REITs, Homebuilders, and the Return of Las Vegas

You can think of real estate in a lot of different ways, but at the end of the day, it's just space. And that space is going through a lot of changes. Interest rates are rising, homes are getting more expensive, and companies continue to struggle with hybrid-work plans.

Motley Fool senior analysts Deidre Woollard and Matt Argersinger discuss:

• Lesser-known office REITs that may be presenting opportunities for investors.
• Homebuilders facing headwinds.
• Lessons from Las Vegas's comeback.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on Dec. 10, 2022.

Matt Argersinger: We can call them cyclical all we want. But the reality is, Deidre, you and I know this, there's a huge demand for homes. We've underbuilt in this country for the past 10 years. There's millions of homes that we need to have, and so even if prices come down a bit, I think they can't go down too much because the demand will certainly come in and fill that. And that's especially true if we get a little bit break on interest rates, maybe next year.

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Chris Hill: I'm Chris Hill and that's Motley Fool's Senior Analyst, Matt Argersinger. There are some popular narratives in real estate. Interest rates are rising, home sales are cooling, and nobody is going back to the office. But some companies are challenging those story lines. Deidre Woollard caught up with Argersinger to talk about how investors can watch the homebuilding cycle, a few potential opportunities in home improvement stocks, and REITs with well-covered dividends.

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Deidre Woollard: I think a lot of real estate companies are actually challenging the narrative right now. Real estate, it's almost polarizing: People are rushing in; people are rushing out. There's a bubble; there's not a bubble. Right now, it feels to me that activity is kind of headed out. Me, I'm staying in, I'm rolling with the cycles, and doing just fine over time. Matt, why do you stay invested in real estate?

Matt Argersinger: I would never not be invested in real estate. First of all, it's been such a historically great performing asset class. To me, other than stocks, there really is no rival to real estate. If you just look at, over the years, whether you're looking at residential, commercial -- it's been a great asset class. It's much less volatile than stocks, and yet it performs nearly as well, if not even better during certain stretches of time. It has proven to be a pretty good inflation and interest-rate hedge as well. Although judging by this year, you probably wouldn't think that, but it's certainly true over time.

What I like about real estate, too ... and this gets lost, I think, because when we look at real estate, we're always thinking about the utilization of that real estate: There's a home, so people are living there; there's an apartment building, so people are renting; there's an office building, so there's a tenant that's leasing it.

But sometimes, I think it's helpful to think of real estate as just space. It's just space. There's a finite amount of land, there's a finite amount of square footage within a building. However that's used, it can be used in a lot of different ways. But there's a value to that, and I think if you take that space, that square footage, or that piece of land, and it's in a place where people want to be or businesses want to develop, there's value to it and there's things you can do with it -- renting it, developing it, just owning it and holding it. So I think real estate as an asset class is just fascinating for that simple reason. It's just that space that people want and demand.

Deidre Woollard: Space. I think that leads me into my next question, because one of the things that you just mentioned, which is true about real estate, is that the same piece of real estate can have many different purposes. Matt, I feel like you and I, we spent the last couple of years talking about office real estate, and the pendulum keeps shifting. I think my thesis has changed four times. We started off in the pandemic with full remote work. Now we've got hybrid work.

I'm looking at 2023, and I'm thinking this is the year when the tide shifts back to more in-office work, although I'm not 100%  sure. But part of that, I think, is that the power has shifted back to the employers a bit. We've seen those high-profile tech layoffs, and we've got -- certainly on the financial side, you've got David Solomon. He's Goldman Sachs' CEO. He wants to see people in the office around 75% of the time. JPMorgan Chase CEO Jamie Diamond, he wants to see people in the office. Snap CEO Evan Spiegel -- he just said recently that he wants to have four days in the office starting in February. Are we all going back to the office?

Matt Argersinger: Well, I was also going to say, you didn't mention Elon Musk too, [who] was just pretty loud about getting Twitter employees back. I don't know. Deidre, I think I'm probably pushing back against that a little bit. I don't know if there's going to be this big tide shifting back to the in-office work. Mainly because I think a lot of businesses have realized, well, our employees are fairly productive. This work-at-home experiment, as disruptive as it was back in March and April of 2020, it's actually worked out well. And I think a lot of businesses are embracing that "virtual first" approach. I agree with you, I think there's an element, though, that businesses, corporations are going to want employees back. I think that's why you're probably going to see this hybrid approach where it's 2, 3, 4 days in the office, but much more flexibility.

I don't know. It's such a tough question. I think it's one we've been grappling with the past few years. But I almost think the pandemic has created a permanent sea change. I don't know if we're going back. If you just look at one data point that you and I discuss often, which is the Kastle keycard data. If you look at New York City, it rose to as high as I think 45% earlier in 2022, and it's been basically flat since. It hasn't gotten back over that 50% mark yet. That, I think, is a pretty good proxy for, hey, here's a big urban office environment which used to bring hundreds of thousands, millions of workers into this one central place for decades throughout history. Yet here we are, almost three years into this pandemic, and we can't even get physical occupancy back to 50%. I think that's pretty telling.

Deidre Woollard: Yes, but I would push back on that because I've seen some data that also says that this phenomenon has tended to be more of a coastal phenomenon, where you've got people not coming back to the office as much in New York or San Francisco. But they are coming back to the office more in the middle of the country or in smaller markets. I think it's just too hard to make a universal statement about this because there's so many different factors. And I think that's one of the things that as I think about investing in office long term, I'm thinking about the fact that you can't really make one decision anymore. It so much depends on a variety of different factors.

Matt Argersinger: Right. I agree. One of those factors, I think, is the asset, the building itself. I think if you're going to attract people back to the office, whether it's New York, San Francisco, or like you said, whether it's the middle of the country, I think -- it doesn't have to be Class A, but it has to be a pretty nice place to work. It has to have sanitation capabilities, hygiene aspects that buildings didn't really need to have in previous years. And that's going to be hard. That's going to take a lot of investment. There are a lot of investors or developers who might not take that risk or office owners who are going to invest the capital to retrofit their office to meet the current environment.

There is going to be an attractiveness back to certain aspects of office. But I feel like there's a whole swath -- and if you look at the Urban Land Institute's recent report, they said anywhere between 10% and 20% of office space is going to either need to be removed or repurposed for other uses. That is hundreds of billions of dollars in value. In New York City alone, that can be about $500 billion of office value, right now, that's probably going away. That's pretty stark. It's going to be quite a challenge. But there is going to be, of course, an element. It just depends on where it is and how it's perceived as an asset.

Deidre Woollard: Right, and I think one of the things that we've already seen is that, like you just said, people have to have a reason to go to the office. It has to be a better experience not just for the employer, but for the worker to actually go into the office. I've seen some companies pivoting their office space into -- it's almost more like a showroom, where you go in maybe to get certain materials or have meetings. It's much more "I'm going in for a reason, to connect with people, to do certain things" than "I'm just going to go in and sit at a desk," because I can do that at home.

Matt Argersinger: Sure. Exactly right.

Deidre Woollard: I think one of the issues here that I'm also thinking about -- and this one has me really thinking -- is, with office, we've got long leases: five years, 10 years. And at the start of the pandemic ... they don't all come due at the same time. We're starting to see more and more of that as we're deeper into this situation, where people are thinking about their space long term. At the same time, companies are going into maybe a recession, maybe a time when they're feeling a little less secure. You've also got this lending environment that worries me. Recently, I chatted with Ben Miller of Fundrise, and he put this idea in my head because he was talking about the great deleveraging, and he was talking about commercial office buildings -- they have debt that restructures every few years. It's coming due in this environment, which isn't a great environment. How much should we think about those two factors: the leases coming due and also the restructuring of debt?

Matt Argersinger: What you presented is the serious near-term challenge. And what we've been talking about prior was the long-term challenge: What is the value of this office space and is it going to be leased in the future? But you're right, most office landlords are facing a serious crunch right now because not only do they have tenants who might not be interested in renewing, they've got debt coming due in upcoming years. Imagine rolling over debt that maybe you're financing right now  your building at 3.5%, a very favorable rate that you've got in recent years. Now you're going to roll that up to a 6% to 7% interest rate. That's a big hit at the same time the cash flows of the building might be falling.

I think what Ben Miller rightly pointed out is that this is a very uncertain world right now for office. And it's going to present some opportunities. But certainly for most office landlords, it's a big-time challenge. I'll just point out -- not to pick on New York too much -- but SL Green, which is the big Manhattan office owner, they just cut their dividend. This is a company that I think had raised their dividend every year for at least 10 years. All of a sudden they just cut it, and you tell that's obviously a move by them to keep their balance sheet strong as they enter this uncertain period.

Deidre Woollard: Well, we've talked a lot about the where. I want to talk a little bit about the what, because I think it also depends on what type of office it is, because that really determines how often you need to be in the office.

You and I, we both own Alexandria Real Estate Equities. I think we both like it for the same reason, not just that the locations are great -- Boston, San Diego, there's lots of great locations for A.R.E. -- but it's life-science focused, and those people can't necessarily do their work from home. But even that one, that's a great REIT. I love it so much. It hasn't been the best year for me with that one. It's down around 25%. How should we be thinking about office-related REITs as investments?

Matt Argersinger: I think that this is when you do focus on an Alexandria Real Estate. You focus on the offices that have tenants that are in critical, like a life-sciences type of industry. Or another one that comes to mind is Hudson Pacific Properties, which is an office REIT on the West Coast. But they're a big owner of film and TV studios. So that's a place where, obviously, you need people there. It's a job that requires you to be on-site.

Or something like Easterly Government Properties, which leases to the federal government in a bunch of various capacities. But they focus on agencies within the government like the FBI, the FDA, the VA, where there's what they call "enduring missions." These are critical missions where people have to get together, it's not work that can be done at home. That's I think where you have to focus on. The great thing is if you're an investor, a lot of these niche office REITs have been thrown out with all the other traditional office REITs. Like you mentioned Alexandria being down 25%. That, I think, presents opportunity for these specific REITs that really have tenants that are going to be on-site, where there's really better visibility into leasing in the long run.

Deidre Woollard: Yeah, absolutely. Well, I want to pivot to the other place we spend all of our time, which more than ever, is home.

It has been such a weird year for residential real estate. We've got these high interest rates and that has made buyers be less interested, and we haven't seen sellers put their homes on the market. You're still dealing with this really low inventory. I invested in real estate brokerage stocks. I'm feeling this, but I'm wondering where the relief comes from, and I'm wondering if I should start paying more attention to homebuilders. Right now it's a tough time for them. They're offering concessions, building permits have dropped, and I think a lot of homebuilders are waiting out the market. This has to shift at some point. How are you thinking about both residential real estate and homebuilders?

Matt Argersinger: Well, no doubt, I think we're already seeing it. We're seeing some slowing, some pain on the residential real estate side. I think it's easy to say that home prices in a lot of markets have to come down because mortgage rates are just so much higher. The mortgage rates are more than double where they were at this time in 2021. That of course has to change things. You can't have someone buy the same house, but have their payment more than double. So that's coming down. I think you're right. I think homebuilders are in a very interesting position in the sense that they've seen the slowdown, it's already hit their stock valuations. They pulled back in a lot of cases. Their backlog of orders has fallen. Their cancellation rates have risen. So there's a lot of concern there.

But I think if you're an opportunistic investor, there might be some values because homebuilders learned a lot of great lessons from the great financial crisis 15 or so years ago. Their balance sheets are a lot better place. They've been a lot more conservative with their land buying and their land holding. And so I almost think they've been unfairly beaten down and gosh, the valuations for these homebuilders -- they look incredible right now. I was looking at Toll Brothers or PulteGroup earlier today, and you can see their PE multiples are below 10, and you're thinking to yourself, wow that's an amazing opportunity.

But you have to remember, a lot of their earnings right now is reflecting trailing numbers, and so their business was actually really good going into the last couple of quarters. So those valuations aren't going to look as great probably by this time next year, but I do think that is the time you get interested in cyclical industries like homebuilding. I mean, we can call them cyclical all we want, but the reality is, Deidre, you and I know this, there's a huge demand for homes. I mean, we've underbuilt in this country for the past 10 years. There's millions of homes that we need to have, and so even if prices come down a bit, I think they can't go down too much because the demand will certainly come in and fill that. I mean, that's especially true if we get a little bit [of a] break on the interest rates maybe next year.

Deidre Woollard: Well I think that's one of the things I'm considering. I know that we all -- investors, analysts, everybody -- we have a tendency to fight the past war. We have a tendency to look at the last cycle and assume that the next cycle will look like this. My intuition is that this cycle that we're seeing, whatever we're seeing in housing, isn't going to take the kind of time that the last one did. Whatever we're going through, I have this feeling that it's going to be a bit shorter, because with 2008, I mean, it took years and years for us to get out of that cycle. This is a very different beast. Do you think that this is something that's going to be a little bit shorter? Am I off here?

Matt Argersinger: No, no. I think you're exactly right. I mean, because not even thinking about it from the homebuilders' perspective. Think about it from, like you said, the homebuyers' perspective. I mean, after the great financial crisis, how many years did it take to get through all that foreclosure backlog, and how long did it take for home prices to get back to where they were? It took years.

Coming into this, credit scores are a lot higher, consumers have a lot better balance sheets. They weren't speculating as they were back when you had the average person trying to flip seven homes at the same time. There just wasn't really anything like that in this cycle, even though it was still a pretty robust cycle for housing. So I think you're exactly right. Whatever decline we get, it's not going to be as long. It's certainly going to be shallower than what we had back in the great financial crisis.

Deidre Woollard: One last question on this. This is something I'm thinking about, which is, what we got out of the great financial crisis was the rise of the single-family rental institutional investor. That was one of the big things that happened. Blackstone and Invitation Homes came out at that. What do you think is the thing that comes out of this cycle? Is it build-to-rent? That's sort of what I'm thinking, but I'm not entirely sure that's the one that we get out of this one.

Matt Argersinger: That's such a great question. I haven't put a lot of thought in that. You've seen the rise of co-living spaces and home-sharing. And by the way, it goes back to our office discussion as well -- the whole WeWork model, which I think might have been ahead of its time, actually might have more relevance in the future. But I also think, relatedly, this co-living concept too could be a big thing.

One last thing I'll say about this cycle, one area of the market that's been hit just as hard -- if not harder, in certain cases, than the homebuilders -- is, if you look at the home improvement stocks, like your Home Depots, your Lowes, of course, but your Trexes, your Sherwin-Williams, your Poolcorps. All these companies that focus on home improvement, they've been crushed. I just think if you're expecting a shallower decline for the home market like we're expecting, that could also be a place to look for opportunities.

Deidre Woollard: Yeah, you just mentioned a bunch of companies that have really proven their value over time, too.

Matt Argersinger: You're right. I mean, great track records, and you're seeing these businesses that, at least on the valuation side, have been crushed. I think that's probably overdone in some cases.

Deidre Woollard: Well, let's talk a little bit about consumer spending and the way that impacts real estate, because this has fascinated me. Inflation is rising. Interest rates also rising. There's layoffs, there's uncertainty. The big R-word -- recession -- keeps looming, and yet we are still spending. Black Friday results were strong. Cyber Monday results were strong. People are spending on more travel and experiences. That "revenge spending" that was supposed to just be a blip after the pandemic -- it keeps going. Should we be considering real estate that relies on consumer activity, both retail and hospitality, right now?

Matt Argersinger: I think so. I think you're right. The consumer resiliency has been something to behold. I do wonder a little bit -- we're seeing credit card balances hit records and we're seeing savings rates plummet. That worries you a little bit. But as we spoke of before, I think consumers as a whole are in much better shape. We know, at least right now, the economy in terms of the employment rate looks very strong. As long as people have jobs and can get jobs -- and there seems to be a lot of job openings still out there for people looking for jobs -- I would expect that spending to continue. You mentioned on the retail/hospitality side, I think we've all been impressed with how resilient retail has been, brick-and-mortar retail, especially.

Again, it's one of those places where we left it for dead. It was already in decline, and we left it for dead certainly when the pandemic hit. But speaking of challenging the narrative, if you look at the results from say, Simon Property Group, which were just tremendous. Their occupancy is up. Their net operating income was higher. They're having leasing success. They raised their outlook again. Now Simon is a little bit different, it's certainly the high-end mall, but it tells a story about the consumer and the spending abilities that the consumer in this economy still has. Then, on the hospitality side, if I look at hotel REITs or even private hotel operations, we're seeing record results, whether it's daily rates or RevPAR. Occupancy is the one I think that's still slightly below 2019, so pre-COVID. But every other metric is at records. And I would expect that "delayed-gratification travel," "revenge spending" -- however you want to call it. I think that has room to go into 2023.

Deidre Woollard: You mentioned one of my favorites, Simon Property Group, and one of the reasons that I love that company is because of the tenant base. I like some other companies because of that. I like Kimco because of the grocery tenants anchoring those properties. What other REITs in those spaces are really appealing right now?

Matt Argersinger: Well, it has more risk to it, but I think something like an EPR Properties, which depending on how you look at it. But I'd say mostly, unfortunately, is that about 40% of their tenant base is movie theaters, and that's been a tough business to be in, certainly in recent years. But they have so many other properties, whether it's hotels or ski resorts or bowling alleys -- things that are attracting people -- to do not just shopping, but also to go out to eat and have a good experience. I think EPR is one to look at. One that we've been excited about recently on the Real Estate Winners service that I'm on is VICI Properties, which just, by the way, did a deal with Blackstone.

I'm sure you saw that, Deidre, where they're acquiring the remaining equity in the MGM Grand and Mandalay Bay that they didn't already own. But you have a company now that essentially owns the Las Vegas Strip. Las Vegas, to me, seems such a great place to bet on. It's become its own ecosystem in a way, and whether or not you think a recession's coming, what you have coming in 2023 is the return of a full slate of conventions, events, F1 racing. I think the Super Bowl's coming in 2024. Either way, this is a company that just has some of the best retail entertainment properties in the country, and that's another one to take a look at. Both EPR and VICI, by the way -- and Simon, which we mentioned earlier -- have really high dividend yields. And I think those dividend yields are more than covered.

Deidre Woollard: I think the story of Las Vegas, I think there's a lesson in there, because during the pandemic, a lot of people counted out Las Vegas. They counted out the idea that people would ever go back to conventions. Here we are, we're two years later. You're absolutely right, convention traffic is up, convention bookings are up. That brings me to thinking about the ways, as we look at real estate ... there are assumptions that we make that then prove not to be true. How can we prevent ourselves from making big sweeping assumptions that don't necessarily pan out?

Matt Argersinger: It's what investors face. I think it's one of those challenges and risks that investors face, which is: How do I not become a prisoner of the moment? How do I recognize that the news I read or see is never as dire as it sounds or as good as it sounds? The truth is always somewhere in the middle. I think early on in the pandemic, it was easy to turn around and say "Oh my gosh, no one's ever going to go to Vegas again. No one ever going to go shopping again. No one's ever going to go sit in a movie theater again. No one's going to ever go see a baseball game in person again." Those were all just way overreactions.

But then on the flip side, I think a lot of us said, "Well, of course we're going to go back to the office. This isn't going to last forever." Go back to March 2020, I think you and I probably did a podcast together, and we were like, "Yeah, maybe by the fall, we'll all come back to the office." Here we are, two-and-a-half, almost three years on, and most of us are still not back to the office, which is stunning in a lot of ways. So in that sense, I think we were probably too optimistic.

It's fascinating to be an investor or a watcher of markets in the news and realize that the truth is always somewhere in the middle. As an investor, the more you can be even-keeled with all these big prognostications on both sides, the better you're going to be.

Deidre Woollard: Absolutely. Don't be a prisoner of the moment. I love that. I think that's a perfect place to end it. Thank you so much for your time today, Matt.

Matt Argersinger: Thanks, Deidre.

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Chris Hill: As always, people on the program may have interests in the stocks they talk about and the Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.