So, while prices are rising in many areas, there are still great investment opportunities in the industry.
Effi Benmelech, professor of finance and real estate at the Kellogg School, recently joined Kimberly Adams, managing director of JP Morgan Asset Management, and Seth Singerman, president and managing partner of Singerman Real Estate, for a panel discussion on the state of the US real estate industry, how inflation and other economic factors are influencing their investment decisions, and what they see on the horizon for investors.
This interview has been edited for length and clarity.
Kellogg OVERVIEW: What excites you most about the real estate industry today?
Kimberly Adams: Whether it’s offices, industries or retail, the pace at which the world is changing in terms of the use of space is extremely exciting. As an industry, this is where the opportunities for investors lie. So there are certainly inflationary pressures and potentially recessive pressures. We are always at some point in a market cycle! But what’s most exciting for us as investors today is being ahead of the curve where the greatest demand for space utilization will be across all sectors.
OVERVIEW: So where do you think this demand for space is heading?
Seth SINGERMAN: Well, for example, the way people travel has been affected by COVID. The length of stay is increasing significantly, which has impacted the leisure markets. It’s been great for Airbnb, but not for the traditional 400-room downtown hotel.
I am convinced that the activity of the group will come back very strongly. There are conferences that people attend every year. People are still going to go there, and maybe it’s more important for people to go now. But the traditional businessman of the road? More of this is done on Zoom. And it will affect business transit, which has implications for hotel demand and utilization.
ADAM: In the past, commuting was part of everyone’s daily life, and when you showed up for a job interview, you didn’t really think about where your home was in relation to work. It was more like, “Okay, this is the job I want, and I’ll figure out how to get it.” What we see today are people saying, “Well, wait a minute, I don’t really want to spend an hour a day commuting. What does my flexibility look like? How long can I recover? Maybe it’s not the right job for me, because the ride doesn’t fit my lifestyle.
This notion is extremely new and results in a different type of desk that is more desirable today. Like Fulton Market in Chicago, where you can live, work and play, all within two or three blocks. That’s hugely attractive to the workforce today, and we as investors need to take that into account. These dynamic nodes in cities are not always the obvious places near public transport.
So it’s less about a particular asset being reused than a change in the variables that go into decision-making for users.
BENMELECH: There used to be a more traditional division between commercial and residential real estate. One of the changes we’ve seen, which started before COVID but accelerated during the pandemic, is that some of our personal space has become commercial real estate. We buy door to door, stream our entertainment, etc.
So there is some displacement of these traditional sectors of real estate, but it’s not as if they are disappearing; we just use them differently. This leads to the growth of some other businesses.
OVERVIEW: And, I imagine, the decline of others. So do you see a lot of distress?
SINGER : There is absolutely some distress that is out there. But where you see distress is not financial distress or overleveraged assets. These are business models that no longer work. To find a good value long-term opportunity, I think you need to assess where the future of that business model is heading, as well as the risk involved in executing the business plan.
BENMELECH: Yes! You must decide whether the company is in financial difficulty or in economic difficulty. If it is in financial difficulty, it would be useful to change the capital structure. If the company is in economic difficulty, it means that it may operate under an outdated business model, so there may be no reason to bid for it. Decisions are not always about real estate itself.
OVERVIEW: One area that has generated some excitement is the repurposing of shopping centers into mixed-use spaces. What is your opinion on that? When evaluating a transaction, what types of factors do you consider?
SINGER : The repositioning of shopping centers is extraordinarily complex because there are many parties involved. There’s the mall owner, plus the companies that own the boxes: Target, Sears, JCPenney. This makes the degree of difficulty of transactions very high.
I will give a perfect example. Everything was working in our favor for one project. Great place. The municipality was in favor of converting one of the big clubs into apartments in a very healthy shopping centre. The problem is that there were three different boxes, all owned by different companies who all wanted residences. So everything had the stars aligned, except you had three companies that were going to fight over which of them was going to reorient.
OVERVIEW: Are there other markets that you are particularly monitoring?
SINGER : We have our eye on industrial outdoor storage, which includes space to park trucks. With the growth of online shopping and distribution, you need more delivery trucks to move goods faster. There is therefore a greater demand for parking spaces, mainly for distribution trucks, but also for other heavy machinery for roads and other types of construction.
ADAM: I agree. Victory in the supply chain is really about having trucks near goods and goods near people. There isn’t always room for trucks at every site that stores goods, so it’s a wild ride to see how far you can get your trucks to your goods. It’s a component of the last mile mentality, and it’s becoming more and more important.
With Amazon, you see the small vans driving through your neighborhood because they don’t bring the big tractor-trailers to those smaller streets. All of these trucks have to rest somewhere at some point.
OVERVIEW: We haven’t talked about residential real estate markets yet. What do you see there?
SINGER : I think you have to separate the sale market and the rental market. The sales market, depending on location, has really been impacted by the migration of people during COVID. In the regions that have benefited from this – Florida, Nashville, parts of Texas – the price appreciation and demand – as well as the lack of supply – have been quite extraordinary.
On the apartment side, the pressure on prices has been very, very strong, because you have seen the growth in wages, especially in the middle and low income segments. This has allowed significant rent increases in this type of asset. And existing buildings are still trading substantially below the cost to replace them with new apartments. They are therefore a good investment at the moment.
BENMELECH: I consider that the risks inherent in residential real estate can extend to the whole economy. We have learned from the global financial crisis that door-to-door transactions are essential for the economy. One of the reasons for this is that when you have more transactions, there are many associated expenses. A large part of consumer spending is on housing, and it will not be spent otherwise. Even those who buy new houses renovate or change them. So a lot of transactions in residential homes lead to increases in consumption that affect a local economy, and we’ve seen a lot of that post-COVID.
Of course, the risk is that as interest rates rise and mortgages become more expensive, this trend will reverse. This not only affects the housing market, but it has significant effects on local economies.
OVERVIEW: Inflation is currently at its highest level in 40 years. Is inflation a big, medium or small concern for you right now as you look to next year?
ADAM: Real estate is extremely attractive today compared to other asset classes. This is a natural hedge against inflation, as you constantly capture rising costs by increasing rents, as long as the economy continues to evolve. I think that’s what’s most attractive right now, especially for short-term rental-type products. The tipping point occurs when rents do not rise as fast as the cost of construction. If rents slow down a bit and costs increase slightly, there is still a reasonable cushion in the profit margin. When rent growth starts to slow, construction may not make as much sense.
SINGER : I think real estate values will follow GDP and labor market trends more than inflation.
BENMELECH: As a teenager, I grew up in a country, Israel, which experienced hyperinflation of at least 400%. My mother gave me money for the bus; two days later the rate would go up and I would have to ask him to give me more. This kind of high, high inflation is very taxing on the middle class and even more taxing on people who live hand-to-mouth or paycheck to paycheck.
That’s not what we expect here. Inflation will be 5-8%, which will be embarrassing, but it won’t be terrible. As long as national institutions remain strong, we can recover. The risk is that if politics gets entangled with inflation, then it is harder to recover from.