Uncertainty dominates Cadre’s commercial real estate outlook this quarter; specific asset selection will be key going forward.
The U.S. economic recovery continued in the second quarter of 2021, despite a credible threat of inflation. Businesses are facing difficulties formulating policy amid new variants of COVID-19, changing public health measures, labor and material shortages, and abrupt shifts in demand. Price increases for commodities, building materials, and labor accelerated earlier in the quarter, before cooling somewhat in June. However, the economy (thanks in part to stimulus payments) continued to prove its resilience to many of the challenges of the pandemic, as the year-over-year change in consumer prices reported this June rose 5.4%, the highest annual growth rate in 13 years.
Hedging Inflation Fears
The rapid rise of crucial metrics such as wages and rent may be consistent with faster economic growth and an inflationary environment. These economic conditions could potentially benefit investors in commercial real estate (CRE).
Commercial real estate owners have the ability to increase rent in line with rising costs in some sectors, while in others they may be able to directly pass expenses through to their tenants. There are also risks associated with CRE investing in inflationary periods, such as higher interest on floating rate loans or potential tenant vacancy, so investors should consider their overall goals and risk tolerance carefully.
Office: Migration to Rising Metro Areas
People had already begun to move from gateway cities like New York, San Francisco, Chicago, and Los Angeles prior to the impact of COVID-19. The pandemic accelerated this pattern of migration. Approximately half of these movers relocated from the urban core to the suburbs during the pandemic. The other half moved further afield, bringing talent and opportunity to smaller, lower-cost metro areas.
Satellite facilities in up-and-coming cities followed the talent as these cities gained highly skilled workers. Businesses such as the Oracle complex in Nashville, the Goldman Sachs Campus in Dallas and Credit Karma announcing a new East Coast headquarters in Charlotte reflected an influx of skilled workers that drove employment growth for smaller and mid-sized cities. As work becomes less tethered to place, many rising metro areas should continue to benefit from the relocation of highly skilled workers.
Multifamily: Quality Matters
Asset selection is essential in the multifamily market. Going forward, great multifamily properties in a thriving location are likely to perform well, but a mediocre property just a few miles away might face a very different reality.
Though both interest rates and 10-year rates are still historically low, Cadre’s Data Science team, which informs our selection of the Cadre 15, helps us to identify markets which we believe will grow faster than the rest of the country. We look for growth in the first few years of ownership to generate solid risk-adjusted returns.
Hybrid May Be Here to Stay
Skilled workers and companies throughout America are realizing that both in-office and remote work have advantages, prompting some of the biggest names in tech and finance, among other companies, to embrace an ongoing “hybrid model” of employment.
These changes are likely to have negative implications for some office markets, particularly in large cities with office-based urban cores. Going forward, office spaces that survive are likely to transform and adapt to the new paradigm in ways we can not yet predict.
Our conversations with business leaders suggest that companies are reassessing their space needs through a strategic lens. Several businesses have made the decision to reduce their physical footprints, as office employees enjoy the flexibility that comes from reclaiming their life/work balance, while still achieving high levels of productivity. Companies eyeing a full(er) return to the office seem to be entertaining larger, more strategic moves like building or leasing in new locations with better accessibility and attractive amenities.
Cadre is cautiously opportunistic about the office sector, as we continue to see a flight to quality. Picking the right assets is more important than ever. The interaction between investing in attractive cities versus choosing individual properties within those cities could be an important dynamic for investment returns in the office sector.
Headwinds in Hospitality
The hospitality sector has been affected in a similar vein as the hybrid office model. Bottom-line savings that come from eliminating corporate travel throughout the pandemic have largely continued into the current recovery. The shift toward remote meetings may yet prove to have a lasting effect on the hospitality sector, which in July saw the highest occupancy rates (71.4%) since summer 2019. July’s occupancy, however, is still 7.8% below its 2019 levels.
Gateway cities (New York, LA, San Francisco, etc.) have been the most affected, as they are the most reliant on international, business, and air travel. These metropolises are unlikely to enjoy the same strong occupancy rates they did prior to the pandemic for the foreseeable future. Even a return to 90% of pre-pandemic levels for business travel would have a relatively large impact on the hospitality sector.
However, the effects of virtual meetings and slower return to air travel is impacting different metro areas in very different ways. Relatively affordable driving destinations (e.g., Savannah, Georgia) are recovering at a much faster clip than gateway cities. Many other smaller, rapidly growing metro areas are also benefiting from people’s desire to drive vs. fly to vacation destinations. Asset selection in the hospitality sector is therefore very important, as specific hotels in select locations could thrive from new sources of growth and revenue, while others may suffer from shifting demand.
We Weathered the Worst of the Storm, but Visibility is Low
Robust growth coupled with a massive amount of investment capital seeking a home belie a lack of visibility into the markets. There are still churning cross-currents that require careful navigation, as the pandemic has far-ranging implications.
Commercial real estate transactions have declined considerably during the pandemic, but remain elevated relative to longer-term trends. The themes that the pandemic accelerated, including the migration to rising metro areas, the shift to a hybrid model in offices and declining business travel are likely to be major drivers (and potentially detractors from) real estate returns in the quarters ahead, depending on where and how you are invested. The longer term impact of these trends in the real estate market is still highly uncertain. As such, we believe that caution will be the better part of valor as the economy settles into its new patterns.
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