Motley Fool Money - 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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If you look at the two ETFs that I follow, if you look at the Ishare's U.S. 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 Maddie 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, Motleyful money's 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

we're 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, 2004 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. But and your headline was Office is dead. And so when you start with Office, I was like, oh, my gosh, what's you 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 for more positive. than office alone. Right. I mean, office, yeah, it just, 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, you know, traditional office. If you're talking about Class B or older office, I just think, yeah, I think my original,

I'll stick with my original headliner. 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 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. You know, we saw the bankruptcies of bed, bath and beyond, of JC Penny, 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 kind of 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 up this conversation, that office aside, commercial real estate is on the rise. So here's the lead of that article. buyers and sellers in U.S. commercial real estate are increasingly convinced that the belagored market

is reaching a bottom. End quote. 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 kind of 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 Ishare's U.S. 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 mentioned 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, CRA 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 CRA market. They 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 facilities.

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 challenge is there, but there are many categories of commercial relationships. 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 to 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 over exposure to commercial real estate and offices in particular. The conference board has calculated that more than a trillion dollars in CRA 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 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 in the loan. A lot of the small and regional banks have already taken pre-servoir. 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, you know, to a certain degree. I mean, banks will have access to more affordable credit. You know, the value of bonds held to maturity on the balance sheets will improve. So their 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, you know, the commercial real estate exposure. but I 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 slow moving train wreck. It's definitely going to hit the, it's 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

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 reet 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 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. You know, Simon's portfolio is just located in really some of the highest end suburbs or exurb locations, you know, 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. You know, high-quality tenants make a big difference.

If you think about a typical Simon Mall or shopping center, you know, you're going to find the Apple Store, the Michael Corse store, Tommy Bahama, Neiman Marcus, Lulu Lemon. 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, you know, work, stay, eat, play. It 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 he's ahead of, that the company's 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, quote, we have never been better positioned. And then goes on to say, I think we are in an absolute unequivocal, 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 like 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, there, 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 reet 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 space, maybe class A spaces, but also some class B spaces and tenants. They don't have the same, near the same draw or pricing power that Simon has, but they are

you know, people, 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, you know, if you've asked 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 there, again, 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, you know, 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 Mid-America, 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, you know, and so that's just a kind of a natural demand supply dynamic that's taking place. But what we've seen, especially since the end of 2022, is that construction is really tiled off. So I think MAA as well as maybe Camden Property Trust, which is another multifamily reed in the markets, in the Sunbelt markets, they're finally seeing less pressure on that occupancy. And so they know how to manage it very well.

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 rates 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 is 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 MMA 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, whether it was because of we have. That's right. I know. Do we have the rest of the day? I mean, it's, 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 a bit, 15, 16 years now. And, you know, and depending on what estimate you look at, we're, you know, we're short anywhere between two and three 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 huge demand for homes, especially first-time homes. And it's just such a problem in a lot of markets. And I don't think it's a problem that can be adequately addressed by private capital. I think it's going to take government. It's going to take zoning changes at the local city level 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 do, 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 or they, you know. 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, you know, 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 home builders, right? And if you follow the home builders, 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, even there, there's a lot of home builders 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 these existing side, paradoxically, actually, a lot of homebuilders don't want those rates to come down because they're in the sweet spot now where they're the almost the only game in town. They can offer kind of lower rates on their own balance sheets. They're the only ones bring a 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, It's just not, 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 Connorsen about a year ago, and this was the headline, the U.S. housing market is now completely broken. So bright, right? Yeah. Senn's point, though, was that mortgage rates, which then had surge as high as 8%, were proving too much for homebuilders, they were reducing new construction. How does that hold up a year later? Homebuilder sentiment is higher now than it was about a year ago. 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 stands right. It is, I wouldn't say it's completely broken, but it's broken. And we could argue that well, now with mortgage rates now in, you know, like 6.2%. That's a lot better than 8%. But again, we have to remember, there are millions, tens of millions of homeowners.

who locked in rates, you know, below 5%, below 4%, even some below 3%, you know, in the sort of 2020-2020 period. And so it's going to take a lot lower mortgage rates to get 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 you're going to, you know, 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 underbuilding. 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 underestimbing 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, you know, 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, you know, kind of unfold, you know, 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 ourselves stocks based solely on what you hear. I'm Mary Long. Thanks for listening. We'll see you tomorrow.