A Commercial Real Estate Update

Josh Barber, CFA: The first thing to note about REITs is that they aren’t real estate in the traditional sense. They include real estate, but conditions in the broad real estate market are different than in the REIT market. First, REITs generally have low-levered, long-term fixed rate balance sheets — so a lot of the rate sensitivity does not affect a REIT’s daily business, which is a good thing. Second, REITs tend to have much higher quality portfolios than what exists in the market. Third, REITs have access to what’s commonly known as the four quadrants of capital — public and private, debt and equity. For example, if you own a building in downtown Columbus, Ohio, you pretty much have just private equity and private debt. You don’t have the ability to do public bonds or joint ventures. On the other hand, REITs have the ability to tap into all four quadrants of capital, which tends to diminish their risk profile.

Finally, every property sector responds differently to these sorts of market events. For example, shopping malls and even some strip retail malls were badly impacted by the expansion of e-commerce. While malls have held up okay, the true winner from the e-commerce explosion has been industrial warehouses and related property types. Today, the office sector — especially central business district office space — is facing challenges, but suburban offices are starting to do well. As the work-from-home (WFH) trend continues, it may not be positive for office space overall, but other property sectors can benefit. One that comes to mind are data centers — more remote workers mean businesses have more remote data needs.

Josh Barber, CFA: No doubt office space is in the eye of the storm as it faces a secular change with the WFH movement. At Diamond Hill, we have had very limited investments in office over the years because it’s a tough business and tenants have a lot of leverage.

The secular shift to remote working has been quick but it will take time to see the long-term effects. Even if companies choose to eventually reduce or eliminate office space, they are still committed to their leases. Most companies are not abruptly giving up 75% of their leases; perhaps instead they will change how they use the space in the interim.

Small tenants usually don’t want to hop around from building to building, and they don’t have the wherewithal to negotiate high capex packages. Additionally, most landlords don’t enjoy dealing with small tenants because it’s a labor-intensive business to lease out 5,000 square feet of a million-square-foot tower. That said, there are property owners who have the platforms and know-how to make it a good business model, especially in supply-constrained markets.

Another trend we might start seeing is a rise in office conversions to housing. For example, in big coastal cities such as New York, Boston, Washington, Seattle, San Francisco and Los Angeles, availability has been one of the biggest constraints on the housing side. Now you have a lot of empty office towers, and people need more places to live. While the conversion process is expensive and time consuming, and there isn’t a ton of government support for this shift, it could be something we see down the road, assuming the exodus of city residents due to tax and crime issues slows down.

Josh Barber, CFA: Multifamily housing is doing well, though more so on the public side than private. In 2021, for example, private players could buy multifamily properties using floating rate debt at very low cap rates (sub 4%). The assumption at that time would have been to invest, refinance in a few years, fix the property, improve your net operating income and then sell. That group is facing some challenges now because they are likely upside down on their current cash flows – their debt yield is higher than their asset yield. That isn’t a problem on the public side where investors use long-term bond-backed financing and have low-cost, long-term financing on their balance sheets. So public investors are going to be in a good spot, especially because their balance sheets have low debt levels putting them in a good spot to buy as properties come to market.

Josh Barber, CFA: The data center sector is doing reasonably well now, and the hyper-scalers also continue to grow their businesses.

Oddly enough, hotels are doing quite well. Hotels don’t tend to be a defensive property type, and they’ve been very defensive for the last year. Perhaps it’s a delayed pandemic effect. Or maybe it’s just that finally some of the bigger hotels can flex their muscles from a branding perspective, but it’s been interesting. I’m not saying to rush out and buy a lot of hotel investments today because, in my opinion, I still can’t see how that sector is doing well in a weaker economic environment, but that’s been the case so far.

And then there’s self-storage, which has been the opposite of office. It has low capex and economies of scale, which means tenants don’t have much leverage. It’s a good business with solid franchises and low balance sheets. If the economy weakens their net operating income will weaken, but that’s a phenomenal business to be in long term.