Motley Fool Money - 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

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You know, right now it's hard to see. see, could rates fall that much? Our home price is going to fall. That's going to be, you know, 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, senior analyst Matt Argersinger. Future Willard caught up with Matt and full 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, 2020 for me, and I, I have to be. I hate to start this wonderful show on maybe a dire note. But 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, you know, 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 it as a, you know, 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, you know, where people come on an infrequent basis to just collaborate, you know, to have meetings, to, you know, 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, 2003, 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, you know, to make matters worse, the Fed embarked on one of the fastest interest rate hiking cycles that we've seen in quite some time. And that drove mortgage rates to nearly 8% just a few months ago. So the result is a dramatically higher monthly mortgage payment for most people buying a new home. And according to the National Association of Realtors, housing affordability is at its lowest point in nearly 40 years. So since housing is the biggest asset that a lot of people own, I think it's a really big deal.

And hopefully this gets resolved, you know, looking forward in 2024 and beyond. Also not. 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 both have, we've all discussed before, that is not really possible. We can't turn all of that class B office space into into housing. So, I mean, people are trying, but that is certainly. No, yeah. I'm glad you brought that point up, Dieter, because it's way too expensive, first of all. And even if it was economically feasible for, you know, this transformation to take place where we can take a lot of this, you know, unused office dock 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 I, unfortunately, I think, not to beat this drum on office, but it almost, I almost think to the point where the only solution to a lot of these Class B office is, 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 sort of like slow burn crisis of the loan issues facing commercial real estate.

I mean, you framed it up with, you know, obviously the demand for office is lower, you know, when you're trying to refinance now, as, as Ant pointed out, you've got those higher interest rates. So, you know, if there's about a billion dollars in, sorry, a trillion dollars in loans coming due in 2024, 2025, which just seems like a snowball rolling at us. So on a scale of one to 10 with one being we're doomed and 10 is, this is a blip. It's not going to work out that bad. where do you put the risk? That's a good question.

I think the risk to the overall market, like if I think about what's the risk of the economy and financial markets, I'm out of four to ten. I think commercial real estate, even this tremendous wave of loans coming due that you mentioned, DeJRA, a lot of these loans will get worked out. They'll be extended. They'll be rolled over.

Some will be refinanced at higher rates, even though that seems 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, we really are talking about office because that's where the trouble is. Yeah, I'm out of 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, you know, year or two. And they really don't want, banks aren't in the business of owning and managing office real estate. So it's going to be really, really tough.

and I think you're going to have to have a lot of workout firms come in and work things out. But 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 and 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. Andrew, are there any sectors that the 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 more, it's further along. Really, of the past decade, malls have struggled with the device in e-commerce. sales. So, 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. And then looking at multifamily, multifamily still has pretty strong yet moderate, 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. So 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 be in a position where you can charge the most rent. So all the money flowed toward luxury multifamily. But, you know, it's really,

rents are sort of stabilizing or stalling out in some markets. And in some of those markets, 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. So 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. And you just mentioned the idea that we've got, we've still got capital flowing in. But it was not a great year for REITs. They do perform, outperform the broader market, over time. Matt has drilled that into my head. But it was not their year. Matt is, is 2024 going to be their year? Wow. I sure hope so, Deacher. I think it will be. I mean,

you mentioned 2023 not being a great year for REITs. Well, it's been a brutal two years for Reets. 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, right? And for the first time, if you ask the average institutional investor, for the first time in two decades, I can get a, or at least 15 years, I can get a risk-free yield of 5% or more, right? And we haven't seen that in a long time. And so if you're comparing that to a REIT that might

also be paying 5%, you know, a 5% dividend yield, it's just not. as compelling because there's risks associated with that investment, right? If I can get risk-free 5%, why am I going to be risky 5%. But of course, I think as most things, investors are, 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 ANTS has found some great data out there that's just 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, REITs are probably set up to have, you know, to rebound pretty strongly. I think that's what we're going to see starting in 2024. Are there any particular areas of REITs that you're more interested in? Because one of them that I'm thinking about is the idea of rebounding in data centers. And there aren't that many of them left in the publicly traded REITs base. But you know, if you see the AI growth, you have to figure that there's a correlation there. The two biggies, digital realty and equinex, 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 data centers are one. And I think, you know, Iron Mountain is another one that Anthony and I talked a lot about that is an emerging player in the data center space. That's pretty exciting to us. You know, I think industrial is going to stay strong. We talked a lot about industrial estate. You know, when I talk about industrial, I mean, you know, warehouses, logistics facilities, your pro logistice of the world, your stag industrials, where they're really riding these two undeniably strong secular trends, right? e-commerce, which we've known about for decades now, but also this more recent trend of, you know, kind of supply chain optimization or redundancy.

You know, since the pandemic, we saw all the challenges that a lot of companies ran into in 2020, 2021. And they're looking to bring, you know, some of that manufacturing home, trying to, you know, 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, you know, the REITES, you know, the REITs. market that I think has been strong and it's going to stay strong. And I'm sure Ann can name

one or two more as well. Yeah, I know I just got done saying that we might see some the stress and multifamily, but I do think some of the multifamily reads present an 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, much 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 Sun Belt area where we've seen so much of the growth over the same. the past couple of years, kind of related to that. I feel like we talk about the Sun Belt all the time. Is the growth story still there, do you think? Is that still where things 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 worry about. You know, there's two,

I'm of 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, you know, because offices have 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 color 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, you know, adjacent real estate, 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 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, you know, the millions and millions of square feet of office space in Manhattan that's probably not being used right now or very underuse. utilized, what happens to all that? I mean, the expense of trying to transform that. 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, it's not a, you know, it's not a written story here. There's a lot more to think about.

In a world full of noise, long-term thinking stands out. On the Capital Ideas podcast, Capital Group leaders explore the decisions that matter most in investing, leadership, and life. It's a rare look inside a firm that's been helping people pursue their financial goals for more than 90 years. Listen to the Capital Ideas podcast from Capital Group, published by Capital Client Group, Inc. 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 the part of all of that that makes me feel optimistic. Before we move on and talk about residential, and I wanted to turn it to you because one of my sort of like weird investing thesis is sort of like follow the asset managers, like follow a Blackstone or 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 outperformer 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're one of the best performing asset classes. And in 2022 and 23 with higher interest rates, they've been one, 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 base. So they're not marked to market their prices

every single day. It's not like a liquid stock like a RET is. So that tends to lead to less volatility over the long run. And so if you're a performance, 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. And I mean, you and I kind of have followed the work fields of the world, the Blackstones of the world. And these firms, you know, 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 and no matter what's happening in the market, whatever cycle is. And they can be countercyclical where oftentimes reits or even publicly traded real estate companies can't be because they're beholden to earnings. They have a balance sheet. 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 to, foreclosures, banks are really struggling. Well, private credit is going to fill a lot of that vacuum, right?

They're going to come in, pick up a lot of those loans, pick up a lot of those distress properties, and really take advantage. And so you're going to see, I think, you know, 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 for, not for equity, but for like 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. You know, whether or not as an individual investor, you'd be, you know, 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 and kind of to kick us off at the beginning of the show talking about that. So, yeah, existing homes did not sell very much in 20, you know, down around 20%. Next year, you know, 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 kind of 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 a 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. And then you also have underbuilding 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.

So the more we can build, I think in the long run, it's going to be better. I mean, look at multifamily rents is a great example of this. 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, you know, what's our kind of headline for

2003. 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 where 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 home buyers 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, you know, 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% mortgage rate that they have locked in for the next 20 plus years, right? So it's an amazing phenomenon. I don't think certainly the agencies and the home market lenders were not ready for this situation that we find ourselves in. 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 right now it's hard to see. Could rates fall that much? Our home price is going to fall. 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, 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. 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 like 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. And now is certainly that's certainly got to happen at some point. You know, how fast can it happen? And will it happen soon enough to resolve this, you know, incredible supply demand gap that we were seeing right now on the market? Probably not. But it'll happen. Well, and that supply and 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 as a simple one. I think it's for everything we've talked about, which is just a, they're pretty much the only game in town. Really? because like we said, the existing home market is frozen.

And so what you have is a situation where home builders can come in, build new homes, offer financing to new home buyers. Oftentimes at rates that are down payment terms and rates that are a lot better than what you can traditionally get from a lender. And so, you know, 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 home building. 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 going to manage those as carefully as possible. So 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. And 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. 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 ourselves 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.