It may be true that “software is eating the world”, as venture capitalist Marc Andreesen wrote a decade ago. But it took the covid-19 pandemic for technology to take a big bite out of the relatively stodgy world of real estate investing and finance.
Now change is coming with a vengeance. The virus is accelerating trends in commercial real estate that are being driven not only by the increasing dominance of working from home. There is also an explosion in streaming content called ‘techtainment’ and a surge of interest in life sciences properties. Plus there is the growing popularity of e-commerce and its insatiable appetite for warehousing, logistics, data centres and the like. Even newly designed multifamily properties will have to incorporate space for the higher volume of packages that will be commonplace in an e-commerce economy.
Moreover, lessees are increasingly demanding such features as connected building apps and touchless technology when considering new leases, according to CBRE’s US real estate market outlook for 2021. Once the covid crisis is resolved, “our attention will again be drawn to the long-term changes to real estate from the digital economy and demographics”, the report says. “It is these and other megatrends as much if not more than traditional supply-and-demand metrics that will determine how far commercial real estate moves from the old to the new normal.”
Tim Savage, an economist and clinical assistant professor of real estate at New York University, says: “The most important thing to recognise is that real estate as an asset class was being disrupted by tech prior to covid.”
The rise of Amazon and e-commerce bolstered industrial real estate at the expense of bricks-and-mortar retail, whose longstanding issues were exacerbated by pandemic-related lockdowns and social distancing requirements.
That has inevitably influenced the market for commercial real estate private lending, which totalled $3.7 trillion as of 30 September 2020, according to an Oaktree Insights piece in November called ‘The Case for Private Debt in Real Estate Investing’. Although debt funds and mortgage real estate investment trusts comprise only about 10 percent of debt outstanding in the commercial real estate private lending market, their proportion grew fourfold between 2009 and 2019. This was largely because the global financial crisis led to stricter regulation of banks, the biggest holders of CRE debt at 39 percent. Indeed, from 2008 through the third quarter of 2020, global real estate debt funds raised some $320 billion of capital, according to research by sister title Private Debt Investor.
“Recently, there’s been an extraordinary amount of optimism toward real estate debt that has been fuelled by the vaccine,” says Justin Guichard, co-portfolio manager of real estate debt and structured credit at Oaktree.
“Millennials want to be in the city, near other young people. There’s nothing about the virus or the re-emergence of the suburbs that’s going to change that fundamentally”
CenterSquare Investment Management
“Liquidity stands ready and available,” adds Alan Todd, head of CMBS research at Bank of America. Gross issuance of private-label CMBS should increase to $80 billion-$90 billion this year, BofA forecasts, from $59.2 billion through early December.
“It’s a lender’s market,” says Matthew Koelliker, president of M360 Advisors, an investment manager. “Demand across sponsors and borrowers of real estate assets remained strong,” even as real estate lending “pretty much stalled” in the spring and early summer, he says.
Deals down, but no meltdown
Although deal volume in 2020 to the end of November fell 40 percent from the equivalent period in 2019, according to Real Capital Analytics’ November US Big Picture report, early fears that the pandemic’s effects could mimic those of the GFC were never realised.
One critical difference is that in the last downturn, “the hole in the debt portion of the capital stack created by the disappearance of the CMBS market led to years of limited deal activity and falling prices”, the RCA report said. But this time around, although the market for commercial mortgage-backed securities came to a temporary halt in the second quarter, CMBS originators regained much of their market share in the third quarter. Prices on commercial properties as measured by the RCA CPPI All-Property Index rose 5.7 percent in November from a year earlier. Industrial and apartments drove the growth, while trends in retail and offices tended to pull down prices.
Although refinancings accounted for more than 50 percent of activity in the first nine months of last year, according to RCA, Uhlmann says there were a number of new-issue deals in the fourth quarter. “Traditionally strong markets will continue to perform, and we will eventually get through this.
”Moreover, we are not seeing the crazy loan-to-values of around 70 percent that we saw in the lead-up to the GFC”, says John Uhlmann, senior strategist of CoStar Risk Analytics. He says current LTVs are 63 percent, and “probably closer to 60 percent if you back out multifamily agencies”.
With record-low interest rates forcing institutional investors to hunt for yield, “you’re going to see allocations increase to private debt, especially real estate credit”, says Matt Salem, head of real estate credit at KKR.
In July, the firm closed on a nearly $1 billion real estate credit opportunities fund, the successor to a $1.1 billion vehicle that closed in 2017. The latest fund has been one of the most active buyers in the CMBS market, Salem says, and follows the same strategy of buying junior tranches of new-issue conduit CMBS. Indeed, KKR Real Estate Credit was the most active buyer of B-pieces from CMBS conduit transactions in 2020, investing in seven conduit deals totalling $6.2 billion, or a 23 percent share of conduit issuance, according to Trepp.
In late September, Blackstone closed on an $8 billion real estate debt fund, the largest ever raised, bringing its real estate debt strategies platform to $26 billion of assets under management. The fund will seek to acquire undermanaged, well-located assets around the world, with no more than 49.9 percent of commitments deployed outside the US. Invesco Real Estate, an $80 billion property manager based in the US, launched a European real estate debt platform in September by agreeing to buy Swiss asset manager GAM’s commercial real estate debt finance business, which has $300 million in assets.
The picture is similar overseas. In Europe, “we continue to see fund launches from a debt perspective, either opportunistic or distressed debt”, says Anita Lyse, group head of segments and global head of real estate at Alter Domus, a Luxembourg fund administrator for the alternative investment industry. However, she cautions that “if you’re in a secondary market or city and you have a retail park then it’s very, very tough”. Nevertheless, she says, “we are seeing both retail and office on a bit of a rebound”, with rent collections rising a bit and occupancy rates not dropping.
In Hong Kong, the market is abundant with liquidity, Ada Wong, chief executive of Champion REIT, said at a conference in November on the ‘Future of Commercial Real Estate’ hosted by Respada, a global platform that frames strategic opportunities in the private markets for wealthy families and individuals. “Even though the geopolitical situation in Hong Kong is cloudy, banking and investor support in terms of real estate is still strong and solid.” She said that bond deals were “very hot”, and that she had seen deals be 10 times oversubscribed.
“The influences from covid have accelerated some existing trends and caused disruption in other areas, and clearly delineated some winners,” KKR’s Salem says.
He points to industrial, already highly favoured going into the health crisis, life science properties and residential real estate, both multi- and single family. “Capital flows are going to be quite high in the winners, and you’re going to see a real chase for what’s left that’s good,” he says.
With non-traditional lenders either exiting the market or pausing, Koelliker of M360 Advisors says “those who have capital can maintain yield targets, enhance credit profiles and cherry pick high-quality assets”.
Oaktree’s Guichard adds: “Covid has put a laser on property types like self-storage and life sciences that have historically been less mainstream but are now viewed as more resilient than investors anticipated pre-covid.”
Debt cheaper in some sectors
Nick Seidenberg, a managing director at real estate investment banking firm Eastdil Secured, says: “There’s massive debt capital flowing into anything related to life sciences, industrial and multifamily.” He adds that the cost of debt capital in some of these sectors is actually cheaper than it was pre-covid.
“E-commerce has helped to make the industrial sector white hot,” says Jonathan Firestone, another managing director at Eastdil Secured. So much capital is being deployed in the last mile for delivery that “traditional industrial investors are getting priced out of that market”, he says. The industrial sector has been the most stable of the national property type indices, growing in the mid-7 percent range over the past few months, according to RCA’s third-quarter report. The sector’s allure has not been lost on institutional investors, which expect warehouses to appreciate by 3.3 percent in 2021, according to a fourth-quarter forecast by the Pension Real Estate Association.
Similarly, cold storage, an area of industrial real estate that is both difficult to understand and underwrite, “has been completely turned on its head in the past 18 months”, Firestone says. He cites the rise of big data that analyse consumer behaviour patterns, and which help restaurant owners and food purveyors to better track and manage their inventories.
In addition, the marriage of big tech and entertainment by content providers such as Apple, Google and Netflix – what Eastdil calls techtainment – is driving billions of dollars in financing of studio sound stages in Southern California, Firestone says. A Blackstone Group partnership with Worthe Real Estate Group announced plans in November to build a new office tower near the Burbank and Warner Bros studio complexes in California, and Netflix agreed to lease 170,000 square feet of space in Burbank in September.
Real estate investment in healthcare, which also benefitted from the pandemic, is on the rise too. Blackstone in late December bought a $3.45 billion life science portfolio in Cambridge, Massachusetts, from Brookfield, in a competitive bidding process that sister publication PERE termed a “feeding frenzy”. The December deal, coupled with Blackstone’s spinout of its $14.6 billion BioMed platform into an open-end, core-plus fund in October, made it the largest owner of research lab and office assets globally.
Earlier in December, Harrison Real Estate Capital raised $720 million in roughly 60 days on its eighth opportunity fund, PERE reported, and will target assets tied to the healthcare sector and senior living. Investment in ‘medtail’, where medical clinics pop up in retail strips, shopping centres and around offices, is on the rise. A Tether Advisors survey, conducted in H2 2020 and released in December, found that 72 percent of private equity respondents believe the outlook for such investment has improved since the onset of the pandemic.
“Recently, there’s been an extraordinary amount of optimism toward real estate debt that has been fuelled by the vaccine”
Oaktree Capital Management
CBRE sees industrial and logistics entering 2021 with the strongest fundamentals. However, it does not expect the office sector to return to normal or undergo a permanent change until the second half of 2021, when workers can safely return. “Work from home is not a viable alternative for the vast majority of people indefinitely,” says BofA’s Todd.
“At the end of the day, younger workers want to be social, and will drive critical mass back to the office,” says Jun Hong Heng, founder and chief investment officer of Crescent Cove Capital, a credit-led investment firm. It was an early and major investor in automotive sensor company Luminar Technologies, whose December IPO made its 25-year-old founder, Austin Russell, a billionaire.
“Investor demand for office assets might surprise on the upside, not least because an expected period of dollar weakness will make US assets very attractive to foreign investors,” the CBRE outlook report noted.
Moreover, a MetLife report on office demand in a post-pandemic world estimated the desire for “pandemic compliant” offices could enhance already existing sustainability policies, reversing office densification and increasing employee space per square foot to 245 from the current 239. According to JLL, real estate assets with high environmental, social and governance ratings can command a 33 percent rental premium over comparable non-green certified buildings.
Hotels, retail ‘clobbered’
But the picture for commercial real estate has not been uniformly rosy. Hotels and retail CMBS as a group are getting clobbered, although there are pockets of value. Through mid-November, overall CRE deal volume fell 42 percent in the Americas from the 2019 period, the worst performance posted by any region, according to RCA. Europe, the Middle East and Africa fared the best, with volume down by only 23 percent year-on-year. Asia-Pacific saw volumes decline 30 percent in the period. Meanwhile, market liquidity fell in 118 of 155 global commercial real estate markets in the third quarter, the highest since the GFC in 2009, RCA reported.
To be sure, there is still a lack of visibility about the long-term effects of covid on the office sector, and particularly on whether the flight from cities to the suburbs and working from home will stick. “It’s not easy to know where we are going to be in two years’ time,” says Stephan Plagemann, chief investment officer of London-based credit specialist Mount Street. His own firm closed its small New York office in January and moved to a fully flexible remote working solution when the lease was up.
As for the arrival of the vaccines, and the optimism around them, Plagemann sees more downside than upside. With many people still highly sceptical about the long-term effects of the rapidly developed vaccines, and operational challenges to organise mass vaccinations within the anticipated timeframe, “there’s a lot of room for things to fall over”, Plagemann says. “It doesn’t look like any of that is priced into the market.”
The vaccine “is actually bad news for many overleveraged borrowers”, says Daniel Zwirn, co-founder, chief executive and chief investment officer of Arena Investors, an institutional asset manager. “They’re not going to be able to blame covid for all of their problems anymore.”
The pandemic’s longer-term ramifications for office “are very serious”, especially in large metropolitan areas like San Francisco, Boston and New York, says Brian Graham, partner and co-founder of Klaros Group, a financial services, innovation and regulatory advisory firm. “Many companies have figured out that we don’t need to be in the office every day,” he says, citing significant cutbacks on space by large companies such as Morgan Stanley.
“The notion that asset prices are baking in that we are going to commute two hours and fight our way through the train station to go to a crowded office that costs $150 a square foot is insane,” says Zwirn, noting that Arena is evaluating its own New York City lease, potentially in favour of a location outside Manhattan that is half the space and half the cost.
Zwirn contends that there is some subterfuge afoot, with Manhattan landlords extending free rent and “pretending they’re getting $80 a square foot when in reality they’re getting $45”.
A Trepp Compstak report confirmed that free monthly rent as a percentage of the lease term spiked to an average of more than 5 percent for recently executed leases at the end of the second quarter, a rise of about 30 percent on the 2019 period. The report found that roughly $3.3 billion of the $145 billion in office CMBS outstanding had been flagged for having requested forbearances as of the third quarter, with urban offices accounting for about 61.4 percent of the total.
“Assets that were bad prior to covid are going to get flushed through the system,” says David Conrod, co-founder and chief executive of FocusPoint Private Capital Group, an independent capital raising and advisory firm specialising in private capital markets. “Assets that were OK before covid, lenders will probably continue to work with.”
Because debt is abundantly available and lenders have generally remained active in the CRE market, “owners are not being forced to sell at ruinous prices” as they did during the GFC, according to BofA Securities’ CMBS Weekly report for 18 December 2020. Whereas sales of distressed assets accounted for 20 percent of total sales in 2010-11, such sales represented only 1 percent of total transaction activity in the second and third quarters of last year, BofA said.
Furthermore, the 2.17 percent growth in delinquencies for office CMBS compares favourably with the 8.90 percent rate for all property types in September, as does the 2.81 percent of office CMBS going into special servicing versus 10.33 percent for all other property types since March, according to Trepp Compstak. Offices constituted a small portion of loans in special servicing as of September, with such loans heavily concentrated in the hotel and retail sectors. But Trepp cautions that there are still some near-term headwinds in the office segment because of a potential reduction in office spacing needs and the rise of flexible working arrangements.
Nevertheless, “companies that have tried remote working arrangements before say it doesn’t work that well”, says Edward LaPuma, co-founder and managing partner of LCN Capital Partners, a sale-and-leaseback manager in North America and Europe. “In a more normalised environment, people aren’t as productive.”
“Work from home is overstated,” says Greg Michaud, head of real estate finance at Voya Investment Management. Although he notes some larger companies may decrease their presence in central business districts, smaller businesses, such as accounting firms, will continue to populate office buildings. “I’ve got friends that run a logistics company who never worked from home,” he says.
And, Conrod asks, if the changes wrought by work from home are permanent, “why is Google taking more space in Manhattan and Facebook redeveloping the old Post Office on Eighth Avenue?”
Indeed, the so-called FAANG stocks “are setting the pace in the office sector”, says Michael Boxer, a managing director in the private real estate debt team at CenterSquare Investment Management. “Just like online retail is at the early stages of a growth spurt, so are these tech companies. They are going to comprise a larger and larger portion of the way we live, work and play.”
Although tech companies like Zoom may have enabled the work-from-home phenomenon, four of the five FAANG stocks – Facebook, Amazon, Apple and Google parent Alphabet – along with Microsoft now occupy some 589 million square feet of US real estate. That represents more than all the office space in New York City.
Tax and other issues notwithstanding, New York has been raising its tech profile. A $2 billion Cornell Tech campus opened on Roosevelt Island in 2017, and Google and Facebook have put down roots in the city, observes CenterSquare’s Boxer.
Facebook, which had already leased more than 1.5 million square feet in New York’s Hudson Yards, in August signed a lease for 730,000 square feet in the Farley Building, also on the West Side. Similarly, a banking group led by Wells Fargo inked the largest real estate construction loan in Manhattan in 2020 for Oxford Properties’ redevelopment of St John’s Terminal, where Google will be the sole tenant.
Google also took advantage of lower prices in London, which in Q3 rebounded from its weakest quarter on record to purchase its Central Saint Giles office complex for £700 million (€777 million), or £986 per square foot – below the central London average, according to RCA.
So much for tech leading the charge in work from home. Although Google and other tech companies have offered employees the flexibility to continue working from home when the pandemic ends, it is clear these growth companies are eager to build a big presence in dynamic markets like New York, where millennial workers typically gravitate.
Despite the fact Oracle, HP Enterprise and Tesla are relocating from Silicon Valley to Texas, “when businesses are growing, the thought that they’d move someplace because it’s lower cost is silly”, says Jim Costello, senior vice-president at RCA. “There’s something of a disconnect between what these tech companies are telling their employees about work from home and what they’re doing in leasing space.”
But the move towards leasing more space in gateway cities indicates that “keeping a highly productive employee happy and sticking around a firm is a lot more valuable” than the cost of an office, Costello says.
Technology rules the roost
Given tech’s influence on properties, real estate lenders “should be evaluating the ‘omnichannel’ capabilities of their lessees and how tech-enabled they are”, says Noah Shipman, a partner at Vistara Capital, an investor in mid- to later-stage tech-related businesses.
Just as retailers with a strong online presence have outperformed during covid, so too have real estate sectors such as traditional office, medical and industrial. They are all relying increasingly on technology because of pandemic-related restrictions and the widespread adoption of home working. Vistara itself recently invested in Vytopa, a data analytics company based in Austin, Texas, that helps companies optimise and manage collaboration tools and office spaces.
Perhaps the strongest argument for tech-related themes to dominate real estate is the rise of global millennials, the digital generation. In KKR’s 2021 Global Macro Outlook, Henry McVey noted “we are at an inflection point for consumption patterns by global millennials”, with Asia’s 822 million millennials – 12 times more than in the US – setting the pace.
McVey also pointed to the high relevance of innovation: “Given all the seismic changes that have taken place in healthcare, security, software and consumerism, we still want to be long the disruptors.”
Even in the middle of covid, “millennials want to be in the city, near other young people”, CenterSquare’s Boxer says. “There’s nothing about the virus or the re-emergence of the suburbs that’s going to change that fundamentally.”
One thing seems clear, says Eastdil’s Firestone: “Work from home ends as soon as millennials start having kids. They’ll want to go back to the office.”
Multifamily stands out in the pandemic
To read some of the headlines last autumn, when covid cases were surging and restrictions were being tightened, one would think that the US multifamily real estate market might be headed for a train wreck.
But then the vaccines came along, nationwide eviction moratoriums were extended through January, and Congress passed a stimulus package that included $25 billion in emergency rent relief.
The fact is that throughout the crisis, “multifamily has displayed the most resilience of all asset classes other than industrial”, says Michael Boxer, a managing director on the private real estate debt team at CenterSquare Investment Management.
Through November, the apartment sector had risen 7.6 percent from a year earlier, second only to industrial’s 9.5 percent growth, per Real Capital Analytics Commercial Property Price Indices. According to CoStar Risk Analytics, US multifamily composite price increases outpaced all other sectors on an equal-weighted basis through November.
Although many owners and operators started cutting rents when the pandemic hit, rents were down by just 1.5 percent in November year-on-year, according to Greg Willett, chief economist at RealPage, a real estate software and analytics provider.
Occupancy rates remained a relatively strong 95 percent. Willett notes that headlines trumpeting huge numbers of missed rent payments and possible widespread evictions refer more to single-family rentals than to traditional apartments.
CBRE expects the sector to fully recover this year, forecasting a 33 percent increase in US multifamily investment to $148 billion. It predicts a 6 percent increase in net effective rents this year, with a full market recovery in early 2022.
Even in the UK, where multifamily housing is relatively new, the sector is on pace for record investment in 2020 of £4 billion (€4.5 billion), up from £2.8 billion in 2019, The Wall Street Journal reported in November, citing data from real estate agency Knight Frank.
Moreover, “the supply pipeline is going to be significantly constrained because construction financing is hard to come by”, says Boxer.
“Once we return to a more normal pace of household formation and the job picture is stabilised, we are going to find ourselves with a dearth in the supply of housing.”