Prime Class A new builds, and good local understanding can help you seek out the best assets, in the right spots and the right sectors.|
|Erik Knutzen||Let’s consider dynamics across sectors. Scott, what are your perspectives?|
|Scott Koenig||I think it’s going to be tough for some time for offices. Class A assets with long-term credit leases are fine, and prices there have stabilized at what are still attractive spreads. The Sun Belt region looks OK for offices. But the outlook is pretty negative for everything else in the sector. There’s a lot of uncertainty, a lot of people sitting on the sidelines, which means valuations and rents are flat or declining. The only saving grace is that new supply should moderate. If you’re going to invest in that sector, you have to do so very carefully.
Hospitality got crushed by COVID, and there was a lot of distress and some trades. But parts of the leisure segment have come back very strongly, with some hotels in our portfolio having a better summer in 2021 than they had in 2019. People really wanted their vacations. There’s still a real question mark over the business travel sector, however. Whether there is a 10% permanent hit or a 30 – 35% hit remains to be seen, but few people think it’s going back to how it was. Again, the saving grace is that new supply should really fall off, and in some markets, we already see hotels being repurposed.
|Matthew Kaplan||I’d pick out the industrial sector. It got hit for maybe two to three weeks back in March 2020, but really nothing stopped and in many cases business actually accelerated. Even before COVID there was the impact of the shift from retailing to “e-tailing,” which was a big tailwind for warehousing, supply chain management and logistics, but also the space to house all these new e-commerce businesses. COVID clearly accelerated that whole shift. Then there were secondary effects, too, as smaller tenants were priced out in favor of larger tenants. Rents in these sectors are sometimes 5% or even 15% above historic averages. Caution is advised because there is a real buying frenzy, but the sector fundamentals are very attractive.
The flipside of that is closing malls. There are 1,300 in this country. We might end up with 300 or 400. That said, people are still going out shopping and eating. If you have a well-located property, good traffic and someone willing to play ball on the leasing side, retail tenants have been very active since the second quarter of 2021, as they started to feel good about their businesses and their balance sheets again. This could be an opportune time to lease space and open up new stores. In addition, some of the omnichannels that have sort of started out online are now coming in and looking at physical space.
Dmitry covered the residential sector supply-and-demand fundamentals really well. Companies with good land banks, good relationships with local government and good access to construction financing can make good money creating the housing units that are so sorely needed.
|Erik Knutzen||What are your views on the prospect of higher interest rates?|
|Scott Koenig||We are always concerned about the impact of rising rates on capitalization rates. Cap rate spreads are still pretty wide, so there’s some room to move, and in general real estate is cheap relative to other asset classes. Still, it’s a concern, especially if higher rates coincide with a slowdown in the business environment.
In terms of strategy, it’s about shortening our horizon. I don't know what rates are going to be five years from now, but I can have a reasonable view of what they might be in the next two to three years. And we always enter into transactions thinking about what the exit cap rates are likely to be in a different interest-rate environment. Investors can get trapped assuming that caps rates are always going to be where they are today. That isn’t likely, so you look for assets that can suffer a 50-basis point or maybe a 100-basis point move and still provide an attractive exit.
|Matthew Kaplan||As Scott puts it, we don't know what interest rates are going to be. What we do know and what we can control is what’s going on within companies. We can start by finding people who can create a lot of cashflow, and the rest we can leave to the market. The other thing we can do is control debt levels. Real estate as an asset class has been through a lot—inflation, deflation, financial crises, you name it. People run into trouble for a lot of reasons, but the most common reason is debt. If you have a company that’s creating cashflow, that has low leverage, that has a sort of long-term strategy in place, you’ll have a lot more resiliency, whatever the business or interest-rate environment is.|
|Dmitry Gasinsky||Interest rates play a major role in our markets, with respect to the valuation of both the underlying real estate and the debt assets. A material uptick in mortgage rates has a pretty meaningful impact, on home values, on borrowing costs, on the cost of debt servicing, on how much buyers are willing or able to pay for houses. That said, the private lending markets are much less sensitive to rising rates than the public markets. It takes quite a substantial move for our markets to react at all. Moreover, right now, we find home development finance to be a particularly attractive segment, and, by definition, those lending opportunities are short duration by nature—about 12 to 24 months in duration—so the impact of higher rates there should be fairly muted.|
This article is based on a webinar hosted by Neuberger Berman on October 5, 2021. A recording is available. Should you wish to see it, please contact your NB representative for details.