Crystal Balls and Commercial Real Estate
The entire commercial real estate industry is in a state of flux. There is volatility, uncertainty, and more questions than answers.
In this article I’m going to cover the challenges in the market and why I think the industrial real market will outperform other asset classes in 2021.
But first, let’s cover the office and retail sectors.
The pandemic has undoubtedly accelerated the work-from-home trend, which in turn is putting considerable pressure on the office market. I believe this will be a short-term aberration though and am optimistic workers will return to the office.
I wrote an article a few months ago suggesting anyone making bold predictions should have some skin in the game. It was right around the time that lazy journalists were writing about how the office is dead, so I went the other way and made an investment in Empire State Realty Trust (which is a publicly-traded REIT which owns the Empire State Building and other office and retail buildings in New York).
I’ll be the first to admit I had some good luck on that bet as the stock has gone up nearly 50% in the past couple of months.
Hopefully none of the sensationalist-pedalling journalists listened to their own drivel and actually shorted it. (Disclaimer: this is not stock advice — the stock could still be quite volatile and quickly head in either direction).
While I’m bullish for a long-term recovery, however, I do acknowledge there could still be some pain in the near future.
According to a recent survey by KPMG — 69% of CEO’s surveyed expect to downsize offices. I still think it’s far too early to predict whether any of these changes will be permanent, but there is clearly a negative sentiment within the companies that actually lease office space.
A lot of these big office users have existing leases in place, so while many downtowns are much less busy than they were at this time last year, most companies are still paying their rent. What will be noteworthy is how many of the companies that expect to downsize actually do when their leases come up. This means any major cracks in the office market might not show up for a few years still.
As I see it right now, the best hope for the office market is that a vaccine can be rapidly deployed and companies who are planning on cutting their footprint change their minds. Or perhaps any drop in demand is offset by a shift away from open concept offices, but it’s hard to imagine any scenario in the next year or two where there will be any growth from pre-pandemic levels.
The struggles the retail industry are facing have been well documented. Last year 17 major retailers declared bankruptcy, and it total there were 9500 store closures. In 2020 there has been another 27 major retailers which have declared bankruptcy.
The pandemic has certainly contributed to this problem, but it’s not a new phenomenon. After all, e-commerce has quickly been stealing a massive amount of market share from the traditional retailers. And in a industry where low margins are the norm, a major loss in revenue can have dire results.
Some retailers have paid close attention to these changing consumer habits and have successfully adapted, while others have been slow to act. The retail industry is evolving, but bricks-and-mortar retail is far from dead. Many shoppers simply enjoy the experience and benefits of going to an actual store, so anyone calling this a retail apocalypse is merely pedalling in sensationalism.
But similar to the office market, it’s hard to imagine how we’ll see much growth in retail real estate. Instead, it’s more likely we’ll see a continued trend away from shop and take home towards order online and have delivered.
Enter the industrial real estate market.
In order to accommodate this shift in consumer shopping, retailers and suppliers have had to significantly increase their warehouse space.
A great illustration of this is a supply change concept called OTIF, or on time in full. Walmart recently announced that their suppliers must achieve 98% OTIF delivery or face a 3% fine. Clearly this is Walmart’s response to intense competition in e-commerce where 1 day and same day delivery is becoming more and more common.
This leads to a term you may have heard before, last mile delivery, which essentially is the final stage of the supply chain in which the product is delivered to the customer’s door.
It means that warehouse space in close proximity to consumers has become a huge priority, which will undoubtedly lead to a combination of new development and adaptive re-use for some of the existing industrial inventory.
Chances are you’ve seen a considerable amount of infrastructure pop up in your market to accommodate this too. In my area, Amazon just built over 1 million square feet of distribution space.
We also can’t underestimate the amount of companies who will increase inventory levels to avoid future stockouts. More inventory naturally means more warehouse space to hold it all.
Furthermore, I also believe some segment of the retail industry takes a closer look at moving to an industrial property. Whether it’s the attraction of lower rates, or just the hybrid ability to handle more storage, I expect more retailers to consider industrial options going forward.
And organizations like the Urban Land Institute and the National Council of Real Estate Investment Fiduciaries also believe industrial will outperform the rest of the market in the next two years.
They surveyed a number of economists and industry analysts, and are forecasting rental income from industrial real estate to grow at an average annual rate of 2.1% through 2022. By comparison, they expect 0.03% average yearly growth for multifamily real estate, a decline of 0.5% for office buildings, a 2.3% drop for retail and a 3.3% decline for hotel revenue per available room.
National Council of Real Estate Investment Fiduciaries forecasts yearly average returns of 6.9% for industrial properties through 2022 with office at 0.9% and retail declining 4%.
Now full disclaimer, these crystal balls, or my crystal ball anyways is quite murky and I could be way off on my prediction.
My comments are also macro in nature and do not take into account any individual market characteristics. An office or retail building in the right area may still be highly desirable and could conceivably still perform quite well.
But generally speaking, I think that there are more reasons to be optimistic about the industrial real estate market then there are for the office and retail market.
I’d love to hear your thoughts on this, where do you see opportunities in this market?
