Motley Fool Hidden Gems Investing - The Commercial Real Estate Revival

Episode Date: October 5, 2024

In the third quarter, real estate was one of the best-performing sectors in the stock market, second only to utilities. A year ago, few investors would have seen that coming.  Matt Argersinger is an advisor at The Motley Fool and heads up our Dividend Investor service. Mary Long caught up with him to discuss: The revival of commercial real estate A company that proves the importance of “location, location, location” What’s needed to address the US housing supply shortage. Vote for Motley Fool Money as Signal’s Best Money and Finance Podcast: https://vote.signalaward.com/PublicVoting#/2024/shows/general/money-finance Companies discussed: SPG, KIM, MAA, CPT Host: Mary Long Guest: Matt Argersinger Producer: Ricky Mulvey Engineer: Tim Sparks, Desireé Jones Learn more about your ad choices. Visit megaphone.fm/adchoices

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Whatever lies ahead, don't change your morning. Let your morning change you. Discover Coffee Plus on Nespresso.com. If you look at the two ETFs that I follow, if you look at the iShares US real estate ETF or the Vanguard real estate ETF, both are around 90% REITs. They were roughly 17% in the third quarter. The overall S&P 500 was up less than 6%. And by the way, over the last 12 months, I was amazed to see this. Both those ETFs are not only outperforming the S&P 500, but they're also outperforming the NASDAQ 100. I guarantee you, Mary, no investor had that possibility on their bingo card a year ago.

I'm Mary Long, and that's Matt Argersinger, an advisor at The Motley Fool, who works on our dividend investor service and is a frequent guest on the show. I caught up with Mattie A. the other day to check in on the real estate market. We also discuss the split between office and all other commercial real estate, a mall rates formula for success, and why some home builders don't want to see mortgage rates come down. Before we dive into today's show, a quick request. Motley Fool Money has been selected as a finalist for Signal's Best Money and Finance podcast. We are up against some really awesome shows from publications like Barron's,

The Financial Times, and Bloomberg. But the winner in this category is determined by your vote. So if you enjoy the show or were a part of your daily routine in any way, consider taking a quick moment and casting a vote for us. I'll drop the link to do so in today's show notes. Thanks, as always, for listening, fools. Matt, I promise you I'm not trying to speed up time. The year is not over yet, but I thought I'd kick us off by asking you, okay, today, October 3rd, what's your headline for 2024 when it comes to real estate thus far? Well, thanks for having me, Mary. Yes, I can't believe we're already in October. I would say when it comes to real estate,

my headline would go something like this. Office aside, commercial real estate on the rise. It doesn't quite rhyme, I know, but I think that kind of captures the year for me so far. I know we're going to get into it, but if you look at most categories of commercial real estate, outside of traditional office, 2024 so far has been fairly positive. Retail, hospitality have held up, multifamily and industrial, although dealing with some oversupply challenges in certain markets, they've done much better than I expected coming into the year. And we know data centers have been on absolute fire. So most things have actually worked this year and I expect they will continue to work. Okay. So I got to say, I looked back, you did a real estate check-in

in like December of last year. And that check-in also began with this like, okay, what's your headline looking back on the year? You had the whole year at that time. And your headline was office is dead. And so when you start that with office, I was like, oh my gosh, what's he going to do? But I mean, that headline has kind of carried through to this year. But as you said, okay, there's other elements of commercial real estate that are looking far more positive than office alone. Right. I mean, office, yeah, it took a while for me to get there. But I think the secular challenges, and we can get into more detail on that, but the secular headwinds are just too strong, especially if you're talking about

traditional office. If you're talking about class B or older office, I just think, yeah, I think I'll stick with my original headline. It is about as dead as it can be, unfortunately. Okay. So we will dive more into the different things that are happening across commercial real estate and other sectors across the market. But before we get there, how about an under the radar story in the space that's caught your attention? We asked for your headline. What about something that's a bit quieter? Yeah. I would say for me, it's the death of the death of retail? Let me explain. So, you know, I mean, for at least, I guess, maybe two decades now, and certainly well before COVID, I think there was a sense, and you could see it,

that physical brick and mortar retail was kind of dying a slow death. And it was easy to make that case. I mean, if you looked at the, you know, the continuing growth of e-commerce as a share of retail transactions, and the fact that we probably had just too much square footage per capita of retail in a lot of markets. And we've seen that kind of play out. We saw the bankruptcies of Bed Bath & Beyond, of JCPenney, more recently Rite Aid and Big Lots just like a week ago. But at the same time, good quality retail, well-located retail has done incredibly well. I mean, Simon Property Group, we'll talk about that company later, I know, is they're reporting some of the highest occupancy rates that they've ever reported. Kimco Realty is another one. It's

one of the country's largest owners of outdoor retail. They just reported record results in the second quarter. So retail is definitely not dead. In fact, in many markets, it's doing better than it's ever done before. And it just reinforces the fact that Americans like to go out and shop, especially if there's other things to do besides shop, which is go to restaurants, go to a gym, go to the salon while also shopping. So the death of retail has been greatly exaggerated. And I don't think it's gotten enough headlines this year. So ahead of this conversation, I'd sent you a Bloomberg article with the headline, the commercial property market is coming back to life. And this kind of lines up with what

your headline was for when we kicked off this conversation that office aside, commercial real estate is on the rise. So here's the lead of that article. Buyers and sellers in US commercial real estate are increasingly convinced that the beleaguered market is reaching a bottom. Is this so-called revival mostly due to the Fed changing its tune on interest rates? How else can you tell when a market has hit its bottom? Well, the Fed pivoting to lowering interest rates is a big deal. When it comes to lower capital costs, more liquidity in the market, that's an important shift.

And I think that's really going to improve. It already is improving the outlook for commercial real estate. But one thing that was really obvious to see, if you're looking to gauge the health of the market, was to simply look at the public markets. If you look, for example, at publicly traded real estate investment trusts, they were huge market laggards coming into this year. In fact, the real estate sector of the S&P 500 is one of the few sectors, it might be the only sector at this point, that has yet to recover its losses from the 2022 bear

market. So it's been a tough place to be. But year to date now, in 2024, real estate has been one of the best performing sectors. In fact, we just wrapped up the third quarter, real estate was the best performing sector in the stock market, second only to utilities. If you look at the two ETFs that I follow, if you look at the iShares US real estate ETF or the Vanguard real estate ETF, both are around 90% REITs. They were roughly 17% in the third quarter. The overall S&P 500 was up less than 6%. And by the way, over the last 12 months, I was amazed to see this. Both those ETFs are not only outperforming the S&P 500, but they're also outperforming the NASDAQ 100. I guarantee you, Mary, no investor had that possibility on their bingo card a year ago.

So the public markets are telling us, and by the way, public markets generally tend to lead the private sector part of the market, both on the way down and on the way up. The public markets are telling us that the market bottomed and that things are improving. And the performance of the last several months has been outstanding. So CRE isn't all office. That Bloomberg article that I mentioned, they chart out commercial property prices since 2020 across three categories. They break it into apartments, offices, and then all other commercial property, which is a pretty big category. But of those categories, office is the one that saw the steepest decline in the four years since COVID. I mean, should we be thinking of office as something

totally separate than the rest of the commercial real estate markets that we're seeing these changes play out in? Yes. I think many investors hear commercial real estate and their minds immediately think of office buildings. But as you've pointed out, I mean, CRE is a massive category. And office, by the way, isn't even close to the largest category. Industrial real estate, which consists of everything from warehouses to manufacturing plants, that's become the largest category. Data centers used to be kind of this small emerging niche part of the CRE market. They've become huge. Cell towers are also a big component. And then we've got retail, you've got hospitality, self-storage. They're also fairly

hefty categories of commercial real estate. And actually, even within office, you've got medical office properties, you've got lab space, you've got research facilities, you've got government, you know, facilities. So, and there's also a big difference between, as we mentioned, you know, kind of newer class A office buildings and class B or older buildings. So, it's a very nuanced view of the market that you have to have. And I would say, yeah, you almost have to separate sort of traditional office as its own category. We know the challenges there, but there are many categories of commercial real estate that are doing just fine. In fact, things like warehouses and data centers have thrived in this post-COVID era, this kind of work from home era. They've

actually been really big beneficiaries and we've seen that play out. We are going to get to some of those other sectors that are in this commercial real estate space, but I want to stick on office for a second, especially since COVID completely upended our relationship with work and the office and downtowns even more generally. Some have been ringing alarm bells about certain banks overexposure to commercial real estate and offices in particular. The conference board has calculated that more than a trillion dollars in CRE loans will come due over the next two years. And they've warned that a number of small regional and community banks that hold a portion of that debt don't have the capital to stomach these losses. We've talked about changing interest

rates and kind of how the CRE market is starting to revive itself a bit. Does that change alleviate these worries that others have flagged? So, no, I'd say unfortunately not, because most of these CRE loans, especially anything office related, they're so underwater that they'll have to be at some point written down or your bank is going to end up taking ownership of the property and marking the asset down and trying to sell it to try and recoup some of the value that's going to be lost on the loan. A lot of the small and regional banks have already taken pretty severe losses against their balance sheets, but I think more losses are going to have to be taken. And some banks will end up needing more liquidity. Lower interest rates will help

that to a certain degree. Banks will have access to more affordable credit. The value of bonds held to maturity on the balance sheets will improve. So lower interest rates are going to help. The Fed easing cycle will help their balance sheets and liquidity. It'll help many banks get through the challenges with their commercial real estate exposure. But make no mistake, I think there are still severe losses that will be taken on the loan books. I tend to call this whole thing kind of a train wreck, but it's a very slow moving train wreck. It's definitely going to fall off the bridge or it's going to hit the wall.

And it's just very slow to play out. And it's not something that I think is going to cause the acute crisis that we're worried about. It's not going to create another financial crisis because it's so varied in terms of banks and what exposure is out there. and it'll take a long time to work out. You kicked us off with an under-the-radar headline about the revival of the retail sector.

So let's talk about retail. Simon Property Group, a REIT that focuses on high-end malls, shared in their August earnings call that their occupancy rate at those malls was 95.9% up from a year ago, even with a 3% increase in base rent. That's pretty impressive. What's going on there?

Very impressive. I would say of all the REITs that I've followed this year, I think Simon has probably been the most impressive. And what's really worked for them, it's kind of that old cliche when it comes to real estate, location, location, location. Simon's portfolio is just located in really some of the highest end suburbs or exurb locations, close to not only high earning shoppers, but places that have high population densities, heavy traffic. I think it also has a lot to do with Simon's tenant mix, high quality tenants make a big difference. If you think about a typical Simon mall or shopping center, you're going to find the Apple store, the Michael Kors

store, Tommy Bahama, Neiman Marcus, Lululemon. You're also going to find, and I think this is key, you're going to find high-end dining options as well. So that mix really attracts shoppers. Even those who don't shop at those stores, other tenants want to be near those stores and locations because it knows the kinds of shoppers that they can draw in having those tenants. So Simon has just done a fantastic job of bringing in and keeping high-end tenants. And it's also invested heavily in evolving its stores away from just being traditional malls. These are now becoming lifestyle centers where people not only shop, but they live, they work, they go to be entertained. So that kind of mixed use location has become very popular. And Simon is capitalizing on that

probably better than anyone. And I do think these sort of all-encompassing places where people can work, stay, eat, play is a little bit of the future. And Simon's kind of in a way ahead of the curve. David Simon, CEO of Simon Property Group, certainly seems to think that the company is ahead of the curve. He talked extremely positively about the company's current positioning and where he sees them going in the future on that August earnings call. He said, we have never been better positioned. And then goes on to say, I think we are in an absolute unequivocal position to improve and to better our company. So again, we don't want to go through a recession, but if we do, the gap between us and everybody else just gets bigger and bigger.

You just talked a bunch about how Simon is so well positioned now, why they're so well positioned now, but let's talk about that gap. Where do other retail REITs stand in comparison to this company? Well, yeah, I would say there is a gap. He's absolutely right. And closing that gap is going to be near impossible just because of Simon's location and tenant advantages. But there are other REITs in the space. I mean, if you look at, we talked about Kimco earlier, there's a Retail Opportunity Investment Corp, one that comes to mind. Tanger is another REIT known for their kind of outlet stores.

These are all fairly well-managed REITs and they oftentimes focus on grocery anchored shopping centers or needs-based shopping centers. So you'll have a mix of kind of needs-based, maybe class A spaces, but also some class B spaces and tenants. they don't have near the same draw or pricing power that Simon has, but they're regularly trafficked. Customers go to these places regularly and find value there. And all these REITs have reported better results this year. In fact, Kimco had, I think, record results in their latest quarter. And so, if you're asking me which one I want to own in the retail space, it's definitely

Simon as an investor. But there are opportunities as well with a lot of these REITs. And again, And the retail renaissance that we've seen has been outstanding, and it's lifted all these boats. So there might be a renaissance happening in another corner of the market as well. Let's turn and talk about multifamily a bit. Is that sector turning a corner? Well, right. No, no. I do believe multifamily has turned a corner.

So in the immediate sort of post-COVID environment, actually even before COVID, there has been this steady migration of people, younger people especially, to the southeast and southwest of the country. So you saw cities like Austin, Texas, Phoenix, Tampa, Charlotte, Nashville, these cities really saw outsized gains in population, corporations moved there, there were a lot of jobs being created. And MidAmerica, MAA was really positioned to benefit from all that just because of their portfolio being so Sunbelt focused. The problem is, of course, the returns got so good and the demographics are so compelling that you had, of course, a lot of developers come in to those markets, building a lot of

new apartments. Interest rates were also very low at the time. So it led to a lot of cases of overbuilding. And now you have a situation where supply is very high, vacancy rates are high. And so that's just a kind of a natural demand supply dynamic that's taken place. But what we've seen, especially since the end of 2022, is that construction is really tailed off. So I think MAA, as well as maybe Camden Property Trust, which is another a multifamily REIT in the Sunbelt markets, they're finally seeing less pressure on that occupancy. And they know how to manage it very well. So I think that in, say, the next several months, you're going to see a big drop off in new supply that is going to coincide with increase in

occupancy and probably increase in rental rates as well. So that puts MAA and probably other multifamily REITs in a pretty good position. Was MAA able to take advantage of weakness that we've previously seen in the multifamily space? Were they buying up complexes from developers that were struggling with debt? How has that kind of positioned them now? Yes. So the good news is MAA, as usually is the case

among multifamily rates, they have a great balance sheet. And one of the things they've been doing is not necessarily buying up ground up developments or developers, but they've been kind of partnering with developers who in a lot of cases have already gone through the zoning, the permitting, maybe even the initial construction work around an apartment complex, and they just lack the capital to complete the project. And so, MAA can step in, provide that capital, even take an equity stake

maybe in the project, or even agree to acquire the development once it's complete. It's a fantastic, really low-risk way for MAA to use its balance sheet. And again, I think those efforts are really going to pay off going forward. We're going to see pretty big increases to MAA's portfolio over the next, say, a year or two. And it's all through these kind of joint ventures or low-risk acquisitions, which they don't really do a lot of, but they've been doing a lot of more of them lately. And I think that's really, really going to pay off once the market really turns, say, beginning next year. I want to move more fully to the residential real estate picture, just as we kind of wrap this up. The housing supply shortage in

the U.S. gets talked about a lot. How exactly did we get here? I know. It is the challenge of our time, Mary. And I would say... You're like, how much time do we have? That's right. I know. Do we have the rest of the day? I mean, whether it was risk aversion, whether it was in many cases, bankruptcies, but we just underbuilt homes pretty much every year since the great financial crisis. So now going on, what's it been? 15, 16 years now. And, you know, and depending on what, so depending on what estimate you look at, we're, you know, we're short anywhere between two and 3 million homes in the country, which is just unprecedented. We've really never been at this point. And it comes at a time when I think your generation, Mary, the millennial generation, I think, you know, is entering kind of your peak first time home buying phase. Like, you know, there's a, there's a huge demand for homes, especially first-time homes.

And it's just such a, such a problem in a lot of markets. And I don't think it's, it's a problem that can be adequately addressed by, by, by private capital. It's going to take, I think it's going to take government. It's going to take zoning changes at the local city level to, to really break the dam and open the market to new housing supply. And for whatever reason, and you might see it play out locally where you are as well, But there's just never a lot of incentives to build a lot of new housing, either on the

government's part or especially from existing homeowners who don't want the added traffic. So it's a really, really big problem. And I don't expect that demand supply dynamic will abate anytime soon, unless, like I said, unless there's some major almost New Deal type government program to really ramp up housing instruction. I'll admit, I sometimes find this such a hard thing to wrap my mind around because like you said, simplistically, if demand is so high, why aren't the incentives there for demand to catch up? Obviously, there's a lot more factors, but just based on that alone, I'm like, how does this continue to be a problem? And that's so tricky for me to wrap my head around. Yeah, it is. And we can look at the homebuilders, right? And if you follow the homebuilders, you know that this has been an extraordinary time for them. Their stocks are at all-time

highs. Their business is doing gangbusters. But even there, there are a lot of homebuilders who still aren't building at the same rate they were building 15 years ago. And again, I think it's that muscle memory from the great financial crisis, the reluctance to really stretch the balance sheet to take risks, to build as many homes as they think they could build because they're worried. They're worried about the change in the cycle. And even with lower mortgage rates, which will hopefully unlock some of the supply, especially on the existing side, paradoxically, actually, a lot of home builders don't want those rates to come down because they're in the sweet spot now where they're almost the only game in town. They can offer

kind of lower rates on their own balance sheets. They're the only ones bringing new supply to the market. And so they really don't want mortgage rates to fall too much because then it locks a lot of existing housing supply as homeowners finally start listing their houses, buyers have more buying power. And so again, there's not a solution that I can see from the private market side that's going to solve this challenge. Bloomberg published an opinion piece by columnist Conor Senn about a year ago, and this was the headline, the US housing market is now completely broken. So bright, right? Sen's point though, was that mortgage rates, which then had surged as high as 8%,

were proving too much for home builders. They were reducing new construction. How does that hold up a year later? Home builder sentiment is higher now than it was about a year ago. I'm looking at November, 2023, technically not October, but it's lower than it was six months ago. Is construction coming back? What's the feeling that you're getting out there? Right. I think Stan's right. I wouldn't say it's completely broken, but it's broken. And we could argue that, well, now with mortgage rates now in like 6.2%, that's a lot better than 8%. But again, we have to remember there's millions, tens of millions of homeowners who locked in rates below 5%, below 4%, even some below 3% in the sort of 2020 to 2021 period.

And so, it's going to take a lot lower mortgage rates to unlock that supply. Because if you're a homeowner with a 3% mortgage rate, 30-year fixed mortgage rate, even if you want to move to a bigger house, even if you want to move to something else, you're really reluctant to give up that rate and then go buy something where all of a sudden your mortgage is going to go up to 6%. Why would you do that? And so, there's that issue. And then there's just the issue of the structural problems that we talked about where we're under building. There's not a ton of incentives, you know, home builders to get to be more active. There are not a lot of regulations from cities or local governments that are enabling housing to be built. And so, gosh, even getting construction levels back to where they were pre-financial crisis, so 15 plus years ago, is going to be an enormous challenge. We've jumped around to a number of different sectors, touched on all different facets of the real estate market. Matt, as we wrap up, are there any real estate stories that we haven't hit on today that are playing out right now and that you find to be pretty interesting and worth noting? Sure. I think we're really underestimating the sheer amount of energy it's going to take to power all these crazy ambitions we have for artificial intelligence and the data center expansion, the compute power that's going to take to realize those dreams. I live just a short distance from data center alley here in Northern Virginia.

And right now, the talk is that any new data center development is going to probably be delayed at least three years, if not as many as seven years, because the utility companies simply don't think they'll have the power to add the new load to the grid, to add these new data centers. Many of these new larger data centers require 100 megawatts of electricity. That, Mary, is enough power to electrify 30,000 homes. And it's one data center. So I'm sure you, like I have, you've seen stories about turning on retired nuclear plants. I think that's a good thing, but it's going to take much more than

that. We're going to have to build a lot more power plants. And as much as we'd like a lot of that power to come from renewable sources for the environment, it just won't be sufficient. So that is, I think, going to be one of the stories of our time. It's going to be fascinating for me to watch play out over the next several years. How do we power this AI future that we see kind of unfolding rapidly in front of us, right? How do we get there? It's going to take a massive amount of power. It's going to take a massive amount of real estate to get there. Matt Argersinger, always a pleasure to have you on Motley Fool Money. Thank you so much for joining us today. Thank you, Mary.

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 Mary Long. Thanks for listening. We'll see you tomorrow.