Economic Drivers in Real Estate: Deploying Capital in a Mature-Cycle Environment

TH:You led a great discussion at today's Real Estate Principal's Luncheon in Los Angeles cosponsored by EisnerAmper and Perkins Coie.
DB:I did indeed and it was definitely a discussion. There's nothing worse than going into a presentation and just having blank stares at you. You want people to have a view, to take a point, and to push you on your arguments, and we definitely had that today, which made it so much more fun for me.
TH:I'd like to give our listeners some key takeaways from your 2020 economic forecast. To start, can you tell us how the current sentiment on the economy and on commercial real estate compares to a year ago?
DB:So, let me just kind of take us back here, like what did the world look like? The S&P 500 was down significantly including down multiple percentage points a day before Christmas. The 10 year treasury rate was in free fall. The trade war was accelerating and we had a lot of other things in the real estate capital market were similar and so far as they were good transaction volumes, lots of dry powder. But there was this palpable sense of uncertainty and risk of recession sweeping over the market. Contrast that with today. We have a tremendous amount of stability in the outlook for monetary policy, we have a 10 year treasury, over a hundred basis points lower and within a very simulative trading range, creating zero upward pressure on pricing. We've had a phase one trade deal signed and we're about to finalize USMCA.

So a lot of policy risk has been taken off the table. And then add on top of that, we have high consumer confidence, recovering business confidence. We've had decelerating growth in Europe, Latin American and Asia last year. Now there's signs of stability and even coronavirus notwithstanding. Overall, I think that both the market sentiment and the underlying fundamentals today are more favorable than they were a year ago. And that's ultimately going to be reflected in real estate performance, real estate sentiment and the broader transaction environment.
TH:What do you see as the salient risks to this sentiment and to your outlook?
DB:I mean, as I said, the biggest risk event of the year is the United States Presidential election. Now, I think that that to an extent has already been priced into people's behavior. I mean, we talked to investors and the general sentiment is, is that the third quarter is going to be a little light on liquidity. In an election cycles past, we've seen that the liquidity impact of election has been overawed by broader macro-economic considerations. So you can look at 2008 and transaction volumes were done a lot. Why? Was that because of the president election or is it because we're in the great financial crisis? Probably the latter.

In other cycles, a strong macro environment, which as I said, I see continuing to be operative tends to wash that out. So the main impact I would see this year from that particular risk event, is a shifting in transaction activity to either later or earlier in the year. And that's certainly been reflected with the kind of BOV activity that we saw starting to perk up in the fourth quarter in the last year. Other risks to the outlook, like I said, the monetary policy risk has essentially been neutralized and that was always the biggest threat to the economic outlook.

Beyond that, I mean, there's a scenario where inflation comes out of nowhere and starts to change that, but I find that as highly unlikely. Additionally, there's always the potential for a Black Swan, but by definition you can't predict that. So the base case has to be continued moderate growth and a healthy labor market and a well-trod consumer.
TH:Given that, how attractive would you rate commercial real estate at this point in the cycle compared to other asset classes?
DB:I think the commercial real estate is highly attractive right now. So for one thing, if we look at measures of valuation, real estate has not looked more attractive than it is from a pricing perspective then since 2012. And that's a result of relatively stable cap rates, even as debt financing costs have come down. So your equity premium, which is the comparison set for the P/E multiple for equities has improved dramatically in the last year. Meanwhile, with the large run up in equities last year, a lot of that monetary easing effect has already been priced through.

That hasn't happened in real estate yet. So I think that it represents a better value compared to equities. The same thing can be said when comparing to a fixed income, both high yield and investment grade. They both had a great year last year as both base rates and spreads compressed. Compare that with real estate at current pricing. Again, it just looks more attractively valued. And in this particular case, if you're an income oriented investor, you're getting better, you're just getting better yield for the level of risk that you're taking. I think that's part of why the net lease sector saw a tremendous amount of acquisition volume increase last year.
TH:So from that, it sounds like you remain bullish on commercial real estate. How about on a risk adjusted basis? How would you rate for where investors can find the best risk adjusted returns?
DB:So from a broader standpoint, that's really... I'm not necessarily saying that real estate's going is going to beat hand over fist, this equity sector or that equity sector. But I'm definitely arguing that on a risk adjusted basis, it's a very efficient allocation of capital and belongs in any diversified portfolio. Within real estate, I think that the consensus is broadly correct in that multifamily investments as well as industrial investments can continue to be well supported on a risk adjusted basis. For the last couple of years, I've been arguing for a shift to more alpha oriented strategies, so things like value add and opportunistic and that being across product types. I am increasingly thinking that it might be time to reorient on the margin back to core. That's not saying that value add an opera bad by any stretch of the imagination, but that I see accelerating fundamentals in the core space and less capital competition. So I think that, particularly looking at seeing multifamily, that's something that investors should be putting more thought into.
TH:I thought we'd do a quick lightning round. I'll state a topic. You give me your assessment ranging from underrated, overrated or appropriately rated relative to market consensus. First suburban office.
DB:Underrated. This is going to continue because we're in an environment that's dominated by income returns. Additionally, if you look at rent growth spreads, vacancies, any number of the actual fundamentals, the gap between suburban office and CB office has never been narrower. Additionally, we haven't seen a large movement of the institutions in that sense, it continues to be dominated by private capital. So I think that that is supporting attractive pricing. The final point is just that suburban office is 70% of inventory. It's a much larger opportunity set.
TH:Moving on, workforce housing.
DB:I love workforce housing, so I'm just going to anchor that there. At the same time, I think that it's probably a bit overrated. It's dogma at this point that it's better than class A, it's better than luxury, that it will be completely immune in a recession, all of these things. And I think there's arguments for all of that. The analysis that I've done suggests that the long-term performance of class A versus workforce is a lot more similar than people think. And that in particular we're seeing an attenuation of core or class A, however you want to phrase it, multifamily pipeline And so it's becoming more competitive, particularly on a risk adjusted basis.
TH:Okay. How about tech markets?
DB:Tech markets I think are about adequately rated and I mean, and this isn't an ebullient market, but the reality is this is that they continue to generate wealth and attract occupiers at a rapid rate. I think that within the tech markets, I am particularly bullish on some of the emerging secondary markets. That doesn't mean you know... I'm from San Francisco. There is no scenario in which San Francisco and Silicon Valley lose the crown. Policy challenges, quality of life challenges in areas like Silicon Valley and others that I'm sure listeners can think of, I mean that secondary tech markets with more attractive cost of doing business, cost of living are going to continue to attract some of the incremental job additions that that existing occupiers create.
TH:What are your thoughts on co-working?
DB:Co-working, I think that it was overrated and that events of the last year have brought things even potentially to be slightly underrated. I mean, watching the news, there was just panic and a lot of the work that people in my firm have done, and we can link to a piece that we put out last year, was both to get everyone to take a deep breath and realize that a retrenchment of the industry was is both necessary and desirable and that the health of office markets is not nearly as dependent in leverage to that sector as some statistics might've suggested.
TH:Last mile industrial.
DB:I think that it's appropriately rated. I think that all of the ebullience around the topic is well deserved. Surface expectations continue to mount. I mean one example is you look at a certain company starting to deliver groceries same day. That among other kinds of things, moving to same day delivery for a range of competing e-commerce suppliers is going to continue to add demand for these properties. In addition, and this is both like the advantage and the problem with last mile is that they are by definition site constraint and competing for other usages that are and often highest best use because you're right there in the middle of the urban core.

While now flip side, what that means is that you are always going to have, if you own that property, it's going to be in high demand. So you're guarded against supply but also there's just a finite set. So if you've raised a few billion dollars for industrial, you're going to have a heck of a time trying to fill that out only with last mile. So there's a maximum exposure to it in any broad portfolio. So that can't, that can't be all of your strategy.
TH:What about retail?
DB:Retail I think is... inside Cushman, it is the house view that it's a tale of two cities. If you tell me that that's the market consensus, then I think that it's probably about right. For a broader public that might be throwing all retail away. That's to use another hackneyed term, that's baby out with the bath water. There are segments of retail that are e-commerce resistant or even malls that have made a pivot over to experiential and are located in high income districts that are killing it. I tried to go to the mall the other weekend, I couldn't find parking. That doesn't happen in a failing center.
TH:Rent control.
DB:Rent control. I actually think that there's a little bit of an excess of pessimism. Let's expand rent control out to a wider range of potential policy interventions. Rent control is bad. I say that as a real estate guy and I say that as an economist, it is a bad public policy and nobody should do it. But even when you do it, the effects can be very nuance. So for example, in California, I think that they'll have a negligible impact on the market because it's not really binding. That's also why apartment associations didn't oppose it vociferously. There are other regulations that have happened that are going to have a much more negative impact on the underlying cash flows and fundamentals for segments in the market. But what people need to remember is, is that as one door closes, another opens.

So if one segment becomes very unattractive to capital, then all of a sudden then there's more capital competition for an alternative set. So something that's regulated versus not. And now that might happen within a market and it might happen across markets.
TH:Here's a relatively newer category, prop tech.
DB:Prop tech. I think that I think everything with technology, whether it's prop tech or not, is a bit overrated if you're looking at the media and the consensus. That doesn't mean that it doesn't have the ability to transform things over time. I think that, in general, the real estate industry, and this is kind of a common sense at this point, is behind in terms of modernization efforts, the penetration of data approaches. I think that we're still very far away from being able to reap the true benefits. And that's because we're fundamentally in a highly fragmented, highly opaque industry without the necessary levels of coordination to really put data to bear to get analytics to where they could potentially be.

I mean that's just the nature of an illiquid asset class. And then when I see it in lot of other technologies, they are exciting, but I tend to think of them as, think about smart locks and an apartment building. It's a great thing, but it's not transformative. And there's a lot of other things like that in technology in general where it's very exciting, it's very interesting, but it's not like the invention of the refrigerator.
TH:And finally the topic that is increasingly on everyone's mind this year, the presidential election.
DB:I think that it's a little bit overrated from a real estate perspective. And I'll tell you why, I mean one is this is that from like a transaction velocity perspective, I think that there is a consensus among the people that we talk to that there's going to be less transaction activity in the third quarter. That to me means that it probably just moves up and I think that it'll overall be dominated by the overall supportive environment. So liquidity is going to remain good this year. You might tactically let that influence when you bring a deal out. I think that depending on what happens, there'll be this market reaction or another. We don't have enough visibility on the democratic side to really talk about that in detail.

I think what's more important is that regardless of what happens, we're going to have a divided government and that that is going to constrain the range of policy outcomes. So even if you have someone coming in that they want to do wild and crazy things, their ability to actuate that is highly circumscribed. So I think, which as is always the case with American politics, there's a lot more policy continuity than our fractious debates suggest.
TH:Thanks David for sharing this valuable information, and thanks to our listeners for tuning in to Breaking Ground. Please email us your feedback or give us ideas for the next podcast at realestate@eisneramper.com. Join us for our next podcast episode, or visit eisneramper.com/re for more real estate news you can use.