This article is sponsored by Macquarie Infrastructure and Real Assets
The US has endured a turbulent summer with covid-19 cases exceeding 6 million, while political discord intensifies in the run-up to what many observers fear will be an unprecedentedly rancorous presidential election. Nonetheless, as the world’s largest and most liquid national real estate market, the US remains impossible for investors to ignore. Christoph Donner, chief executive of Allianz Real Estate in America, and Eric Wurtzebach, head of the Americas – Real Estate at Macquarie Infrastructure and Real Assets (MIRA), consider the effect on the market of the rapidly evolving situation and how investors are adjusting their strategies to respond.
The presidential election
Eric Wurtzebach: At the beginning of the year we were focused on the potential impact of the presidential election on liquidity in the US real estate market. Covid took that spot and rendered the election largely irrelevant in terms of its impact on transaction levels. The election is just one more big, disruptive event in 2020 that we must deal with.
Christoph Donner: There is clearly a lot of political noise around how the country is handling the covid crisis, and that is not helping investors’ confidence while they wait to see how that is going to play out. What some of them may be missing is that while the US provides less of a socio-economic cushion for individuals and businesses in times of crisis than European countries, it also has tremendous pent-up energy and capacity for innovation. The US is a strong, vibrant, liquid market with a high-quality workforce, extensive natural resources and the ability to print US dollars. A vaccine is key for the world to move on, and when it does there may well be a very quick bounce back to the US becoming a leader in terms of GDP growth. Most investors in the country will try to ignore the political noise while retaining a positive long-term view of the prospects for investment.
Logistics still the most attractive sector
EW: Millennials are reaching their peak earning years. They spend more online and are the largest part of the population demographic. E-commerce requires three times as much logistics space as bricks-and-mortar retail, so that is a powerful driver of demand. Meanwhile, only 30 percent of existing US industrial stock is modern. This should bode well for the industrial sector in the long term.
CD: Alongside the increase in online sales, some manufacturing activity that had been relocated offshore is now returning to the US, which is increasing the need for distribution space. The only note of caution I would sound on the logistics market is around sustainability. At some point there will be repercussions when people start to understand the carbon footprint that is created by the online shopping world. Historically, Europe has led in addressing these issues, but ESG is a fast-growing topic among investors in the US too.
Changing dynamics in the office market
CD: Working from home is here to stay. Some people see value in that arrangement because it allows them more time with families, they prefer to work in a quiet space or just want to avoid the daily commute. And right now, a lot of people do not want to be on public transport because of the virus. Investors will need to analyze the data to figure out what the ongoing impact of that will be once the ‘new normal’ becomes clearer. Companies will continue to have an office hub to promote collaboration and innovation, but office space in the post-covid world will look different: people will be more spread out, and more office functions will be non-touch and operated by smartphones. In dense, high-cost cities like New York, young people will want to come into the office because their home environment is not conducive to work. Meanwhile, employees living in the suburbs may wish to work from home more.
EW: Office REITs have seen their values fall this year, so the investor universe is saying that there are some significant risks related to the office market. Covid has accelerated the working from home trend and migration to locations that offer better lifestyles, and that is expected to affect the big tier-one cities. However, because of the virus, we will likely also see the trend toward densification reverse, so employers will want larger footprints.
Prospects for residential
CD: Rent collection has remained good across the country in our multifamily assets and the long-term demographic trends around household formation in the US continue to be positive. While we continue to see good opportunities in multifamily in some markets, like Austin and Nashville, the rental growth we have seen in the past may slow, given the economic downturn and the relatively elevated levels of new construction we have seen in recent years. The popularity of single-family rental is increasing because the millennials moving out to the suburbs have become used to the convenience and flexibility of renting. Historically, the very tight yields have made it difficult for larger investors to achieve their returns through the multifamily sector in prime markets. More broadly, we don’t believe investors will see substantial rental growth – that is, make outsize returns – like they have in the past. But we do see the sector providing good returns in the long term.
EW: Many multifamily tenants in the urban Northeast and West Coast have let their leases expire and have moved elsewhere. Manhattan multifamily, in particular, will face challenges until there is a vaccine and offices start reopening, at which point we would expect to see a pretty sharp and swift rebound. While things are beginning to improve, vacancy is at historical highs right now in those markets. As tenants return, a lot of managers will likely be managing toward occupancy, which will subdue rental growth. However, the fundamentals for multifamily in these locations suggest they will rebound well over the long term.
Continued growth in the Sun Belt
EW: In recent years, we have seen businesses and employees moving from cities like New York, Los Angeles, Boston and San Francisco to the Sun Belt and other growth markets in search of lower taxes and costs, and better lifestyles. However, it is important to appreciate the difference in the overall scale of those markets. New York is a 400 million-square-foot office market, while Austin is 48 million and Nashville is 40 million. The move of 1 million square feet of demand would not significantly dent the New York market, but it could have a big positive impact on those smaller cities.
CD: Those ‘18-hour’ cities have been growing more attractive as places to live and work, although issues such as traffic congestion may limit their capacity to grow. People leaving the denser markets may reduce some of the overheating in the multifamily space in San Francisco and New York, but the attractiveness of the biggest cities to people and capital will return once the covid issues are solved. Liquidity is also an issue in smaller markets. For a big overseas investor like Allianz, structuring complex transactions is much easier when an investment is $500 million than when it is $150 million.
CD: The cycle came to an abrupt end because of a medical crisis, not because the real estate fundamentals changed or through a collapse in the economy. We saw resilience in the past cycle because there was limited construction in historic terms and leverage was modest. There is some stress in the market, but most investors have the wherewithal to hold their investments through a crisis, unless they are in retail, hospitality or restaurants, where revenues may have dropped to zero. I don’t think we are out of the woods yet in terms of the economic impact, though.
EW: Based on data from Trepp, rental delinquencies in the lodging space are 23.8 percent, compared with 1.8 percent last July. Retail delinquencies have increased to 16.1 percent from 4.4 percent over the same period, but to date lenders have not been foreclosing on businesses or homeowners. Everyone is waiting to see what happens when there is a vaccine and the world normalizes. When it does, we will be watching the flow-on effects in the capital markets closely.
EW: Our view is that global growth should continue to recover through the second half of 2020 and into 2021, but there will be a lagging labor market recovery and some lingering impacts on global consumption and GDP relative to pre-crisis trends. A V-shaped recovery is still possible if it is supported by a vaccine in the near term.
CD: Over the next 12-18 months we are underwriting a certain cushion when we make investment decisions because we anticipate a reduction in net operating income because of unforeseen tenant bankruptcies causing hits to the bottom line. That is our way of taking a slower recovery into consideration when making investment decisions. Nevertheless, our view on US real estate remains positive on a long-term basis, even if the next two years are not as good as we would hope. One thing that the virus has emphasized is how closely-connected the world is, and that may have positive implications for future collective efforts to deal with the much bigger problem of global warming.
View of the pandemic
Christoph Donner on how the crisis is impacting markets and Allianz’s investment approach
“Covid-19 has accelerated existing market trends, but it is primarily a medical crisis, not an economic one. Well-capitalized investors able to take a long-term view should be able to work through it.
“Before the pandemic, like many other investors, Allianz recognized that we were in a fairly heated stage of the market cycle already. We were therefore more disciplined and defensive in our investment strategy in the US and elsewhere, looking at long-term allocations and prioritizing ongoing trends in sectors like industrial while under-allocating to retail. We will continue to focus on stable long-term returns in core and core-plus strategies, highlighting the trends in industrial, sticking with multifamily and pursuing any attractive opportunities that emerge in the office sector.
“There may be opportunities in the retail sector in combination with logistics and last-mile distribution, but it is still too early to see how, and to what extent, that will play out.”