December Thoughts from the Research Desk
This past year has undoubtedly been challenging to navigate on various levels, including investing. This pandemic has shifted individual's perception of risk, what they value in their lives, and, for those that are able, how a shift to remote work affects how they think about lifestyle. Throughout this difficult year, portfolio managers and investment strategists that I've been in constant communication with have identified two key themes, both for the U.S. economy and the broader capital markets. The first is the theme of "resilience," and the second is the idea of "accelerated change." All of those factors are directly tied to the real estate market. In this month's piece, I take a deeper dive into the different market components and what investors are thinking.
One of the biggest storylines of 2020 has been the strength of the home market. Per State Street, from 2.28.20 through 9.30.28, new home sales are up 34%, existing-home sales are up 14%, and housing market data is at or near historic highs across the board. These record numbers make a lot of sense – one of the themes of 2020 has been this shift away from office work to working remotely. Surprisingly, this shift has proved viable to employers, and per Green Street Advisors, experts believe reduced in-office work may cause office space demand to decline by 10%-15%. With employees working remote, the need for extra space, and even more importantly, the lack of the necessity of being close to the office has driven a lot of people out of densely urban areas into the suburbs, and, in a lot of cases, away from high-income tax states such as California and New York.
There has been a lot written about the housing market demand, but not so much about the supply. Through the end of March 2020, U.S. home prices have grown 57.8% cumulatively since 2008. However, this has been primarily driven by a lack of new housing, especially entry-level homes. Through this time frame, developers have focused on building more expensive homes due to high construction costs. There are signs that this is beginning to shift, and, with more demand, housing developers are looking for ways to streamline costs and increase the starter-home supply. The problem is that there is usually a two year lag between the times the homes get planned and the time they come to market, and with the COVID-19 pandemic, there has been a lot of disruptions on construction sites. And, lastly, due to low-interest rates, the cost of renting vs. owning still favors homeownership in many parts of the country. Per JP Morgan, year over year, purchase mortgage applications are up 22%. For many, it's more cost-effective to own a house in the suburbs than pay for rent in a city. This factor has been a significant driver of the migration out of cities in 2020.
The biggest drawback to homeownership remains how expensive it is to put down a down payment. Per DWS, "despite lower interest rates making homeownership more affordable than it was a year ago, first-time homebuyers still do not have sufficient savings for a down payment while in many cases also paying down student debt; in 2019, 30% of this group used down payment assistance from family and friends, and the median down payment was only 6%. Combined with stricter lending standards due to the recession, these buyers will continue to find it very challenging to qualify for a mortgage." This aspect will continue to keep apartment demand high.
For 2020, apartments in smaller, regional markets (like Charlotte, Orlando, Raleigh, and Salt Lake City) boosted some of the highest total returns. Those cities have benefited from the migration of those leaving large cities for smaller ones where the cost of living is significantly less. Denver, Phoenix, Washington D.C. were the largest positive contributors to multi-family housing returns while New York and San Francisco struggled.
With the immediate lack of new single-family homes coming to market, families have been staying in apartments. From talking to our real estate managers, on aggregate, tenants have been renewing their lease at a good rate. Obviously, there has been a lack of rent growth in cities such as San Francisco and New York, but it's been positive in other markets. Another dynamic that should support multi-family housing is the sheer amount of young professionals still living with their parents. Per DWS, "more than 14 million young adults nationwide — or 21.9% of people ages 23 to 37 — live with their parents, up from 12.7% in 2000." This dynamic represents a large source of untapped rental demand as well as demand for future housing supply.
The positive thing about the housing market's strength is that it creates a ripple effect on other parts of the market. As people buy new homes, they look to purchase new furniture, new appliances, new flooring, etc. If they were living in an urban area, they might choose to buy a new vehicle as well. (In fact, this summer, there was significant price appreciation in used car sales as there was an increase in demand for cars, but with auto-factories shut down due to the pandemic, there was a lag in supply, forcing car buyers to settle for used). In tracking high-frequency economic data, we noticed that people have generally maintained the same level of transactions. A lot of that has shifted away from travel and entertainment and into "nesting." We saw this previously play out in the years after 9/11, as people re-evaluated their travel plans and focused more on spending on their homes. Through December 14th, home improvement stocks are up 28% YTD (vs. 15% for the S&P 500).
This increased demand by consumers has been felt by home builders as well. Right now, there are a lot of shortages in many home-related goods such as furniture, appliances, and materials. All of this has helped the manufacturing sector and has been a big part while the Purchasing Manufacturers Index has bounced back.
On the corporate office front, this pandemic has forced many to rethink what an office environment looks like. Companies such as Facebook have announced that their employees will now work remotely through September 2021. Mark Zuckerberg has even come out and said that "over the next 5-100 years, I think we could have 50% of our people working remotely, but we're going to get there in a measured way." Other companies have already decided to go entirely virtual. Many companies and corporate landlords have begun to create "less dense" office space. In 2009, there were 211.4 office square feet per person; in 2017, it was 193.8 – an 8.3% decline. Real estate investors expect this trend to reverse as employers will look to give their employees more space. In addition, there is a growing expectation that the majority of businesses will have a more flexible work from home policy, keeping the daily count of office workers lower than pre-pandemic. Despite all of the challenges businesses faced in 2020, the rent collection rate for October stood at an impressive 95%.
The big issue moving forward will be around cost. How expensive will it be for landlords and tenants to set up their offices in a way that makes sense for them? Corporations may want more space but would be unwilling to pay for it in areas such as New York and Silicon Valley. Already some have begun to look to cut costs and move to cheaper locations, such as Austin, Texas, which has been a big beneficiary of companies moving away from Silicon Valley. The question is – to what extent will that trend continue? Also, there have been many office jobs eliminated as a result of this COVID-19 induced recession. How many of those are permanent eliminations, and what impact will that have on the office space moving forward? All in all, it's a very fluid area and, despite the negative sentiment, there are still opportunities for investors.
Large corporate office moves have a direct effect on nearby retail. Strip malls that house restaurants, dry-cleaners, and convenience stores that generate a lot of business from being close to a large corporate office will look to move to an area where they would create more business. Or, some could very much go out of business entirely. All of that will hurt the retail real estate market. It shouldn't be a surprise to hear that this segment of the market has been the area that's been damaged the most in this pandemic. Malls anchored by necessity based centers, such as grocery stores, have held up relatively well; other areas have been weak. The longer this pandemic goes on, the more likely other businesses start to fail and put pressure on this space. On aggregate, in October, the collection rate of retail tenants was 80%.
The rise of industrials has countered the retail space's weakness, and many managers have shifted allocation away from retail to this space. This year, there has been a large investment and need in warehouses, data storage centers, and logistics centers. Just this past Tuesday (12.15.20), Amazon announced that they would spend $200m on a site in SF to develop their infrastructure further. Real estate investors have been able to purchase land and retail space in order to convert it to desirable needs. This shift is not new, which is one of the components of accelerated change that I alluded to earlier. The rise of e-commerce was happening well before the pandemic - it just merely accelerated this year. Whether consumers go back to retail malls to the extent they did prior to the pandemic is a big question to answer.
While this has certainly been a challenging year, a look through the real estate landscape shows us a glimpse of where we are headed and how many questions are still left to be answered. It's easy to be encouraged by the rebound and appreciation of the equity markets in 2020. However, there are still many unknowns moving forward, and a glimpse into the real estate market showcases that. It will be interesting to revisit this a year from now and see where things stand. To see which of these trends materialize and which ones were simply a byproduct of a pandemic.
-ST