The Real Estate Conundrum

Friday Reflections | July 31, 2020

The Real Estate Conundrum

This week stocks drifted incrementally higher – despite two economic data releases that reaffirmed the grim state of the broad economy.

The first report covered second quarter GDP, showing the US economy shrank at a -32.9% annualized rate from April through June, by far the steepest decline since WWII. This wasn’t a surprise to investors; the expectation had been a drop of -34%. The second data point was harder for investors to ignore, as it offered a bleak real-time view on the economy:  unemployment claims increased again, with another 1.43 million Americans filing last week for the first time. Together these data points tell us that economic recovery is stalling as coronavirus cases spike and re-opening plans halt. Today’s expiration of supplemental unemployment benefits adds urgency to the very real impact on millions of unemployed Americans, and the continued need for government support.

Beyond additional stimulus still under negotiation in Congress, the Fed has tried to assuage fears by reiterating their commitment to low interest rates. According to Chairman Jerome Powell, the Federal Reserve “… remain[s] committed to using our tools to do what we can, and for as long as it takes, to provide some relief and stability, to ensure that the recovery will be as strong as possible, and to limit lasting damage to the economy.” Storied investors including Warren Buffett and Seth Klarman have cast doubt on the sustainability of this path, and opined how Fed buying programs distort the market ability to effectively price risk.[1] The ‘lasting damage’ most investors and consumers worry about, though, is the damage to purchasing power that inflation represents.

Historically, real estate has been a reliable hedge against inflation. Hard assets, such as real estate or gold, have disproportionately increased in value during inflationary periods of modern history. Real estate is able to produce income from rents that rise with inflation, while also offering long term price appreciation. For many people, this adaptable income provides a buffer against the risks of rising prices. Whether it makes sense to invest in real estate right now to protect against the loss of purchasing power is unclear; coronavirus has clouded that picture in unusual ways.

In real estate, the prevailing wisdom is that location matters above all else – and we expand that to include different sectors of real estate. Currently, commercial properties are under dramatic pressure, while residential single family homes (especially in suburban areas) are seeing price increases. In the same quarter that delivered historic GDP declines, the median sale price for an existing home in the Bay Area rose 3.4% compared with last June, and Alameda County saw prices increase 6.1%.[2]

Multifamily housing is an area we have long favored, both as an inflation hedge and portfolio diversifier that tends to be resilient in recessions. When the economy is weak, people still need a place to live and apartment demand often increases. With distancing protocols, though, the density of apartment buildings suddenly represents an element of risk. For some properties, distributions have already been cut by management companies in order to create liquidity to handle increased expenses for expanded cleaning protocols and expectations of marginally higher rates of vacancy. Nonetheless rents have overall remained stable, with collections hovering at 94% in June.

Purchase prices for residential properties pushed higher in part thanks to record low mortgage rates. The ability to borrow money for 30 years at or under 3% has been a powerful force supporting prices. This may only be a short term benefit. Rates can’t go much lower, and prices would feel downward pressure instead if mortgage rates return to 5%, which is where they were at the end of 2018.

A second reason for high prices on the residential side is the fundamental power of supply and demand. With much of the spring market delayed by the initial shock of the pandemic and restrictions on in-person showings, there has been pent-up demand. Many people, especially those in small urban apartments, are re-evaluating their housing needs and looking for more space, especially outdoor space. The increase in remote work means fewer geographic constraints. Coupled with a limited supply of houses for sale, suburban home prices have remained particularly high.

Since the early days of the pandemic, there has been speculation of a bleak future for office buildings. Companies were adapting quickly to work-from-home logistics, and it seemed natural that many would be happy to let go of their expensive leases permanently. Companies ranging from Twitter to UBS and Unilever have all announced that employees would have certain flexibility to work remotely on a permanent basis.[3][4] At North Berkeley, too, we have discovered a resiliency in remote operation that we expect to complement our office resources as we move beyond this pandemic. As employees shift professional work into the home, many companies will need less physical space.

On the other hand, there are new sources of demand in commercial real estate in our new circumstances. Not everything (in fact, not most things) can translate effectively to a Zoom format. Processes like manufacturing or lab tests require physical presence. As companies adapt to new guidelines around social distancing of workstations and stringent hygiene requirements, a larger physical footprint becomes an advantage. These companies may actually need to increase their space to continue operating effectively and within regulations.

For owners of commercial property, the real pain won’t arrive immediately. Most commercial tenants are tied into longer-term leases that average four to eight years, and have heavy costs to exiting rental agreements early. That said, data analysis shows at the end of last year, vacancy rates were 5.4 percent in San Francisco. Now, vacancy rates are nearly 10 percent.[5] Landlords are hoping that by the time the decision of renewal comes up, the world may look very different, and the benefits of conducting business in person will be back.

As the pandemic has lingered, and the recovery timeline appears increasingly long, those speculations of permanent behavior changes and innovative adaptation seem more likely. We made a huge leap very quickly to working flexibly in multiple locations, but once it is safe to be in offices again, we’ll see the next phase of change. Integration of remote and in person business gatherings won’t just be a little of each, but will likely have absorbed benefits of both for different uses, and created a more complex, newly effective combination.

Investors (and people broadly) are afflicted by “recency bias” – meaning that an outsized weight is assigned to a risk that is more visible or recent. Once the risk has subsided, it loses some of its power to impact decisions.

Jonathan Miller, CEO of a New York based appraisal firm, commented on the outbound migration from urban living after 9/11. Fear gripped the city, and what was a desirable place to live suddenly became a risk. Eventually fear subsided and the trend reversed after three years. Closer to home, a San Francisco based developer similarly observed that “every time we have a major earthquake or major economic downturn people leave San Francisco, people say San Francisco is gonna die and there’s no hope. The Bay Area is a gateway coastal city it has U.C. Berkeley, it has Stanford, it has Silicon Valley … eventually new and more interesting things happen — it’s just part of the cycle.”[6]

The fear of high-density living is elevated right now, but once the virus threat is solved that fear will fade with time. In the near term, we prefer real estate funds that diversify beyond the traditional commercial and residential sectors to include newer areas as well, such as cell towers and data centers that are essential in a digital economy. History tells us that real estate is additive to both return and stability in a diversified, long-term portfolio, and beyond this pandemic will still serve a key role in guarding against the eroding force of inflation.

[1] Billionaire Seth Klarman says Fed aid ‘infantilized’ investors and decoupled the stock market from fundamentals. By Ben Winck.  Published on July 30, 2020.  Business Insider / Seth Klarman Letter

[2] Coronavirus: What pandemic? Bay Area home prices continue to rise. By Louis Hansen. Published July 30, 2020. Mercury News

[3] Twitter says staff can continue working from home permanently. By Brian Heater. Published May 12, 2020. TechCrunch.com

[4] UBS says remote work might be permanent for one-third of staff. By Justine Coleman. Published June 22, 2020. The Hill

[5] San Francisco turned ghost town? Here’s how empty the city really is. By Stephanie Sierra. Published July 29, 2020 ABC7 News

[6] Bay Area office, retail rents expected to drop due to COVID-19. By Maureen Kelly. Published Jul 29, 2020. KRON 4 News