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Harken back to the days of visiting companies and touring assets. For real estate investors, that was easy. Now, ethereal drivers like the government and politics have a stranglehold on real estate markets. While interest rates, GDP growth, and the U.S.-China trade “war” get most of the press, let’s look at three less obvious factors impacting real estate investing in 2019.
Replacing white collar with tech vibes will lead to re-pricing of risk
Here’s an office statistic to summarize the shift to co-working: since 2013, Washington, D.C. law firm occupancy has shrunk by 2.3 million square feet, while flexible space occupancy has grown by 1.3 million square feet.1 Co-working continues to reshape the U.S. office market, growing by roughly 23 percent each year since 2010.2 Last year alone, it made up nearly two-thirds of the country’s office occupancy gains and roughly one-third of all rent collected. Some studies see no ceiling for co-working’s meteoric rise, with JLL forecasting growth that jumps from less than five percent to roughly 30 percent of all U.S. office stock by 2030.2
The question remains, “what does this mean for office from an investment perspective?” First, you must know how co-working structurally differs from traditional office. Co-working companies take space and view it as a capital expenditure, then search for tenants to lease it on a short-term basis. If they find them, they take on additional space. If they fail, they quickly turn off the spigot and return the space to the landlord.
There are no long-term lease guarantees and most tenants are start-ups, consultants, or small tech firms with weaker credit profiles. This creates an asset-liability mismatch against the landlord. Instead of renting out space with long-term leases to creditworthy tenants, the space is being filled more quickly by riskier tenants who may not be in a position to withstand the end of the economic cycle.
This will eventually lead to a re-pricing of risk in the office market. In some markets, co-working is hiding the “shadow space” caused by densification and reconfiguration. More than 7.3 million square feet of shadow space is projected to hit Chicago’s downturn in 2019 and 2020 combined.3 Also, landlords are faced with onerous capital expenditures to re-tenant space that meets the flexible office craze, a heavy financial lift with rent growth already slowing. Coupled with low cap rates and low fundamental growth, it’s easy to see why office stocks are trading at significant discounts to private market values.
At the end of the cycle, if co-working firms like WeWork struggle to fill space, landlords may see quick spikes in vacancies and further dampening of already flat rent growth. (Effective rent growth that nets out landlord concessions only increased 0.5 percent in Q4 2018). We believe it may be best to avoid office – other than actively identified opportunities – as the market reprices, especially as a moderating economy continues to slow.
Rising labor costs will have biggest impact on retail
As if the retail market needs more bad news, rising labor costs will likely cut into an already low-margin business. Traditional brick-and-mortar retail is labor-dependent – you need to pay employees to work the floor and drive sales. Increasing wage inflation stemming from a tight labor market may cut into retail REIT stocks’ cash flows, hurting values. While one could argue that rising wages puts more money into consumers’ pockets for retail purchases, the “share of wallet” continues to shift to experiential retail and e-commerce.
Skilled nursing, which may also be impacted, requires highly compensated labor to operate in an environment of potentially shrinking Medicare and Medicaid reimbursement costs. The industry continues to shift from traditional fee-for-service Medicare patients to Medicare Advantage patients, hurting its profitability.4
With wages going up, investors should look at sectors with minimal manpower costs. It only takes a few people to work concession and run a projector at movie theaters, while apartments require just a small sales staff and maintenance crew. And we don’t add labor costs to the risks facing office investments. Once a building is leased up, a doorman and a few maintenance workers may be all a landlord needs.
Real Estate M&A in 2019: Look for privatization of public companies
There were a dozen merger-and-acquisition transactions approaching $76.3 billion in value completed or announced last year, with public-to-private transitions accounting for about one-third of all activity.5 Volume could again reach those levels in 2019 if REIT values continue to normalize as expected following a shift higher in Q1. After climbing in January and February, March brought the public REIT market back down to a two percent discount to private market values, a more typical position as we get longer in the cycle. If the public markets move back to their late-2018 position (a 10-to-15 percent discount to NAV), investors will be more likely to jump at the arbitrage to private market values.
The private market is sitting on nearly $300 billion of “dry powder” earmarked for real estate investment. In the search for income-focused returns and broad diversification, private companies may look again to public real estate where they can deploy capital on a large scale, taking out companies trading at steep discounts. Essentially, they are getting the same real estate assets at a better price.
