Motley Fool Hidden Gems Investing - The Deal on Real Estate

Episode Date: December 23, 2023

Offices = empty. Housing = expensive. But don’t let the gloominess fool you! There are still bright spots in real estate markets. Deidre Woollard caught up with Motley Fool analysts Matt Argersinger and Anthony Schiavone to reflect on real estate trends in 2023 and look ahead toward the year to come. They discuss: - Three scenarios for housing affordability - A void that Blackstone and Brookfield could be looking to fill - Why REITs are poised for a rebound Tickers discussed: DLR, EQIX, IRM, PLD, STAG, MAA, BX, BN, STWD, ZG, RDFN, CSGP Host: Deidre Woollard Guest: Matt Argersinger, Anthony Schiavone Producer: Mary Long Engineers: Dan Boyd, Annie Pope Learn more about your ad choices. Visit megaphone.fm/adchoices

You've got to try breakfast at A&W. You've got to try breakfast at A&W. And what better way than with the delicious Pret Organic Coffee? Starting with just one dollar, all day, every day, now until December 31st. You've got to try breakfast at A&W. At participating A&W locations in Ontario. You know, right now it's hard to see. Could rates fall that much? Are home prices going to fall? That's going to be hard to see. And can we really realistically

kickstart a lot more building? You know, I think Zillow's latest data says we're still short something like 4.3 million homes, you know, given the demand. And it just feels like since the financial crisis, we've never been able to close that gap. And gosh, it's hard to see it closing anytime soon. I'm Mary Long, and that's Motley Fool's senior analyst, Matt Argersinger. Future Willard caught up with Matt and Fool analyst, Anthony Chavone, to look back on the year that was in the world of real estate. They discuss our changing relationship with work and its impact on the future of cities, why more Americans are locked into their current homes, plus when and where you just might want to follow the asset managers.

Let's start with 2023. What is your biggest headline for the year, Matt? Well, 2023 for me, and I hate to start this wonderful show on maybe a dire note, I think 2023, to me, really put the nail in the coffin for traditional office real estate. Entering the year, I felt like we were sort of beyond the worst of the pandemic. Companies, corporations, business was getting back to normal. And we were kind of embracing maybe a more hybrid work schedule. And I just thought that that was going to bring back a little bit of more traditional office, bring back the demand, bring back the activity, the office visits, the occupancy.

And boy, it didn't. And I think for a certain segment, particularly of office, class B office, I think the nail is in the coffin. I think that particular part of the office market is really dead. And unfortunately, I think even though newer class A office is going to find demand and have a slightly better future, I also worry that it's also not really an investable asset class going forward. I just think we've had such a secular shift in the way, the worker relationship with the office. In fact, I don't even think we should call it office anymore, guys. I was actually thinking we should almost call office like collaboration centers, where people come on an infrequent basis to just collaborate, to have meetings, to collaborate on specific

projects or tasks. And it's not necessarily a regular thing anymore. Maybe that's too far extreme on one side, but I do think that, for me, is what I'm always going to remember 2023, first and foremost. All right. So, that's off to a gloomy start. Yeah. For me, it's all about housing affordability. Since 2020, by some estimates, median home prices are up around 30%, which is just incredible growth in such a short amount of time for something like housing. And then, to make matters worse, the Fed embarked on one of the fastest interest rate hiking cycles that we've seen in quite some time. That drove mortgage rates to nearly 8% just a few months ago. The result is a dramatically higher monthly

mortgage payment for most people buying a new home. According to the National Association of Realtors, housing affordability is at its lowest point in nearly 40 years. Since housing is the biggest asset that a lot of people own, I think it's a really big deal. Hopefully, this gets resolved looking forward in 2024 and beyond. Also, we have some gloomy things here. The first thing that comes to my mind is, man, I wish that we could find a way to put the housing into the offices, but as we've all discussed before, that is not really possible. We can't turn all of that class B office space into housing. So, I mean, people are trying, but that is certainly... No, yeah. I'm glad you brought that point up, Deidre, because it's way too

expensive, first of all. And even if it was economically feasible for this transformation to take place where we can take a lot of this unused office stock and turn it into other uses, it's not practical in certain cases because of the way the buildings are structured. And we've talked a lot about that in the past. So, unfortunately, I think, you know, not to beat this drum on office, but I almost think to the point where the only solution to a lot of these Class B offices, you know, in the near term, it's foreclosure. But in the long term, I think it's demolition. I think we almost have to clear out a lot of this stock before we can get to a point where we can redevelop the space. Well, yeah. And that's one of the things that I wanted to

talk about, too, was this has been the slow burn crisis of the loan issues facing commercial real estate. You framed it up with, obviously, the demand for office is lower when you're trying to refinance now. As Ant pointed out, you've got those higher interest rates. There's about a trillion dollars in loans coming due in 2024, 2025, which just seems like a snowball rolling at us. On a scale of one to 10, with one being we're doomed and 10, this is a blip. It's not going to work out that bad. Matt, where do you put the risk? That's a good question. I think the risk to the overall market, if I think about what's the risk to the economy and financial markets, I'm at a four to 10. I think commercial real estate, even this tremendous wave of loans

coming due that you mentioned, Deidre, a lot of these loans will get worked out. They'll be they'll be extended they'll be rolled over some will be refinanced at higher rates even though that seems a very like a very typical expensive thing to do right now but the risk to commercial real estate itself and of course when i say commercial real estate in this context really are talking about office because that's where the trouble is yeah i'm at an i'm at an eight eight out of ten i think you know the impact that it's going to have on a lot of banks especially regional smaller banks who have a lot of office loans on their books you know they're going to be owning a lot of office real estate in the next year or two. Banks aren't in the business of

owning and managing office real estate. It's going to be really, really tough. I think you're going to have to have a lot of workout firms come in and work things out. It's going to be much more contained. This is not a 2008 style crisis where what we saw then was the collapse of the housing market and all these loans that went bad caused just tremendous ripple effects across the economy in financial markets. I don't think so. I think this is going to be more of a slow burn for the market. But specifically for the commercial real estate segment itself, it's going to be very, very difficult. And are there any sectors outside of office that you're looking at as potential risk for next year? Yeah. So I think office is definitely the big one.

And Matt explained that very well. I would probably say malls and then also, kind of surprisingly, multifamily. We'll start off with malls, because I feel like malls is kind of a similar story to office, but the story is further along. Really, over the past decade, malls have struggled with the rise in e-commerce sales. I think high-quality malls will be fine, but a lot of your Class B, Class C, lower-quality malls, they're going to have trouble refinancing their debt when it eventually comes due. Then looking at multifamily, multifamily still has pretty strong, yet moderating operating fundamentals. Occupancy is still pretty strong. Rent growth is slowing and negative in some markets. But I think the thing that worries

me about multifamily a bit is that a lot of loans were originated in 2020, 2021, 2022, and over the next couple of years, that debt is eventually going to be refinanced at a dramatically higher interest rate. I do think we could see some pockets of distress in multifamily of the next couple of years. But like Matt said, I think it's going to be relatively contained and it won't be widespread. And also too, you have a ton of private equity capital that's going out there and looking to take on loans that maybe regional banks won't want to take on. So there's still a lot of capital flowing into real estate. Maybe not the speed it was in 2021. So I think it's largely going to be contained. Yeah. I like the point you made about multifamily,

because the part that worries me is that high end luxury, because you're sort of in a, if you're trying to pencil out a deal, you kind of want to have the most, you want to, you want to be in a position where you can charge the most rent. So all the money flowed toward luxury multifamily, but you know, rents are, rents are sort of stable, stabilizing or stalling out in some markets. And in some of those markets, there's, there's a risk of oversupply and the risk that some of those apartments might be too small based on the fact that now everybody works from home. I think you brought up a really good point. That is an area that worries me as well. Well, let's talk a little bit about REITs. You just mentioned the idea that we've still got

capital flowing in, but it was not a great year for REITs. They do outperform the broader market over time. Matt has drilled that into my head, but it was not their year. Matt, is 2024 going to be their year? Wow. I sure hope so, Deidre. I think it will be. You mentioned 2023 not being a great year for REITs. Well, it's been a brutal two years for REITs. You really got to go back to the beginning of 2022, really when the Fed started its rate hiking cycle, and REITs have just gone in the opposite direction for two years now. And yes, historical data is on our side. REITs should outperform coming out of this. And I think part of the problem that REITs have faced is because a lot of institutional investors treat REITs like bond proxies. And for the first time,

if you ask the average institutional investor, for the first time in two decades, or at least 15 years, I can get a risk-free yield of 5% or more. We haven't seen that in a long time. If you're comparing that to a REIT that might also be paying a 5% dividend yield, it's just not as compelling because there's risks associated with that investment. If I can get risk-free 5%, why am I going to do risky 5%? But of course, I think, as most things, a lot of investors are missing the bigger story here, which is with a REIT, you have real assets, you have rent-producing assets, you have assets that can grow, assets that oftentimes are resistant to inflation, leases that rise with inflation. And so I think there's a lot of growth

that can be had with REITs as well, in addition to, especially today, really nice dividend yields. And you'll read a lot of reports, and Ant has found some great data out there that suggests you know, a lot of REITs, even if you strip out office, which we know is really facing a lot of trouble, REITs are trading at or below their net asset value. And anytime you see that in a broad way, uh, REITs are probably set up to have, um, you know, to rebound pretty strongly. And I think that's what we're going to see starting in 2024. Are there any particular areas of REITs that, that you're more interested in? Cause like one of them that I'm thinking about is the idea of rebounding and data centers. And there aren't that many of them left in the, in the break,

in the publicly traded REIT space, but, you know, with, you see the AI growth and you have to figure that there's a correlation there. They, you know, uh, the two biggies, uh, digital realty and Equinix, they are performing better than they were, but what sectors are you looking at? Yeah. I mean, I'll let Ant answer this as well because, um, yeah, data centers are one. And I think, you know, Iron Mountain is another one that Anthony and I talked a lot about that, uh, is a, is an emerging player in the data center space. That's, that's pretty exciting to us. I think industrial is going to stay strong. We talked a lot about industrial estate. When I talk about industrial, I mean, warehouses, logistics facilities, your prologists of the

world, your stag industrials, where they're really riding these two undeniably strong secular trends, e-commerce, which we've known about for decades now, but also this more recent trend of supply chain optimization or redundancy. Since the pandemic, we saw all the challenges that a lot of companies ran into in 2020, 2021. And they're looking to bring some of that manufacturing home, trying to increase their inventory levels. And that just means a lot of demand for industrial space. We just don't have enough industrial space in this country. So that is one area of the REIT market that I think has been strong and it's going to stay strong. and I'm sure Ant can name one or two more as well. Yeah. I know I just got done saying that

we might see some distress in multifamily, but I do think some of the multifamily REITs present opportunity because a lot of them, like for example, Mid-America Apartment Communities is one that has a super strong balance sheet, a management team that's been with the company for decades. I mean, they're not going to run into the same refinancing issues that maybe a private owner might run into, because they have access to liquidity, low cost of capital. So I think they'll be able to weather a downturn. And if distress does occur, they'll be able to be on the aggressive and maybe acquire some properties at attractive valuations. So that's a sector that I'm still looking at, even though there might be some distress in the coming years.

Well, I like Mid-America too, because they're focused more, like the name kind of says, not at the high end of the market and really in the Sunbelt area where we've seen so much of the growth over the past couple of years. Kind of related to that, I feel like we talk about the Sunbelt all the time. Is the growth story still there, do you think? Is that still where we should be looking for opportunities is in those markets that have been expanding rapidly? And what do you guys think about the sort of gloom stories that we've seen about San Francisco and about New York? Well, I'll start with the latter, the doom loops scenarios that we're worried about. You know, I have two minds on this.

Of course, I don't think cities like New York City, San Francisco, Chicago are going to face some kind of doom cycle where things just get worse and worse over time because offices are declining, people are leaving the city. I do think at the same time, though, we have to sort of broaden our idea of what cities mean, major cities mean for the country and for how we live our lives, right? Because for the longest time, for decades, really almost the entire 20th century and well into the 21st century, cities were kind of the central hub of where work and commerce happened. You know, we, millions and tens of millions of people, hundreds of millions of people kind of, you know, we're commuting into these central offices, right, to do work, collaborate with employees and get things done. That, at least at the white collar level, has been completely changed in just the past few years. And if that is the case, I mean, just think about what that means for adjacent retail real estate, restaurants downtown, entertainment downtown, public transportation, all of which is seeing less and less demand because there's just less people moving downtown on a daily basis. And so I think that I think cities have a future. And I certainly don't think, you know, we're going to just see an endless down cycle for cities. But I do worry a lot about, you know, what the current environment, what the work relationship and change means for cities. And I just think it's too early to say. And if we aren't able to do this tremendous transformation of all that unused office space downtown, right? I mean, New York City, think about just the millions and millions of square feet of office space in Manhattan that's probably not being used right now or very underutilized. What happens to all that? I mean, the expense of trying to transform that.

And if we can't or aren't able to, what does that mean for, you know, a city like New York's tax revenues? What does it mean for, you know, occupancy over the long term? What does it mean for, you know, the economies, the central economies of those cities? It's just so many, you know, unanswered questions right now. So it's not a, you know, it's not a written story here. There's a lot more to think about. You just found out that your sales team is at risk of missing quota. Don't panic.

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Yeah, I think that's true. And one of the things I think about with that too is with the Sunbelt cities that are growing and you have this opportunity to do the urban planning side of it better, which hasn't quite played out as much as I'd like, but also with big cities, you have a chance, there is a chance to sort of reimagine what a city is. And that's the thing that makes me optimistic. I mean, yes, there are worries about, you know, about funding public transportation and things like that. But there is also the opportunity to think of, like, how can we how can we do things better?

How can we make how can we make changes that are that are great? Like the idea of the 15 minute city or the sort of like super block neighborhoods where you get everything you need in one location. So that's that's the part of all of that that makes me that makes me feel optimistic. Before we move on and talk about residential, Anne, I wanted to turn it to you because one of my weird investing theses is follow the asset managers, like follow a Blackstone or a KKR. And I'm wondering what the opportunities are on the private equity side and what we can learn from what private equity is doing right now. All right. So if we look at public REITs over the last four years, we mentioned how they outperformed over the long term, but they've

been very volatile over the last four years. 2020 had the pandemic. They were one of the worst-performing asset classes. 2021, they were one of the best-performing asset classes. And then 2022 and 2023 with higher interest rates, they've been, again, the worst-performing asset class. So, I think that does present an opportunity for the institutional side, the private equity side of real estate to maybe take some market share. Because the way that private real estate, the way they measure their returns, it's backwards looking, it's appraisal based. So they're not marked to market their prices every single day. It's not like a liquid stock like a REIT is. So that tends to lead to less volatility over

the long run. And so if you're a portfolio manager for a pension fund and you're looking to invest money, you're probably going to like that lower volatility because you don't have to worry about the daily fluctuations in stock prices. So I think that does present an opportunity for institutional capital to continue taking share. Yeah. And I'll just add to that. That's great, I mean, you and I kind of have followed the Brookfields of the world, the Blackstones of the world. And these firms, it seems like they can just go through bad periods, but they never have issues raising capital. It just seems that they can always launch a new fund and raise billions of dollars no matter what's happening in the market, whatever cycle is. They can be

counter-cyclical where oftentimes REITs or even publicly traded real estate companies can't be because they're beholden to earnings, they have a balance sheet, and they can't react fast enough often. They can't recycle capital in the same way a private equity firm can or raise new capital. And so, I do think, and earlier in the show, we talked about, well, gosh, there's all these loans coming due, foreclosures, banks are really struggling. Well, private credit is going to fill a lot of that vacuum. They're going to come in, pick up a lot of those loans, pick up a lot of those distressed properties, and really take advantage. And so, you're going to see, I think, a Blackstone, Brookfield, maybe even Starwood be able to really capitalize on the current

environment. It might be dicey in the short term, but the money they're raising now and the money they're going to be investing in the short term could really, really pay off in the years ahead. Well, and I think another factor that I've seen, especially on the real estate crowdfunding side too, is raising money not for equity, but for mezzanine loans and things like that. And preferred debt, preferred equity. Yeah. Yes, exactly. Because it's been such a challenge for certain projects to get funded is that now there's this other thing. And I feel like this is a temporary, this is a window of opportunity based on interest rates and things like that. But that's where I'm seeing another area where some money has definitely been funneled. Yeah, that's right. I

mean, you're seeing that a lot. I think that's a great point. Whether or not as an individual investor, you'd be better doing that versus just investing, say, in the equity of, in the stocks of private equity firms or REITs today. I don't know because, you know, as we know, a lot of those crowdfunding sites, you know, investing in single asset deals, you know, a single market, and even though a preferred equity rate of, say, 12% might sound great, you have to ask yourself, could I do better, especially on a risk-adjusted basis, by sticking with the public markets today? I would probably say yes to that answer. That definitely seems to be how it has worked out. Let's pivot and talk a little bit about residential. Ant kind of kicked us off

at the beginning of the show talking about that. So, yeah, existing homes did not sell very much it in 2023, down around 20%. Next year, I've seen the reports from Redfin and Zillow. Everybody's doing their forecast right about now. They're saying that prices may go down a little bit, sales may go up a little bit. It seems like it's still on pause. What do you think? Are we going to shake out of the pause? Yeah. So I think eventually, I think everything will sort itself out. In the near term, I think there's three scenarios that can improve the housing affordability situation. It's either mortgage rates fall, home prices fall, which will lead to lower monthly mortgage payments, or we could build more housing, which I think in the long term is probably the

best solution. We just had so much demand for new housing. You think about a large millennial cohort that's moving into their prime home buying years. You have work from home, which is increasing demand for more space in general. Then you also have underbuildings since a great financial crisis, so supply is low. You've had a lot of government stimulus over the past couple of years. You had strong wage growth and full unemployment. There's a lot of demand drivers chasing limited supply. The more we can build, I think in the long run, it's going to be better. Look at multifamily rents is a great example of this. In the Sunbelt, in 2021, 2022, you saw double-digit rent growth. And now there's a massive wave of supply coming into the Sunbelt. And now you're seeing rent

growth tick down to 1%, 0%. In some cases, you're having negative rent growth because there's more supply coming online. So if we could do that with the residential market, single-family houses, I think that in the long run is a great way to fix this situation. Yeah. Dieter, you asked us at the beginning, what's our headline for 2023? I went with office, but my second headline, if I was going to go with it, was just the phenomenon of this lock-in effect that we've seen in the existing home market. I don't think we've ever seen anything like this in history. I guess you could go back to maybe from the 60s to the 70s, when we had a period where homebuyers were able to buy in and lock in very low rates, and then we had a period of just

rapidly rising rates. But I don't think there's anything like this because of just how acute rates have risen since early 2022. And so, you have a situation where we've talked about this, where something like two-thirds of homeowners currently have a fixed mortgage rate under 5%. I think if you go under 4%, it's still like 60%. And so, obviously, there's a huge reluctance on the part of existing homeowners to list their house, even if they wanted to, or even if they wanted to buy a bigger house or move to a different, you know, location, they're just not willing to give up their 3%, you know, mortgage rate that they have locked in for the next 20 plus years. Right. So it's a, it's a, it's an amazing phenomenon. I, you know, I don't think

certainly the, the, the agencies and the home market lenders were not ready for this situation that we find ourselves in. It's, it's, it's almost like a deep freeze. And I think, yeah, the forces that Ann brought up, those three forces would certainly change the market, but But right now, it's hard to see. Could rates fall that much? Are home prices going to fall? That's going to be hard to see. And can we really realistically kickstart a lot more building? I think Zillow's latest data says we're still short something like 4.3 million homes, given the demand. And it just feels like since the financial crisis, we've never been able to close that gap. And gosh, it's hard to see it closing anytime soon.

Yeah. And it's not just the lock-in effect. It's also those who've paid off their mortgage is a huge part of this. So almost around 40% of homes don't have a mortgage right now. And about over half of those people are in retirement age. So maybe they move at some point. But I think the other factor, not to be really grim, but the other factor here that's going to shake this out eventually is the aging of America and the demographics that shift, that eventually people will have to leave their homes. People want to age in place, but that's not always possible. Right. It's certainly got to happen at some point. How fast can it happen? Will it happen soon enough to resolve this incredible supply-demand gap that we're seeing right now in the market?

Probably not, but it'll happen. Well, and that supply-demand gap has been good news for home builders. You and I have talked before about the fact that, you know, at one point about a third of the houses on the market were new homes, which just like never happens. That's usually around 10%. And so you've got this situation that should be good for home builders, but as we mentioned, they're not really building. So, you know, they may, they're building, but they're not building as maybe as exuberantly as they could because they're still kind of cautious, but what's your thesis for home builders right now? My thesis is a simple one. I think it's for everything we've talked about, which is, it's just a, they're pretty much the only game in town

really. But because like we said, the existing market, the existing home market is frozen. And so what you have is a situation where home builders can come in, build new homes, offer, you know, offer financing to new home buyers. Oftentimes at rates that are a lot down payment terms and rates that are a lot better than what you can traditionally get from a lender. And so, if no existing homes are for sale, and all you have are new homes being built by homebuilders, they are in a position where they can charge whatever they want. But at the same time, while their margins are great, they're interested in protecting those margins, and they don't want to overbuild in a situation where there's less demand or uncertain demand. And so,

like you said, it's a perfect environment for them, but they're also being very cautious. And so, if this is the status quo for the next year or so, homebuilders are going to do great, because they're going to pick their spots, they're going to work through their backlog, they're going to earn incredible margins, the highest margins they've ever earned on homebuilding. But they've got other forces they have to worry about. They've got uncertain demand, uncertain economy, they've got higher costs, labor costs and input costs, and they're just just going to manage those as carefully as possible. To answer the larger question, home building isn't a solution to the housing crisis that we face in this country, the affordable

housing crisis. But as an industry, they are certainly in a great position right now. If you're an investor in home builders, you've seen the results of that over the past 18 months. It's been a great place to be invested. Thank you. as always people on the program may have interests 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 whether this is your first time with us or you're a seasoned fool our team is taking a break these next few days to enjoy the end of the

year. We'll be back next Friday, December 29th for a 2024 preview show. See you then, fools. From all of us at Motley Fool Money, we wish you and your loved ones a very happy holiday season, a wonderful end to 2023, and of course, a foolishly fruitful new year.