After numerous conversations with investors, CFAs, data scientists and economists in conjunction with my own understanding and study as a CFA candidate, I thought it would be worthwhile to share my thoughts on how I think this crisis will affect the commercial real estate markets in the short and long run, with a few ideas on how to position ourselves to succeed.
To do this effectively, I think we need to look at the economy as a whole on a macro level to consider which factors will influence supply and demand for investment real estate. Looking at it from this perspective allows us to simplify the problem by characterizing our hypotheses in the language that serves as the basic building blocks of how our markets come together to set prices. We need to get into the details at a later date to understand more about timing, but economics can give us hints as to the general direction of the market over time and with so much uncertainty still, that might be the best we can hope for.
Short Term Demand Goes Down
I believe that in the short run, commercial real estate values (and other financial asset values) will decrease, with a period of reinflation leading to valuations much higher than their pre-crisis levels. This is fueled largely by the shifts in demand that occur as a result of lower consumer confidence, lower incomes, tightening credit and US monetary policy.
First off, I would like to say that until we have a better understanding of the timeline for which we expect businesses to be closed, new transactions will be at a near standstill. People will still complete a few deals that were in progress and those in the middle of exchanges for example, will be motivated to make those purchases.
However, until we know how much of an economic effect this will really have, it will be nearly impossible for buyers and sellers to come together on valuations. If you are a seller and have a large amount of your net worth tied up in your real estate asset, you would have a very hard time accepting a steep discount until you know empirically that you have no other option. Likewise for a buyer, they need to price that uncertainty into their acquisition basis. This creates dissonance between the two parties and is what is leading to the current “wait and see” approach we are so often running into anecdotally at Obsidian Group. Put simply, no one really knows for sure what these buildings are worth right now.
Eventually, as a few deals are done, we will start to see a large enough sample size to begin feeling more confident in the new market conditions and word will spread to sellers that it may no longer be viable to expect the price levels that marked the irrational exuberance at the end of the previous expansion.
How This Happens
As a result of the pandemic we are already seeing decreased consumption across US markets, which results in decreased revenues for businesses, which results in less money to pay to employees. Eventually, this means less pay and higher unemployment. When people don’t have jobs and make less money, they have less money to spend, which perpetuates the cycle for consumers.
As incomes decrease, people’s creditworthiness decreases which gives them even less purchasing power. Because people have less income AND less credit, the amount they can pay for commercial real estate (or any financial asset) decreases, driving down their values. Banks, seeing the value of these assets (which serve as their collateral) go down, further tighten up their lending practices, removing even more money from the market and creating another vicious circle of decreasing demand, consumption and incomes.
As business revenues decrease, those that are tenants begin defaulting on their leases, leading to instability in the landlord’s revenue stream. When landlords are not as confident in their tenant’s ability to pay, the investment becomes less desirable, which means they require a higher return in order to price the risk of default into their models. To make this even worse, many landlords and investors feel compelled to sit on their money to ensure they have adequate reserves to weather the financial storm in the event that their tenants cannot perform. Keeping this money on the sidelines as an austerity measure furthers the decrease in demand because there is even less money going towards buying buildings.
In summary, the self-reinforcing patterns of behavior of investors, lenders and consumers decrease short term demand, which drives down asset prices. Until demand reaches the same level as it was before the crisis, prices will be lower. This demand tends to lag in the real estate markets, because real estate is illiquid and therefore by definition, less responsive. This cycle is the reason I am not as optimistic as some that once this clears up, we are back to business as usual.
The Balloon Reinflates
In order to increase demand, the US is increasing the money supply by dropping interest rates and through quantitative easing (colloquially known as “printing money”). When we have more money to spend, we demand more. This is the Fed’s attempt to stimulate the economy and put a stop to the cycle described above (and in this case, out of necessity to keep people alive).
In a perfect world, we should be attempting to print precisely the amount of money that is lost through the disappearance of credit and consumer confidence to keep demand stable. Once the other demand factors return to their previous levels (consumer confidence leading to higher employment, income and consumption), the money supply would be ideally reduced to maintain equilibrium by increasing interest rates. Unfortunately for the stability of our economy, the massive amount of debt in the US, makes this nearly impossible to do. We simply would not be able to service our debt.
The danger with substantially increasing the money supply in an environment where you can’t increase interest rates is that you can potentially create a substantial amount of inflation. During the last recession, we used similar monetary tactics and those policies had this exact inflationary effect.
Hidden Inflation
But wait, didn’t the US inflation rate stay close to the targeted 2% in the last decade even after the monetary policy of the Great Recession? That depends entirely on what you are measuring.
The most commonly reported figure for inflation is the Consumer Price Index (CPI). This index is flawed and does NOT factor in the values of financial assets. Additionally, a lot of the items that are measured in the CPI don’t have higher demand when incomes rise. For example, how much more milk do you consume after you get a raise? Indexes like these are hiding the inflation taking place in our country.
In a low interest rate environment, people become much less likely to save than to invest because your savings earn next to nothing in interest. You are losing money to inflation while it sits there, which creates incentive to go find somewhere to place it that earns a return.
This leads to increased demand for financial assets, which leads to higher prices. Anyone who has invested in real estate, purchased a home or invested in the stock market over the past decade knows anecdotally that we have been dealing with much more than a 2% increase in asset values over that time. The chart below illustrates this point beautifully.
This inflation as a result of US monetary policy has been hiding in asset values and is largely what is responsible for increasing the wealth gap in our country. Between 2008 and 2016 the Fed increased its balance sheet to its then peak of $4.5 trillion. Today the Fed’s balance sheet is currently over $6 trillion, with projections of $7 trillion by June and $10 trillion by the end of 2020.
This unprecedented increase in the money supply will have a dramatic effect on asset values, inflating them well beyond their previous highs by putting more money in the pockets of investors who compete for a finite supply of assets, driving prices up because of the increased demand. How long all of this will take is anyone’s guess, but when investors and lenders once again feel confident that the value of these assets will rise, we will see the feeding frenzy begin.
OK, But Now What?
What to do with your real estate depends entirely on your need for liquidity and what sort of timeline you can operate within. If you think you need to sell in the next few years, now seems to be the best time to do so. The last recession began in 2008 with real estate values bottoming out in 2010 (according to Costar’s industrial metrics) before gradually increasing to well above their previous peak in 2019.
However, if you own real estate with a durable income stream, with high-demand space like multifamily industrial or something with long-term, credit tenants, it seems very reasonable to me to hold onto that asset to receive the benefit of the long term appreciation that seems sure to come.
The biggest winners in this crisis will be those who have the aptitude to manage their portfolio through the hard times, the resources and courage to buy when no one else wants to and the knowledge to recognize that time when it comes.
Please keep in mind that these are my own personal views and that nothing here is intended to be investment advice. Instead I hope to start a conversation and share what I am seeing in the hopes that through collaboration, we can all have better outcomes going forward. Also note that many of these factors can change, but by analyzing them through the correct prism, we can make better adjustments as new data becomes available. The sooner we all get on the same page, the sooner we can do something about it and I look forward to more conversations with you all.
