Motley Fool Hidden Gems Investing - Investing Opportunities in Transforming Office Space

Episode Date: June 18, 2022

We’ve got a lot of space. And a whole lot of it is unused in office buildings, city centers, and shopping malls. We also need a lot of space for multifamily housing, data centers, and warehouses. Is there some opportunity in the middle for investors? Deidre Woollard and Matt Argersinger discuss: - The complexities in transforming an office building into apartments - Commercial real estate trends catching their attention - Ideas for investors who like dividends. Stocks/REITs mentioned: BX, AMZN, HHC, PLD, SRG, STAG, DRE, ARE, MAA, VICI, EPR Host: Deidre Woollard Guest: Matt Argersinger Producer: Ricky Mulvey Engineers: Rick Engdahl, Dan Boyd Learn more about your ad choices. Visit megaphone.fm/adchoices

Don't you wish you could just hit skip on the worst parts of your life? You know, the same way you can skip an ad? I get it. I'm Siaya and I live in Ice Cove. I've made some questionable decisions that didn't end up the way I planned. And today I'm still figuring it out. Somehow things usually get worse before they get better. Apparently, that's how I roll.

So bundle up and come along for the bumpy ride. Stream a new episode of North of North Tuesdays on CBC Gem. The idea that you can take an office space, maybe in the suburbs, that isn't going to be really appealing in this post-pandemic world, but can I turn part of it into maybe a warehouse space, a data center, a light industrial light manufacturing space, maybe to do some prototyping, to do some R&D, and then build an office component that's attached to it, I think that's really appealing. I'm Chris Hill, and that's Matt Argersinger, head of The Motley Fool's Real Estate Investing

Services. We're taking a closer look at space and how it's transforming. Shopping malls, skyscrapers, and suburban office parks were rocked by COVID, so maybe they can help fill the need for data centers, multifamily housing, and warehouses. Today, Deidre Woolard and Matt Argesinger discuss commercial real estate trends to watch, why it's not that easy to transform an office building into an apartment building, and a few ideas for investors who like dividends. There are so many question marks about the future of central business districts and about suburbs. So I want to talk to you because you recently went through a journey as an investor. You were part of a large planned office conversion in Atlanta in a central business

district, and it didn't quite go as planned. So let's talk about it. All right. Well, Deidre, I'm going to take you back to the summer of 2019. And I know in COVID years, that seems like ancient history. So all the way back to the summer of 2019, I'm in Atlanta with Greg Martz, who at the time was the head of operations for our Million Acres service. And we were looking at a beautiful mid-century office building in Atlanta. A developer was going to come in and redevelop that building into a newer sort of Class A boutique business office space. And the plans were great. They had already ordered the tall windows that were going to replace all these old windows, and they went and redo the whole facade of the building and all the internal

parts of the building. It looked fantastic. At the time, Atlanta was really seeing a lot of growth in population, employment, office space was getting absorbed pretty quickly, and there was a real need for the versatile boutique office space in that part of Atlanta. That was 2019. Everything's great. We invested in that project via our mogul service. Of course, then COVID hits in early 2020, those plans get foiled a little bit. Not only do construction prices go up, the demand side for office really gets hurt in the sense that already by that time, 100 Edgewood, which was the name of the building, was already going to be pre-leasing, seeing all this demand. That demand completely evaporated by the summer

of 2020. Here we were with an office building that was being converted, but probably wasn't going to have any tenants. And so it just became this really kind of fragile situation for our investors. We were really worried about what the outcome was going to be. We were looking at big losses. Fortunately, the developers at the time, they were able to strike a deal all the way, now going to January 2022, with a company that was going to come in and acquire the building and turn it into apartments, which right now in central Atlanta, downtown Atlanta, those are in more demand. The building also sits adjacent to Georgia State University, which has really expanded its campus. There's a need for either apartments or student housing, a residential space less than

an office space. Luckily, the developer that we invested alongside was able to sell the building to that new developer. We took a loss on the building, but it was a minimal loss. Our losses would have been much more if they had tried to sell it as an office building, or at least gone through the development and met really poor demand. That was an example where I feel really fortunate that we got out of a situation because there was a residential developer coming in that was going to redevelop the building into something that was more in demand. The reason I wanted to talk to you about that story was because because this office to residential conversion thing, I think is really fascinating. And maybe

we're at the beginnings of it. It's really hard to know. You know, one of the things that is interesting to me is I moved to Alexandria in 2019. It's where the Motley Fool was founded. And through the mogul service, we had a couple of different projects in that area. One of them was kind of near my house, an office condo conversion project. So I love to go to construction sites. So I went over there with my phone, like taking pictures a couple of different times and watched, you know, you think an office building conversion to residential, maybe it's just, you just add more bathrooms and kitchens. Nope. This was just that things are being torn out. The whole facade is off. There's things being added. Why is residential conversion

not quite like a just quick flip solution? Right. I think there's some confusion or misinformation in the market, that people just look at all these vast office buildings in places like New York City or Washington, D.C., where you live, and it's sort of like, well, why can't we just convert all these underused office buildings to apartments or condos? It seems easy, right? Easy solution. Well, it's actually very, very difficult to do. And I'd say most office buildings just aren't structured correctly to have that kind of conversion. So we just actually invested in a deal in an office building in Alexandria, actually not too far from where you live, that is in the process of being converted into apartments. But if you look at this particular

office building, you've got double-loaded corridors, which means you have a narrow central corridor. And on each side, you've got a lot of ample space, windows. So from a Bones perspective, really convertible to apartments. You also have larger floor plates, wide column spacing, ideal for fitting in dozens of apartments per floor. It also has good utilities. When you're converting office to apartments, the biggest thing is water, because as you said, you're adding dozens of bathrooms, kitchens that are going to be more in use. You're going to be using a lot more water. Fortunately, this building has sufficient utility capacity to really upsize to handle the additional water load. It also comes with ample parking. This particular

building is in the suburbs. Usually, in that case, when it's not a walkable area, you want a 1.5 to 1 or 2. Essentially, 1.5 parking spaces per apartment. This building has that by quite a margin. We had to check a ton of boxes to make this a workable investment for our investors. But think about that for your average office building, your skyscraper or maybe a really large office building in New York City that has huge floor plates where you're not going to have a lot of access to windows, you're going to have to really build out the internals. It becomes very expensive and very difficult. This is not the panacea to the office conundrum that we have. I still think we have so much office space in this country.

A lot of it, it's too costly and too capital-intensive and labor-intensive to convert it to residential. I have a follow-up question on that. I was just thinking about this. There's not really a public market investing play for these types of conversions, right? The two projects we just talked about, they're private projects. There's not really someone who's doing this as a single thing, right? Right. Well, yeah. There's no direct play that I can think of in the public markets. I mean, you've got office REITs, and in some cases, multifamily REITs, who are doing these kinds of redevelopments, but it's a relatively small percentage of their portfolio. Incrementally, it's going to add very little to their net operating income over time. There's not really

a direct play. The two deals that we've discussed so far were private deals. Equity was raised on a crowdfunding platform. We invested in that way, but these were single-asset deals by smaller developers, not exactly your public REITs, mega market cap kinds of companies. Well, let's talk about one that is public, which was a REIT until it recently changed out of the REIT structure. Again, in Alexandria, we have this massive mall redevelopment taking place. The landmark mall has been an eyesore for a few years. It's now being rebranded as West End. It's going to be anchored by a hospital. There's going to be apartments, retail. It's this massive project between Howard Hughes, another publicly traded company,

Seritage Growth Properties, and Folger Pratt. So, this one's kind of interesting because you just mentioned parking. Like, there's no issues with parking when you're converting a mall, which is a great thing. And so, we're seeing these kind of really taking a mall and turning it into a community, walking paths, apartments, retail, maybe office or industry, but it takes so much capital. So with Seritage, they've really been struggling to kind of keep going. And especially during the pandemic, we've been following that one a little bit. What do you think? Right. Well, I like this particular deal makes a lot of sense to me because you mentioned Howard Hughes, Seritage and Folger Pratt, by the way, which is private,

but they're one of the largest developers in Washington, D.C., really specializing in apartments. And this kind of development makes sense to me, because you've got a huge amount of space, you're developing what's a mixed-use kind of property. And if you think about what's in need in a place like Alexandria, which we're talking a lot about during the show, but right outside, a massive suburb right outside of D.C., more apartments, more medical office space for sure. Retail of a different kind, more of a walkable place with amenities, experiential properties. This landmark redevelopment, I think, is emblematic of a lot of these kinds of property redevelopments across the country that I think there's a real need for.

I think we're building out these mega mixed-use projects around the country that can mix together a residential office to a certain extent, hospitality, retail, amenities, all in one place in a walkable or easily accessible type of area. I think there's huge demand for that. So, Ceratage Growth Properties, yeah, they've been in this transition redevelopment phase for a while now. I can't speak to whether or not they're going to be successful because they've got a lot of real estate on their books to convert this way. But these kinds of projects, the Landmark project that you've described makes a ton of sense to me. I think that's going to be one that's really successful. It's really those class B malls, the malls that maybe

weren't doing so great. We're losing tenants even before the pandemic. And I think that's really something to pay attention to because before Landmark started the conversion process, it was being used a bit as a fulfillment center. It's kind of this sort of piecemeal solution, but we saw that a lot during the pandemic. Amazon was buying up malls, but also working with malls to take over spaces. But here's the thing. We're starting to hear a little bit about Amazon delaying the opening of fulfillment centers, subleasing space, scaling back. Is this whole turning unused space into fulfillment centers a trend that might be kind of waning a little bit? I don't think so. I know, yeah,

Amazon comments definitely sent a little bit of a chill to the market. You can see the valuations. The market, we know, has been extremely volatile this year. It's not a surprise to see stock prices down really across the board. Real estate has not been spared. But when I look at the industrial rates, whether it's Prologis, whether it's Stagg Industrial, Duke Realty, it's now being acquired by Prologis, but all of these valuations just got hit really hard really since that Amazon comment in late April. I think it's a little overplayed. I think the e-commerce expansion, it's a much broader, much bigger story to me. CoStar recently came out with a report, and they were looking at just the leases signed across the country. In May, for example, there was 80 million square feet

of industrial leases signed. That's up 16% from the same month in 2021, and 85% higher. This number blew my mind. 85% higher than May 2019, and that was almost a year before the pandemic. That, to me, tells me there's still a lot of momentum within the space. I think the country still needs a lot of warehouse fulfillment space in a lot of parts of the market. You had Prologis, I mentioned. They finalized a deal to acquire Duke Realty. That's a $26 billion all-stock deal that was just done this past week. Blackstone acquired PS Business Parks, another big one, for about $8 billion a few months back. These are some of the smartest industrial real estate operators in the world. These transactions might even signal a short-term

top, but I also think they reflect a long-term belief in the asset class. I just think there's so much more to play out, more runway here for industrial real estate. Yeah. One of the things I always think about, I'm like, never bet against Blackstone. They far more than I do. I watch that company to really understand things. But I think there's something else interesting that Prologis is doing. They've bought a couple of office parks recently, and I'm starting to wonder about a new type of industrial real estate that we're starting to see more tech-enabled, a little bit less just a box, and a little bit more amenities for the workers, but partly because they'll be running more robotics and things like that. Is that

kind of where we might be going with this? I think that's an exciting area of development. I think what you're describing, it maybe used to be called a flex office, but that's a term that's been around for a long time. The idea that you can take an office space, maybe in the suburbs, that isn't going to be really appealing in this post-pandemic world, but can I turn part of it into maybe a warehouse space, a data center, a light industrial light manufacturing space, maybe to do some prototyping or to do some R&D, and then build an office component that's attached to it? I think that's really appealing. I think there's a huge demand, we know, on the R&D side, on the lab space side, medical office, and that kind of development

or kind of build out of an existing office space is much more in demand than your traditional office space built with offices and cubicles. I think we all agree that that might be a thing of the past in a lot of cases, that traditional office. But there is. And so, we talked about transformations. We talked about the transformation of old retail space. Old office could be the new office, if it's converted in a way that's more flexible, as you said, maybe it's more collaborative spaces, lets the building offer more things, more amenities, but also more flexibility in terms of what kind of work that can be done there. I think that's a real trend. Yeah, absolutely. Our podcast producer had asked us about data centers and transforming malls and anchor stores

into data centers. I did a little digging on that. It's interesting because in the current situation, probably not just because there's so much energy and water issues designed for data centers. They don't quite fit into smaller spaces like that. But as data centers evolve, as they need less space, as we see more edge computing coming online, I think there might be a potential thing there. I think it's still five years down the road maybe, but But what do you think? Is that a place we could go as well? Yeah, I think so in certain cases. But I agree with your first comments, which was, the data centers right now, it's a little bit of a scale game.

And I think the most efficient way to do it, and by the way, I live in Loudoun County here in Virginia. The home of data centers. I was going to say, I mean, you can't, wow. Just the development is just incredible. But you have these large companies buying up hundreds of acres of what used to be farmland and turning that into data center space. They could do it really efficiently. Like you said, the utilities, they can add solar panels, water is accessible. Cooling these massive spaces with utility costs that you can keep down is key. I think that's where,

say, 80% to 90% of development is still going to take place. You'll see your occasional small-scale data center around in certain markets. But the game is still, I think, a big space, big open area needs. Yeah, I would agree with that. Well, let's talk about interest rates. I feel like everyone's talking about interest rates these days. But there was some analysis I saw recently from MSCI Real Estate Assets showing the commercial real estate property sales down by 16% in April year over year. What do you think we're going to see in the commercial real estate side? And is that going to slow down maybe some of these conversions? I think, yeah. I mean, I think we're certainly seeing the impact of

rate rises right now. You're going to see that slow down. It'll probably be a short-term thing. I mean, you have developers, real estate operators that, you know, they're already facing serious construction costs, inflation, labor shortages. Well, now they're facing higher interest rates. And we have to remember, on the development side, most of these developments and conversions are often financed with short-term floating mezzanine bridge construction debt. That's the debt that's in place during the initial build phase. It gets refinanced later, hopefully, to longer-term fixed rates. But in the short term, there is a lot of floating debt out there. Higher interest rates can have an impact on a development's cash flows or a bank's desire

to fund something of that scale early on in the project. We have to remember, I think if you step back, 2021 was such a big year for transactions in the commercial real estate space. According to Real Capital Analytics, $809 billion worth of transactions. That was more than double the figure in 2020 and well ahead of the previous record, which was $600 billion in 2019. So even if we weren't facing the additional headwind of interest rates, I think we'd expect at least some kind of slowdown already this year because just 2021 was such a booming year. Yeah, no doubt. So if we're looking at potential danger signs here, interest rates, potential concern, supply costs, price of steel, lumber, things like that, potential for rents to go down,

which doesn't seem to be the case right now in terms of multifamily rentals all across the country are seeing double-digit increases over last year. Is there anything else that people should be looking for as a potential sign that we might be facing trouble? I think you ticked off all of the major concerns on the supply side. My worry now is if we do enter a slowdown, even an economic recession, you're going to see a slowdown on the demand side. Right now, I think developers are trying to get any kind of project they can get through because they know the demand is there, whether it's residential or even hospitality or some of the things we talked about, data centers, warehouses. They see the demand there. They're

just having issues on the supply side. Now, if we enter a slowdown, that demand side is going to get hit. Therefore, that could have a double whammy effect on the ability to get a lot of these projects done and put a lot of them in danger. That's something I think we need to watch. If interest rates get ratcheted up too high too fast, could that slow down the economy too quickly to the point where now we're in a situation where employment is going up, businesses are seeing a huge slowdown in orders, and all of a sudden, all these projects that penciled a few months ago, even at higher interest rates, don't make sense anymore. So, that's what I'm watching. I think the supply issues are things that should be transitory. I

hate to use that word, but I think by six months from now, we can look back and say, yeah, a lot of that stuff probably leveled out. The demand side is, I think, right now the big question. Yeah. So, we've talked about this for a while now, and it just seems it's murky to me. There's so much that isn't clear. As an investor, though, what are you seeing that might be interesting. What stocks have caught your attention? Well, there are a few that stand out to me. I'm looking at REITs. I think the outlook has certainly changed in the last few months with high inflation, the higher interest rates. Stock prices have been hit hard. Real estate usually holds up better, but that's not been the case this year. That's caused some REITs

that I follow to really fall to their lowest valuation in years in terms of things like stock price to funds from operations, dividend yield. A few that look really interesting to me, one is Alexandria Real Estate Equities, ticker is ARE. I've probably talked about this one in the past, but it's the leading life sciences office REIT. Incredible track record, incredible management team. I think it's just been thrown out with all the other biotechnology, because biotechnology is a big component of their rent roll. This has been clobbered down around 40% from its recent high, and trading for around 16X funds from operations this year. Wow, you just never see that kind of valuation for Alexandria Real Estate Equities. Another one is MidAmerica

Apartment Communities. It's the second largest owner-operator of apartments in the country, predominantly positioned in the Sunbelt markets, and really seeing no let up in demand, no let up in occupancy rates or in rental rates. I just think they're doing outstanding. Yet, the stock price is, again, down 25%, 30% roughly from its high. That seems like an opportunity. On the hospitality side, I was looking at Vici Properties, which essentially owns Las Vegas, Deidre, as you probably know, since they acquired MGM Properties a few months ago. I think the hospitality space is really interesting. The dividend yield on Vici is almost 5%. I think there's a real bounce back in hospitality, especially in large events and

conferences later this year and into 2023. That one looks really interesting to me as well. What about you, Deidre? Yeah, I like VGN. It's one of those ones I keep liking more and more. I interviewed their CEO at Petoniak last year, and I just heard the commitment to the company. Since then, I've been following it. They got that MGM Growth Properties transaction done. Las Vegas is back, all the tourism numbers and even the convention numbers are coming back. But the interesting thing is kind of what's next for them. The Flamingo is on sale on the strip now for a reported billion dollars. There was talk about that on the call. Of course, they would say nothing about it. I don't know if they're going to get that one. But what they did announce recently

is the first project in their deal with Cabot, which is an owner and developer of golf communities and resorts. So on that earnings call, they talked not just about gaming, but moving into experiential. And that's really interesting to me right now. And the other one in that space, kind of the giant in that space is EPR properties, which is ticker EPR. I know you have covered that one before. They just announced on the other deal too, for a couple of Canadian properties, a resort and a water park. I have a little bit of concern about a fall in discretionary spending, because of inflation and people watching their wallets, but I also feel like there's that pandemic buildup. I just like EPR because the diversification inside their properties in terms

of having resorts, movie theaters, which not so great, but they're dealing with that. Ski properties, it's really an interesting one to me right now. I think a 7% dividend yield or almost on that one right now, at least at the price as we're taping the show. I agree, lots of good values out there. I think coming into this, the good news is for investors that REITs have some of their best balance sheets that they've had in their history. And so, I'm glad a lot of these companies are playing offense. They're actually going out and acquiring properties, as you mentioned. And I think that's going to pay off a few years from now. You just have to live with this rollercoaster ride, I think, for the next several months. But coming

out of it, I think a lot of these will look really, really good. Well, and I think the lesson that I've taken from this conversation and thinking about real estate in general is that real estate will always, it will shift. It will shift to be what is valuable at the moment. So it may be an office today. It may be an apartment building tomorrow. Real estate is fascinating to me because everybody needs somewhere to be and the buildings and the land will shift to be what we need it to be for now. And then it'll shift again for the thing that we need next. Absolutely. space will find its demand and smart operators, smart owners, landlords will find the right way to position that property. Absolutely. Well, Matt, thanks as always for chatting real estate

with me. Tons of fun. Thank you. Always a pleasure, Deidre. Thank you. As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.