Henry Bullock Professor of Finance & Real Estate; Director of the Guthrie Center for Real Estate Research; Director of the Crown Family Israel Center for Innovation
As anyone who converted their dining room into a makeshift office or made the leap from in-store to online grocery shopping can tell you, the last few years have had a pretty profound effect on the ways people use space. The pandemic economy has spurred new trends, accelerated others, and rendered some long-cherished real estate passé.
So while prices are rising in many areas, there are still some great investment opportunities across the industry.
Effi Benmelech, a professor of finance and real estate at the Kellogg School, recently joined Kimberly Adams, managing director at J.P. Morgan Asset Management, and Seth Singerman, president and managing partner at Singerman Real Estate, for a roundtable discussion of the state of the U.S. real estate industry, how inflation and other economic factors are influencing their investing decisions, and what they see on the horizon for investors.
This interview has been edited for length and clarity.
Kellogg INSIGHT: What most excites you about the real estate industry today?
Kimberly ADAMS: Whether it’s office, or industrial, or retail, the pace at which the world is changing in terms of how people use space is extremely exciting. As an industry, that’s where the opportunities lie for investors. So certainly there are the inflationary pressures and potentially recessionary pressures. We are always at some point in a market cycle! But what is most exciting to us as investors today is being ahead of the curve in where the greatest demand for space use will be across all sectors.
INSIGHT: So where do you think this demand for space is headed?
Seth SINGERMAN: Well, for example, how people are traveling has been impacted by COVID. The length of stay is growing significantly, which has impacted leisure markets. That’s been great for Airbnb but not great for the traditional 400-room hotel that’s sitting downtown.
I’m a big believer that the group business is going to come back very strong. There are conferences that people go to annually. People are still going to go to those, and they may be more important for people to go to now. But the traditional road-warrior businessperson? More of that is being done over Zoom. And that’s going to affect business transit, which has implications for hotel demand and usage.
ADAMS: In the past, the commute was an assumed part of everybody’s day-to-day, and when you went to interview for a job, you didn’t really think about where your house was relative to the job. It was more, “Okay, this is the job I want, and I’m going to figure out how to get there.” What we’re seeing today is people saying, “Well, wait a minute, I don’t really want to spend an hour a day commuting. What does my flexibility look like? How much time can I get back? Maybe this isn’t the right job for me, because the commute doesn’t fit my lifestyle.”
That notion is extremely new, and it translates into a different type of office being more desirable today. Like Fulton Market in Chicago, where you can live and work and play, all within two or three blocks. That is extremely attractive to the workforce today, and something that we as investors have to take note of. These vibrant nodes in cities aren’t always the obvious places near mass transit.
So it’s really less about one particular asset being repurposed and more about a change in the variables that go into decision-making for the users.
BENMELECH: There used to be a more traditional division between commercial real estate and residential. One of the changes that we have seen, that started happening before COVID, but accelerated during the pandemic, is that some of our personal space became commercial real estate. We shop from home, stream our entertainment, et cetera.
So there is some displacement of those traditional sectors in real estate, but it’s not as if they’re disappearing; we are just using them differently. This leads to the growth of some other companies.
INSIGHT: And, I would imagine, the decline of others. So are you seeing a lot of distress?
SINGERMAN: There absolutely is some distress that’s out there. But where you see distress, it isn’t financial distress or over-leveraged assets. It is business models that don’t work anymore. To find a good-value, long-term opportunity, I think you need to assess where the future of that business model is headed, as well as the risk in executing the business plan.
BENMELECH: Yes! You have to decide whether the business is in financial distress or in economic distress. If it’s in financial distress, changing the capital structure would help. If the business is in economic distress, that means it may be operating under an obsolete business model, so there may be no reason to bid for it. The decisions are not always about the real estate itself.
INSIGHT: One area that’s gotten some buzz is the repurposing of retail malls as mixed-use spaces. What’s your take on this? As you assess a deal, what kinds of factors are you taking into consideration?
SINGERMAN: Repositioning malls is extraordinarily complex because there are lots of parties involved. There’s the mall owner, plus whichever companies own the boxes: Target, Sears, JCPenney. This makes the degree of difficulty for the deals very high.
I’ll give a perfect example of that. Everything was working in our favor for one project. Great location. The municipality was supportive to converting one of the big boxes to apartments in a very healthy mall. Problem is, there were three different boxes, all owned by different companies that all wanted residential. So everything had the stars aligned, except you had three companies that were going to fight over which of them was going to get to repurpose.
Real estate is extremely attractive today relative to other asset classes.
— Kimberly Adams
INSIGHT: Are there other markets that you are watching particularly closely?
SINGERMAN: We have our eye on industrial outdoor storage, which includes space to park trucks. With the growth in online shopping and distribution, you need more delivery trucks to get goods to people faster. So we’re seeing a greater demand for places for parking, primarily for distribution trucks, but also for other heavy machinery for roadway and other kinds of construction.
ADAMS: I agree. The win in the supply chain is really having trucks close to the goods and goods close to the people. There’s not always room for trucks in every site that is storing the goods, so then it’s a mad dash to see how close you can get your trucks to your goods. It’s a component of the last mile mentality, and it’s becoming more and more important.
With Amazon, you see the small vans driving through your neighborhood because they’re not bringing the big semis down these smaller streets. All those trucks have to rest somewhere at some point.
INSIGHT: We haven’t talked yet about residential real estate markets. What do you see there?
SINGERMAN: I think you need to bifurcate the for-sale market and the rental market. The for-sale market, depending on location, has really been impacted by the migration of people during COVID. In areas that have been takers of that—Florida, Nashville, parts of Texas—the price appreciation and demand—as well as a lack of supply—have been pretty extraordinary.
On the apartment side, pricing pressure has been very, very strong, as you’ve seen wage growth, particularly in the middle- and lower-income segments. That has allowed for significant rental increases in those type of assets. And existing buildings are still trading materially below the cost to replace them with new apartments. So they are a good investment at the moment.
BENMELECH: I see the risks inherent in residential real estate as potentially extending to the broader economy. We learned from the global financial crisis that home transactions are instrumental for the economy. One reason for that is that when you have more transactions, there are many related expenses. A lot of consumer spending is related to housing, and that won’t be spent otherwise. Even those who buy new houses still renovate or change them. So a large number of transactions in residential homes leads to increases in consumption that affect a local economy, and we’ve seen a lot of it post-COVID.
The risk of course is that as interest rates go up and mortgages become more expensive, that trend reverses. It’s not only affecting the housing market, but it has significant effects for local economies.
INSIGHT: Inflation is currently at its highest rate in 40 years. Is inflation a large, medium, or small concern for you right now, as you look out into the next year?
ADAMS: Real estate is extremely attractive today relative to other asset classes. It is a natural inflation hedge because you’re consistently capturing the rise in cost by increasing rents—as long as the economy continues to move along. I think that’s what is most attractive right now, particularly for shorter-term-lease-type products. The tipping point is when rents don’t grow as fast as the cost to build. If rents slow a little bit and costs rise marginally up, there’s still a reasonable cushion in the profit margin. When rent growth starts to slow, building may not make as much sense anymore.
SINGERMAN: I think real estate values are going to track GDP and labor market trends more so than inflation.
BENMELECH: As a teenager, I grew up in a country, Israel, that experienced hyperinflation, at least 400 percent. My mother would give me money for the bus; two days later, the rate would increase and I would have to ask her to give me more. That kind of high, high inflation is very taxing for the middle class and even more taxing for people who live hand-to-mouth or paycheck-to-paycheck.
That’s not what we are expecting here. Inflation will be 5 to 8 percent, which will be inconvenient, but it won’t be terrible. As long as national institutions remain strong, we can recover from that. The risk is if politics get entangled with inflation, then it’s harder to recover.