Catalyst Funds
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Key Takeaways:
- The housing market has remained robust throughout 2020 amid social distancing and work from home orders, spurring consumer preferences to suburban living
- Multi-family rent growth and single-family rent growth are historically recession resistant when compared to home value appreciations
- Real estate recovery in retail markets is expected in 2021 with hospitality and office space experiencing slower recoveries
- Investors can gain exposure to real estate segment outperformances through traditional equities, corporate bonds, convertible bonds or mortgage-backed securities.
Throughout 2020 economic dislocations ran rampant. However, one segment of the economy that we believe has fundamental strength and has remained vibrant throughout this pandemic is the U.S. housing market. Social distancing, historically low mortgage rates, robust refinancing appetite, a mass exodus from densely populated cities, and increased demand for suburban residential housing continues to enable the U.S. housing market to surge from the March lows.
Even with vaccine inoculations starting, the U.S. housing market remains supported by strong demand and low-interest rates. Behavioral shifts in consumer demand seeking larger spaces amid the pandemic accompanied with existing homeowners refinancing activities will likely linger well past a pandemic cuffed economy. The psychological impact on an individual’s capital allocation and the residential housing sector appetite should not be ignored. Existing home sales, single-family rentals and single-family starts have been consistent bright spots since March.
Outside of the strong consumer demand, as indicated above, single-family residential credit providers have also benefitted. However, this is not a new story. Pre-pandemic single-family rental demand has been steadily increasing since 2005, as has other rental markets (i.e., multi-family). This changing consumer preference and affordability have been driving demand for rental housing, with the COVID-19 pandemic accelerating this behavioral trend to other areas of the residential real estate market.
Despite strong behavioral demand for the single-family rental segment, single-family rental growth remains robust as historical data shows single-family rent has traditionally remained positive throughout recessions, including the 2008 housing crisis. With that said, multi-family (apartment) rental growth also displayed historical strength throughout housing market recessions, remaining robust throughout the pandemic (despite near-term COVID headwinds) with attractive fundamentals supporting potential organic demand growth in 2021.
Residential housing, industrial & logistics, and alternative sectors such as life sciences, cold storage, and data centers have all thrived during COVID-19; meanwhile, office, retail, hospitality, assisted living facilities and skilled nursing facilities have all suffered. As mentioned above, single-family rentals and suburban multi-family (i.e., Southeast) continue to display recession resistance (risk averse) amid notable improving fundamentals. The beginning of 2021, amidst early-stage vaccine inoculations, may spur some sectors to grow (i.e. multi-family expected to rebound 33% in 2021), despite investor demand thwarted by lingering COVID-19 headwinds throughout 2021. A full real estate recovery will likely lag that of the broader economy.
Real Estate Leaders, Laggards, and Risk Averse Sectors Throughout 2020
Furthermore, this trend remains supported through the most current economic data. U.S. existing home sales have steadily risen since March, U.S. new home construction outpaced forecasts to a nine-month high for November, residential starts rose 1.2%, single-family building permits (5 or more units) have risen to 6-year highs (historically volatile as it includes apartments and condos), single-family starts rose for a seventh straight month (the highest since 2007), homebuilder confidence in December remained near all-time highs, new construction strength remained broad-based nationally, housing starts climbed in all four regions (led by the 12.9% rise in the Northeast) and applications to build (a proxy for future construction) rose to 1.639 million (the highest since 2006). Meanwhile, multi-family permits and starts remained rangebound.
What will real estate sectors look like in 2021?
We believe that the most relative strength will remain, in the first half of 2021, within single-family rentals, industrials, residential housing (luxury, existing home refinancing, etc.), new construction and some alternative segments such as life sciences, cold storage, and data centers (as indicated by CBRE). In the first half of 2021, we may see a slow and variable recovery to assisted living facilities and skilled nursing facilities as a U.S. administered COVID-19 vaccine is administered. Multi-family rentals are set to outperform in 2021 as investment volume will likely pick up. Midwest and Southeast regions are poised to provide the best multi-family opportunities. However, Class-A assets in urban submarkets (New York City, Los Angeles, Miami, Chicago, Miami, etc.), which saw greater market deterioration, may not completely stabilize until the latter part of 2021.
Meanwhile, traditional commercial real estate such as retail, hospitality (hotels), and office space may see varying degrees of recovery. Retail locations and brick-and-mortar retail sales have the potential to grow/recover in 2021 as e-commerce sales potentially level off. Meanwhile, the hospitality market and more specifically the hotel industry could continue to sustain lingering impacts from psychological excuses caused by the pandemic’s uncertainty. CBRE noted that hotel occupancy should return to pre-COVID levels by 2023, despite positive outlook for travel. Furthermore, the office space’s recovery is expected to be the slowest as reoccupation appears scattered and depend on locations. The debate of a prolonged or continuation of remote work remains a popular topic, potentially hindering a robust office real estate recovery. This new employee option casts a large cloud of uncertainty for office space demand post-pandemic. Office investment and performance will likely remain well below pre-COVID levels in 2021 with secondary markets (Charlotte, Seattle, etc.) performing slightly better than their large city counterparts.
These takeaways are fundamentally displayed in the capitalization rates (cap rates) for each real estate asset type. Cap rates are a reasonable estimate for gauging a property’s rental income potential, factoring in investment dollars, taxes, and other cost variables. Generally, the higher the cap rate the more risk and the lower the cap rate the less risk. COVID-19 slightly caused current and projected NOI to be at risk, potentially causing distressed asset selling, thus, traditionally causing cap rates in the retail and hospitality sectors to rise (i.e. hotels discounted 30% from fair market value). Counterintuitively, cap rates have remained relatively stable as distressed asset selling has been contained, potentially a result of the looming uncertainty stunting the sellers’ market. Though distressed selling may occur in slower recovery assets like hospitality and office space, cap rate expansion is likely to remain more limited in this downcycle than in the past. Massive equity market liquidity and, perhaps more importantly, the Fed buying mortgage and other bonds will reduce overall risk, limiting cap rate appreciation. This has created more positive leverage (the difference between the cap rate and the cost of debt) than in almost seven years, further limiting upward pressure on cap rates.
How can investors take advantage of the opportunities that remain in the real estate market?
Investors can take advantage of the current opportunities in the real estate market amid asset recoveries. Traditional equity investments in REITs and independent real estate creditors with portfolio’s overweight the winning real estate sectors can provide attractive exposures. Furthermore, corporate bonds and convertible bonds exhibiting wide spreads, high yields, and low prices, could be unfairly compensating fixed income investors for their risk with attractive credit fundamentals. For example, company’s like Arbor Realty Trust, a real estate lender, has exhibited exceptional relative strength, unfair risk accommodation (high yields), improving creditworthiness (since April), attractive concentration of loan originations within the stable multi-family real estate market, strong borrower creditworthiness, low portfolio defaults, and risk-averse loan concentrations (i.e., bridge loans and small mezzanine loans). Alternatively, investors can get pass through exposure to residential housing through agency or non-agency residential mortgage-backed securities made up of pools of residential mortgages issued by either government agencies or private institutions. Though investors may think that finding value or investing in the real estate market as a considerable feat, there are many options to gain exposure and take advantage of the arbitrage opportunities present in this sector.
All in all, the general understanding of social behavioral shifts, consumer demands, selling activity, and cap rate stability can deliver the necessary tools to indicate which real estate sectors could rebound, continue to grow, or continue to be beaten up by sentiment. We continue to see value lurking in the real estate market from both an equity and fixed income perspective. Mainly, fixed income securities have generated the most relative value with yields increasing in March to accommodate the uncertainty risk from COVID-19. Since then, spreads have tightened, and equity markets have started to look past the uncertainty haze amid vaccine results. Therefore, finding value within this unprecedented environment remains viable and is likely to continue into 2021.
