WMRE: What are the three biggest headwinds facing the U.S. commercial real estate industry today?
Kevin Brown: Higher interest rates. Given the capital-intensive nature of investing in commercial real estate, nearly all real estate owners must utilize debt to finance a significant portion of the investment. Therefore, if interest rates go up and stay at the new, higher level for an extended period of time, then real estate owners will face ever-increasing interest expenses as current debt comes due and must be replaced with higher-rated debt. However, given that most owners stagger their debt maturities that increase will be gradual. The larger, more immediate impact will be on owners that are actively expanding or recycling their real estate portfolio. Owners actively acquiring or developing new properties compare the expected acquisition cap rate or development yield to their weighted average cost of capital before they move forward with the investment. Higher interest rates raise the WACC, which in turns reduces the expected return on the acquisition or the development project. Not only do lower returns hurt the acquirer, but they also hurt the seller as there will be less demand for the property being sold, which potentially lowers the asking price for the property being sold. Therefore, higher interest rates will have a larger impact on active real estate investors compared to ones with static real estate portfolios.
Higher operating costs. Inflation has caused nearly all operating cost categories to go up significantly over the past year and that looks to continue through the rest of 2022. However, this has a disproportionate impact based on the real estate sector. On one end are real estate owners that have triple-net operating leases with their tenants as they require the tenant to pay nearly all of the operating and maintenance expenses for the building. Mall owners will also see a smaller impact as they typically bill each tenant a proportionate share of the mall’s total operating costs and expenses. However, more operationally intensive sectors will see their cashflows negatively impacted by higher operating costs. Hotels and seniors housing both operate at lower EBITDA margins than most other sectors, with a large percentage of their costs coming from labor, so wage inflation may cause operating margins to fall.
Tenants facing higher costs. While higher operating costs are either passed along to the tenant or can be offset by higher rents for most sectors, landlords need to worry about the health of their tenants and if they are able to bear the brunt of higher costs. Tenants in many sectors, such as large retail anchors or skilled nursing facility operators, operate at single-digit margins, so even small increases in costs can affect the profitability of those tenants. Real estate landlords will have a difficult time passing along rent increases on tenants with very low operating margins and may face occupancy declines if higher costs cause many to be unprofitable, forcing the tenants to close down or move out. Therefore, while not all real estate sectors are negatively impacted by higher inflation, many will find that inflation does put a cap on how quickly they can raise rents.
If we do enter a recession in the next 12 to 24 months, we don’t anticipate it will be like the prior two recessions. Those recessions were both event-driven and we don’t anticipate the U.S. entering those situations again. If we do face a recession, we wouldn’t expect it to be either severe or long lasting. The most likely cause would be over-tightening from the Fed, which means that economic activity could quickly rebound as the Fed course corrects. While tenant might have their cashflows negatively impacted by a recession for a short period of time, the long-term leases for most real estate sectors should protect rent payments. Additionally, while the number of bankruptcies might increase and potentially cause retail occupancies to fall, we don’t anticipate a significant drop in occupancies, given the current health of most retailers. The mall REITs just reported that occupancy costs… are at the lowest point in six years, suggesting that tenants can absorb a short-term drop in sales from a mild recession before they move out. So, while a recession might force some tenants on the margins to move out, we don’t anticipate it having a major impact on most landlords.
WMRE: If we are, in fact, heading toward a recession, what lessons can commercial real estate investors and landlords apply from previous recessions?
Kevin Brown: The biggest lesson I think landlords learned from the ‘08-’09 financial recession was that high financial leverage can be dangerous. Many landlords were over-levered prior to the recession, so when debt markets froze, many were forced to sell assets at significantly reduced prices just to pay off maturing debt. Most landlords learned their lesson and as a result entered the pandemic with significantly lower leverage. Therefore, despite cashflows to real estate owners seeing a much larger decline during the pandemic, there were far fewer forced asset sales. Since the financial leverage situation remains similar today as it was during the pandemic, we believe very few landlords will be forced into a situation where they must sell assets to cover operating expenses or pay off maturing debt.
Given the large, illiquid nature of the asset class, real estate investors should remember to focus primarily on the long-term fundamentals and health of the sector and not get caught up in any short-term fluctuations. Many real estate sectors are seeing record levels of net operating income growth as either they are recovering from the pandemic [or] some additionally benefitting from high levels of inflation translating to high rent growth. Conversely, a potential recession could cause a slowdown in NOI growth for several quarters. Investors should focus on where these sectors are going to level out once all of the current economic turmoil subsides to determine which sectors could potentially generate the highest returns.
WMRE: Which property types are most likely to thrive over the next 12 to 24 months? Why?
Kevin Brown: We think the best real estate sectors over the next 12 to 24 months are ones where demand is not highly correlated with economic growth and sectors with short lease terms that can quickly turn high inflation into higher rents.
The top sector that stands out with these attributes is the self-storage sector. Demand for self storage is countercyclical as increased disruption in the economy and in people’s lifestyles leads to more movement of the population and thus more demand for storage. Lease terms are also typically very short, so many self-storage owners have been able to turn the high inflation levels into double-digit rent growth.
Another sector that should do well is seniors housing. The correlation between economic growth and demand for the sector is low because when seniors have medical needs that exceed the ability for them and their families to provide [for them], then a move into a seniors housing facility is almost a necessity despite economic circumstances. The sector is still recovering from the pandemic, so while occupancies are currently low, they should continue to grow even if the country experiences a mild recession. Demand is also growing at an accelerating pace as baby boomers reaching the target age of 80. Finally, leases are typically only for a year at a time, so rising operating costs can be passed along relatively quickly as higher rents.
Finally, we think multifamily should perform well over the next several quarters. While demand is more correlated with economic activity than seniors housing, everyone still needs a place to live and with lease terms of only a year that should allow the landlords to quickly pass along rent increases. Additionally, a recession may cause millennials to put plans to buy a new home on pause, delaying that potential headwind for the sector by another year or two.