How to weather hypersupply and recession

Question

First, thanks to @Douglas Dowell and others for switching me onto Glenn Mueller. His latest commercial real estate cycle analysis is here: http://www.irem.org/File%20Library/Events/IFLC/IFL...

I am worried about overbuilding in Class A apartments and about the long-term prospects of big box retail, office and industrial properties with current employment and technology trends. But that doesn't mean we have to withdraw from real estate altogether.

Based on Dr Mueller's analysis and my own observations, I am looking at the following as good sectors to invest in real estate and ride out a possible crash in the next few years.

- Suburban B/C apartments. These are the workhorses of residential investing, and nobody is building new inventory so supply is constructed.

- Niche neighborhood plays. Every market is made up of individual pockets and they cannot all be oversupplied.

- Local retail and strip malls. If we are moving to a "gig economy" all those new business owners are going to need cheap space. Have to be careful not to rely on businesses that will be displaced by the internet.

- Hotels in the right market. Raleigh and Dallas stand out as two that seem underserved compared to the economic growth.

Do you guys have other good sectors or cities to weather the storm?

Giovanni Isaksen · Answer

@Nick L. great post and great discussion everyone. A couple points about Mueller's Cycle Monitor: First, your link is to Glenn's August 2014 Cycle Forecast of positions in Q2 2015 which is different than his quarterly Cycle Monitor which is a report on where he believes the markets actually are. Unfortunately it turns out that his predictive powers aren't better than throwing darts blindfolded*.

Another point to keep in mind is that even the Cycle Monitor reports have had markets in far different positions than they objectively were in at the time. See my posts here and here for research backing this up that I reported on earlier this year.

The Cycle Monitor reports used to be posted on Dividend Capital's website but no longer are. The most recent report I can find online is for Q1 2015 here. I have the reports going back to 2005 and am happy to share them with you if you request them via email (email address is in my signature, don't message me here for them).

*As part of my report I was going to analyze Mueller's predictions but between the track record of the Forecasts being what it is  and understanding what can objectively known about the future it wouldn't have added any real value.

Good hunting-

Bill S. · Answer

I can't speak for other markets but I agree that Class A apartments are being over built. Not sure where the tipping point is but I know there is one. I don't like the burbs. I think the play is in the urban core for anything that is valued less than the cost of construction. There are no class B and C being built in the urban cores but there are some A's that will slide like @Dmitri L. pointed out. Still the demand should easily outstrip the supply. Land is so expensive and construction costs are so high that there will still be a scarcity in the urban core.

Matt Dorsten · Answer

Doug, I'm in Industrial Real Estate in Denver and while our market is very healthy and outside of the norm for the rest of the US, manufacturing is coming back to the US and other factors are increasing warehouse demand.  Marketwatch.com put out a good article on the increase in manufacturing jobs and some supporting reasoning why "Made In America" is coming back (http://www.marketwatch.com/story/us-flips-the-script-on-jobs-reshoring-finally-outpaced-offshoring-in-2014-2015-05-01).  Another aspect driving demand is urban redevelopment with warehouses being turned into a plethora of uses ("open loft office" warehouse conversion, indoor trendy mini-malls, and lofts).

Giovanni Isaksen · Answer

@Cameron Skinner I agree completely with your strategy for weathering downturns.

@Nick L. Happy to help. I don't have predictions (I'm writing a post about that now) but I do have a couple overarching themes that I use to guide my sector and market selection.

The first is that most people underestimate the effects of the Great Recession on Millennials and Gen Z. I think it will have a large influence on their housing choices similar to the way people who came of age in the Depression were affected. Most housing people seem to think 'it's just a phase but eventually they'll all want to own a sfr' but I'm not as convinced. Between seeing their parents and their friends' parents lose their homes or be trapped underwater in them, the amount of college debt they're graduating with and their need to be able to move to where the job opportunities crop up as well as a couple other factors makes it look like apartments and rental houses will do well for quite a while.

The second theme is that the country is being divided into haves and have nots based on the answer to this question: Got tech? Markets with tech clusters will do well. Seattle & the Bay Area being the poster children but also Austin, Denver & Boston plus a number of other places that might not come immediately to mind such as Pittsburgh. A lot of cities like Pittsburgh are trying to develop tech clusters that may or may not catch on but I have only half-jokingly suggested doing apartment market research the way Burger King used to market research; be across from McDonalds. Only in the case of apartments it's go to the markets where Google has an office. This will affect all the CRE sectors as well as single family rentals, but that's for another post.

Another theme is that because of the extraordinary measures the Fed has taken (and as of yesterday is still afraid to undo) there is a lot of capital looking for yield, desperate for yield that they normally would be getting it from bonds and other debt instruments. That has pushed a lot of capital into real estate markets compressing cap rates. Think about the large pension funds who are responsible for providing hundreds of thousands of about to be retired peoples' X% of final year's salary for the rest of their lives. Oh and these about to retire people will live about 10 years longer than we planned for 30 years ago. Try hitting those numbers with a fifty-fifty or sixty-forty portfolio of stocks and bonds. On top of that there's a lot of Asian money that would like to be owning US real estate and we have a recipe for cap rates staying lower longer than most people expect. For more on this theme see here, here and here.

Those are the major themes that along with a number of minor themes go into where we think different  real estate sectors will do well going forward.

Good hunting-

Cameron Skinner · Answer

@Giovanni Isaksen is correct no one can predict the future and what trends will grow and what will wither and die.  The best way to weather the next down turn is to grow conservatively don't over leverage and have large reserves.

J Scott Hamilton · Answer

The downtown Dallas hotel market is crazy overbuilt. When I left in 2010 the Downtown occupancy was only about 60%, and since then they have built and renovated like crazy.  The aristocracy there thinks that putting more hotel space next to the Convention Center will make the center more popular and draw more events, which will fill up the rooms. So think of it like supply side economics.  But those of us who actually lived in the Central Business District think they are all nuts.

Now the luxury hotel space, that's an entirely different story. They are demolishing older buildings in Uptown in order to erect more residential and hotel space, and it looks like that space rents out well.

Malls

That's a danger area. Online shopping is gutting retail sales. Even those of us working in higher end merchandise are getting spanked. Luxury class might survive, but the rest of us squeezed between Target and Saks are feeling the pinch.

Nick L. · Answer

@Walter W.

That's another great perspective. Hard to say with Sam Zell or Starwood is on the right side of that deal. I'm guessing Zell though.

I am glad I started this thread and got so many thoughtful responses. You guys have really given me a great strategy for the next few years. Thank you.

Here's my new, more positive outlook based on what all the experts here have said:

- Buy urban core properties in tech-centric cities

- Retail is also good as long as you stick to urban properties in areas with growing populations and get destination-type tenants

- Industrial may also be coming back but you really have to know that sector in detail

- Grow conservatively and keep large reserves

- Cap rates are likely to stay low for a while due to low interest rates, capital inflows and a generation of renters rather than buyers

Thank you again guys. This discussion has given me a great direction. I'm off to buy some properties in downtown Austin!

Justin Pierce · Answer

I agree with Matt Dorsten.  I really like the warehousing market.

Joel Owens · Answer

I am going to post about retail. I hear a lot of people touting doom and gloom about retail yet they have never owned the asset or specialize in it.

They have owned SFR or Multifamily and are on the outside looking in with just a very basic concept of the asset class but not deep level knowledge. I hear this many times a month and it gets old........... : )

Just like anything regardless of the cycle if you understand the asset class there is money to be made.

I contend retail is not any riskier than multifamily. There have been and will continue to be people who lose money in both and those who have gained a bunch of money.

A sampling of some of my clients one has made over 1 million in equity growth since 2012 with cap rate compression. Another 400,000 with an  auto store. Yet another multi millions with a retail project.

Online sales are growing there is no doubt about it. Big box retailers with 50,000 and 60,000 or more sq ft spaces no longer need that size. Micro stores are in the future about half the size. 90% of all retail closings just so everyone knows last year were clothing and furniture related stores.

My clients who are high net worth and ultra high net worth investors I am not looking at big box stores regardless of cap rate. Kroger, Publix, HEB etc. that are grocery anchored are still strong performers. The problem is once you go above about 15 million the REIT's and pension funds get involved as buyers and pay a cap rate that doesn't work for the little guy. If a little guy puts 15 million into one property it better throw off mucho cash at a higher cap rate.

These public companies own 30 or 40 larger anchored centers so if one goes out then they have others throwing off cash. A regular investor can't do that strategy unless they are worth hundreds of millions and can accumulate many multiples. This is why most of my deals center around strip centers not anchored with tenants from 1,000 to 2,500 sq ft in size with great demographics. Mostly national tenants with a few mom and pop sprinkled in. I focus on destination type tenants such as barber shops, vet places, regular doctors office, emergency clinics, restaurants, karate schools, fitness centers, environmentally friendly dry cleaners, etc.

These are places people HAVE to go to do business. This helps tenants with sales to pay owners the rent versus a customer going into a store looking at things and buying cheaper elsewhere online leaving your tenant without a transaction. Brick and mortar retail is NOT going away. The structure of it just has changed and will continue to do so just like any asset class.

Another fallacy is retail takes a dive to lose value in economic times of difficulty. If you have national tenants they set reserves per store in the good times to weather downturns. In bad economic times they offer discounts to drive sales and maintain customer base and market share until things improve again. Where strip centers get hurt is rural type areas with all mom and pop small tenants that mortgaged the house to start a business. Any little blip in sales and rising of the costs of goods they can go from making money to losing money.

National tenants tend to not go in rural areas because demographics and diversity of employers along with other metrics are not there. In the warm belt states where baby boomers are retiring suburban areas are rocking. The cold belt states is where suburban and rural is dying off as retirees ( snowbirds ) flock away with net migration to warm weather states. Urban core is still performing well in cold belt states but tends to be frothy in cap rate compression with rates at 4 to 5 caps and some lower than that. I am not a buyer at those top end levels.

I review about 500 properties a week for retail. Maybe 5 percent of them I like to show to my clients.

Dmitri L. · Answer

@Nick L.

I agree with everything except for class B/C apartments. If you think class A is being overbuilt, there will be an oversupply of these on the market. Some of these will get priced down to compete with B class properties. Some B properties in turn will fall through to C, and C.. Well you get the picture

Hotels.. Hmmmm ;)

D

How to weather hypersupply and recession

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