In this podcast, Motley Fool host Deidre Woollard caught up with Motley Fool analysts Matt Argersinger and Anthony Schiavone to reflect on real estate trends in 2023 and look ahead to 2024.
They discuss:
- Three scenarios for housing affordability.
- A void that Blackstone and Brookfield could be looking to fill.
- Why REITs are poised for a rebound.
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This video was recorded on Dec. 23, 2023.
Matt Argersinger: Right now it's hard to see, could REITs fall that much? Our home price is going to fall? That's going to be hard to see. Can we really realistically kick-start a lot more building? I think Zillow's latest data says we're still short something like 4.3 million homes given the demand and it just feels since the financial crisis, we've never been able to close that gap and it's hard to see a closing any time soon.
Mary Long: I'm Mary Long and that's Motley Fool Senior Analyst Matt Argersinger. Deidre Woollard caught up with Matt and Fool Analyst Anthony Schiavone to look back on the year that was in the world of real estate. They discuss our changing relationship with work and its impact on the future of cities, why more Americans are locked into their current homes, plus when and where. You just might want to follow the asset managers.
Deidre Woollard: Let's start with 2023. What is your biggest headline for the year Matt?
Matt Argersinger: Well, 2023 for me and I hate to start this wonderful show on maybe a dire note, but I think 2023 to me really put the nail in the coffin for traditional office real estate. Entering the year I felt we were beyond the worst of the pandemic companies, corporations, business was getting back to normal and we were embracing maybe a more hybrid work schedule and I just thought that was going to bring back a little bit of more traditional office, bring back the demand, bring back the activity, the office visits, the occupancy and boy, it didn't. I think for a certain segment, particularly of class B, I think the nail is in the coffin. I think that particular part of the office market is really dead. Unfortunately, I think even though newer class A office is going to find demand and has a slightly better future. I also worry that it's also not really an investable asset class going forward. I just think we've had such a secular shift in the worker relationship with the office. In fact, I don't even think we should call it office anymore guys. I was actually thinking we should almost call office, collaboration centers where people come on an infrequent basis to just to have meetings, to collaborate on specific projects or tasks, and it's not necessarily a regular thing anymore. Maybe that's too far extreme on one side but I do think that for me is what I'm always going to remember 2023, first and foremost.
Deidre Woollard: That's off to a gloomy start.
Anthony Schiavone: For me it's all about housing affordability. Since 2020, by some estimates, median home prices are up around 30% which is just incredible growth in such a short amount of time for something like housing. Then to make matters worse, the Fed embarked on one of the fastest interest rate hiking cycles that we've seen in quite some time and that drove mortgage rates to nearly 8% just a few months ago. The result is a dramatically higher monthly mortgage payment for most people buying a new home. According to the National Association of Realtors, housing affordability is at its lowest point in nearly 40 years. Since housing is the biggest asset that a lot of people own, I think it's a really big deal and hopefully this gets resolved looking forward in 2024 and beyond.
Deidre Woollard: Also now we have some gloomy things here. The first thing that comes to my mind is, man, I wish that we could find a way to put the housing into the offices, but as we've all discussed before, that is not really possible. We can't turn all of that Class B office space into housing. People are trying.
Matt Argersinger: No. I'm glad you brought that point up Deidre because it's way too expensive first of all and even if it was economically feasible for this transformation to take place where we can take a lot of this unused office stock and turn it into other uses. It's not practical in certain cases because of the way the buildings are structured, and we've talked a lot about that in the past. Unfortunately, I think not to beat this drum on office, but I almost think to the point where the only solution to a lot of these Class B offices in the near term, it's foreclosure but in the long term, I think it's demolition. I think we almost have to clear out a lot of this stock before we can get to a point where we can redevelop the space.
Deidre Woollard: Well, and that's one of the things that I wanted to talk about too was this has been the slowburn crisis of the loan issues facing commercial real estate. You framed it up with, obviously the demand for office is lower. When you're trying to refinance now as Ant pointed out, you've got those higher interest rates. There's about a trillion dollars in loans coming due in 2024, 2025, which just seems a snowball rolling at us. On a scale of 1-10, with one being we're doomed and 10 is, this is a blip. It's not going to work out that bad. Matt, where do you put the risk?
Matt Argersinger: That's a good question. I think the risk to the overall market, like if I think about what's the risk to the economy and financial markets. I'm at four out of 10. I think commercial real estate, even this tremendous wave of loans coming due that you mentioned Deidre. A lot of these loans will get worked out. They'll be extended. They'll be rolled over. Some will be refinanced at higher rates even though that seems like a very difficult and expensive thing to do right now. But the risk to commercial real estate itself, and of course when I say commercial real estate in this context, we really are talking about office because that's where the trouble is. I'm at eight out of 10. I think the impact that it's going to have on a lot of banks, especially regional, smaller banks who have a lot of office loans on their books. They're going to be owning a lot of office real estate in the next year or two and they really don't want. Banks aren't in the business of owning and managing office real estate. It's going to be really tough and I think you're going to have to have a lot of workout firms come in and work things out, but it's going to be much more contained. This is not a 2008 style crisis where what we saw then was the collapse of the housing market and all these loans that went bad caused just tremendous ripple effects across the economy and financial markets. I don't think so. I think this is going to be more of a slow burn for the market. But specifically for the commercial real estate segment itself, it's going to be very difficult.
Deidre Woollard: Anthony, are there any sectors outside of office that you're looking at as potential risk for next year?
Anthony Schiavone: I think office is definitely the big one and Matt explained that very well. I would probably say malls and then also surprisingly multifamily. We'll start off with malls because I feel malls is in a similar story to office, but the story is more, it's further along. Really over the past decade, malls have struggled with the rise in e-commerce sales. I think high quality malls will be fine, but a lot of your Class B Class C lower quality malls. They're going to have trouble refinancing their debt when it eventually comes due. Then looking at multifamily. Multifamily still has pretty strong yet moderate operating fundamentals. Occupancy is still pretty strong. Rent growth is slowing and negative in some markets but I think the thing that worries me about multifamily a bit is that a lot of loans were originated in 2020, 2021, 2022 and over the next couple of years, that debt is eventually going to be refinanced at a dramatically higher interest rate. I do think we could see some pockets of distress in multifamily over the next couple of years. But like Matt said, I think it's going to be relatively contained and it won't be widespread. Also too, you have a ton of private equity capital that's going out there and looking to take on loans that maybe regional banks won't want to take on. There's still a lot of capital flowing into real estate, maybe not the speed it was in 2021. I think it's largely going to be contained.
Deidre Woollard: I like the point you made about multifamily because the part that worries me is that high end luxury. Because if you're trying to pencil out a deal, you want to have the most. You want to be in a position where you can charge the most rent. All the money flowed toward luxury multifamily but, rents are stabilizing and stalling out in some markets, and in some of those markets, there's a risk of oversupply and the risk that some of those apartments might be too small based on the fact that now everybody works from home. I think you brought up a really good point. That is an area that worries me as well. Let's talk a little bit about REITs and you just mentioned the idea that we've still got capital flowing in, but it was not a great year for REITs. They do outperform the broader market over time. Matt has drilled that into my head, but it was not their year. Matt, is 2024 going to be their year?
Matt Argersinger: Well, I sure hope so Deidre. I think it will be. You mentioned 2023 not being a great year for REITs. Well, it's been a brutal two years for REITs. You really got to go back to the beginning of 2022, really when the Fed started its rate hiking cycle and REITs have just gone in the opposite direction for two years now. Yes, historical data is on our side. REITs should outperform coming out of this. I think part of the problem that REITs have faced is because a lot of institutional investors treat REITs like bond proxies. If you ask the average institutional investor for the first time in two decades or at least 15 years. I can get a risk free yield of 5% or more and we haven't seen that in a long time. If you're comparing that to a REIT that might also be paying 5% dividend yield. It's just not as compelling because there's risks associated with that investment. If I can get risk free 5%, why I'm I going to do risky 5%? But of course, I think as most things and just a lot of investors are missing the bigger story here, which is with REIT you have real assets, you have rent producing assets, you have assets that can grow, assets that oftentimes are resistant to inflation. Leases that rise with inflation. I think there's a lot of growth that can be had with REITs as well, in addition to, especially today, really nice dividend yields. You'll read a lot of reports and Ant has found some great data out there that suggests a lot of REITs even if you strip out office, which we know is really facing a lot of trouble. REITs are trading at or below their net asset value and anytime you see that in a broad way, REITs are probably set up to rebound pretty strongly. I think that's what we're going to see starting in 2024.
Deidre Woollard: Are there any particular areas of REITs that you're more interested in? Because one of them that I'm thinking about is the idea of rebounding in data centers, and there aren't that many of them left in the publicly traded REITs space. But you see the AI growth, and you have to figure that there's a correlation there. The two biggies, Digital Realty and Equinix, they are performing better than they were. But what sectors are you looking at?
Matt Argersinger: I'll let Ant answer this as well, because data centers are one, and I think, Iron Mountain is another one that Ant and I talked a lot about that is an emerging player in the data center space that's pretty exciting to us. I think industrial is going to stay strong. We talked a lot about industrial estate. When I talk about industrial, I mean, warehouses, logistics facilities, your pro-logistics of the world, your stag industrials. They're really riding these two undeniably strong secular trends. E-commerce, which we've known about for decades now. But also this more recent trend of supply chain optimization or redundancy. Since the pandemic we saw all the challenges that a lot of companies ran into in 2020, 2021, and they're looking to bring some of that manufacturing home, trying to increase their inventory levels. That just means a lot of demand for industrial space. We just don't have enough industrial space in this country. That is one area of the REIT market that I think has been strong and it's going to stay strong, and I'm sure Ant can name one or two more as well.
Anthony Schiavone: I know I just got done saying that we might see some distress in multifamily, but I do think some of the multifamily REITs present opportunity. For example, Mid-America Apartment Communities is one that has a super strong balance sheet, a management team that's been with the company for decades. They're not going to run into the same refinancing issues that maybe a private owner might run into, because they have access to liquidity, low cost of capital. I think they'll be able to weather a downturn, and if distress does occur, they'll be able to be on the aggressive and maybe acquire some properties at attractive valuations. That's a sector that I'm still looking at even though there might be some distress in the coming years.
Deidre Woollard: Well, I like Mid-America too because they're focused more, like the name says, not at the high end of the market and really in the Sun Belt area where we've seen so much of the growth over the past couple of years. Related to that, I feel we talk about the Sun Belt all the time. Is the growth story still there, do you think? Is that still where we should be looking for opportunities is in those markets that have been expanding rapidly? And what do you guys think about the loom stories that we've seen about San Francisco and about New York?
Matt Argersinger: Well, I'll start with the latter, the doom loops scenarios that we worry about. There's two minds on this. Of course, I don't think cities like New York City, San Francisco, Chicago are going to face some doom cycle where things just get worse and worse over time, because offices have declining, people are leaving the city. I do think at the same time, though, we have to broaden our idea of what major cities for the country and for how we live our lives. Because for the longest time, for decades, really, almost the entire 20th century and well into the 21st century, cities were the central hub of where work and commerce happened. Millions and tens of millions of people, hundreds of millions of people were commuting into the central offices to do work, collaborate with employees, and get things done. That at least at the white collar level has been completely changed in just the past few years. If that is the case, just think about what that means for adjacent real estate, retail real estate, restaurants, entertainment downtown, public transportation, all of which is seeing less and less demand because there's just less people moving downtown on a daily basis. I think cities have a future, and I certainly don't think we're going to just see an endless down cycle for cities. But I do worry a lot about what the current environment, what the work relationship and change means for cities, and I just think it's too early to say, and if we aren't able to do this tremendous transformation of all that unused office space downtown. New York City, think about just the millions and millions of square feet of office space in Manhattan that's probably not being used right now or very underutilized. What happens to all that? The expense of trying to transform that, if we can't or are unable to, what does that mean for a city like New York's tax revenues? What does it mean for occupancy over the long term? What does it mean for the central economies of those cities? It's just so many unanswered questions right now. It's not a written story here. There's a lot more to think about.
Deidre Woollard: Yeah, I think that's true, and one of the things I think about with that too is with the Sun Belt cities that are growing and you have this opportunity to do the urban planning side of it better, which hasn't quite played out as much as I'd like. But also with big cities, there is a chance to reimagine what a city is, and that's the thing that makes me optimistic. There are worries about funding public transportation and things like that, but there is also the opportunity to think of, how can we do things better? How can we make changes that are great? Like the idea of the 15-minute city or the super block neighborhoods where you get everything you need in one location. That's the part of all of that that makes me feel optimistic. Before we move on and talk about residential, and I wanted to turn it to you because one of my weird investing theses is follow the asset managers, follow a Blackstone or a KKR. I'm wondering what the opportunities are on the private equity side and what we can learn from what private equity is doing right now.
Anthony Schiavone: If we look at public REITs over the last four years, we mentioned only perform over the long term, but they've been very volatile over the last four years. 2020 hit the pandemic, they were one of the worst performing asset classes. 2021, they were one of the best performing asset classes, and in 2022 and 2023 with higher interest rates, they've been, again, the worst performing asset class. I think that does present an opportunity for the institutional side, the private equity side of real estate, to maybe take some market share. Because the way that private real estate, the way they measure their returns, it's backwards looking. It's appraisal-based. They're mark to market their prices every single day. It's not like a liquid stock like a REIT is, so that tends to lead to less volatility over the long run. If you're a portfolio manager for a pension fund and you're looking to invest money, you're probably going to like that lower volatility, because you don't have to worry about the daily fluctuations in stock prices. I think that does present an opportunity for institutional capital to continue taking share.
Matt Argersinger: I'll just add to that. That's great, Ant. You and I have followed the Brookfields of the world, the Blackstones of the world, and these firms, it seems like they can just go through bad periods, but they never have issues raising capital. It just seems that they can always launch a new fund and raise billions of dollars and no matter what's happening in the market, whatever cycle is, and they can be countercyclical, or oftentimes REITs, or even publicly traded real estate companies can't be because they're beholden to earnings, they have a balance sheet, and they can't react fast enough often. They can't recycle capital in the same way a private equity firm can or raise new capital. I do think and earlier in the show we talked about, well, gosh, there's all these loans coming to fore closures, banks are really struggling. Well, private credit is going to fill a lot of that vacuum. They're going to come in, pick up a lot of those loans, pick up a lot of those distressed properties and really take advantage. You're going to see, I think, a black so in Brookfield, maybe even Starwood be able to really capitalize on the current environment. It might be dicey in the short term but the money they're raising now and the money they're going to be investing in the short term could really pay off in the years ahead.
Deidre Woollard: [inaudible] I think another factor that I've seen, especially on the real estate crowd funding side too is raising money for, not for equity but for like mezzanine loans and things like that.
Matt Argersinger: Prefer debt, preferred equity.
Deidre Woollard: Exactly. Because it's been such a challenge for certain projects to get funded is that now there's this other thing. I feel like this is a window of opportunity based on interest rates and things like that. But that's where I'm seeing another area where some money has definitely been funneled.
Matt Argersinger: That's right. You're seeing that a lot. I think that's a great point. Whether or not as an individual investor you'd be better doing that versus just investing, say, in the stocks of private equity firms or REITs today, I don't know. Because as we know, a lot of those crowdfunding sites investing in single asset deals, a single market and even though a preferred equity rate of, say, a 12% might sound great, you have to ask yourself, could I do better especially on a risk adjusted basis by sticking with the public markets today? I would probably say yes to that answer.
Deidre Woollard: That definitely seems to be how it has worked out. Let's pivot and talk a little bit about residential, it kicked us off at the beginning of the show talking about that. Existing homes did not sell very much in 2023, round down around 20%. I've seen the reports from Redfin and Zillow, everybody's doing their forecast right about now. They're saying that prices may go down a little bit, sales may go up a little bit, but it seems like it's still on pause. What do you think? Are we going to shake out of the pause?
Matt Argersinger: Eventually I think everything will sort itself out. In the near term I think there's three scenarios that can improve the housing affordability situation. It's either mortgage rates fall, home prices fall, which will lead to lower monthly mortgage payments. Or we could build more housing, which I think in the long term is probably the best solution. We just had so much demand for new housing. You think about a large millennial cohort that's moving into their prime home buying years. You have work from home which is increasing demand for more space in general and then also you have under building since the great financial crisis so supply is low. You've had a lot of government stimulus over the past couple of years, you had strong wage growth and full unemployment. There's a lot of demand drivers chasing limited supply. The more we can build, I think in the long run it's going to be better. Look at multi-family rents is a great example of this in the Sun Belt. In 2021, 2022, you saw double digit rent growth and now there's a massive wave of supply coming into the Sun Belt and now you're seeing rent growth tick down to 1%, 0%, in some cases you're having negative rent growth because there's more supply coming online. If we can do that with the residential market, single family houses, I think that in the long run is a great way to fix this situation.
Anthony Schiavone: You asked us at the beginning, what's our headline for 2023? I went with office but my second headline if I was going to go with it was, just the phenomenon of this lock in effect that we've seen in the existing home market where I don't think we've ever seen anything like this in history. I guess you could go back to maybe from the '60s to the '70s when we had a period where home buyers were able to buy in and lock in very low rates and then we had a period of just rapidly rising rates. But I don't think there's anything like this because of just how acute rates have risen since early 2022. You have a situation where we've talked about this, where something like two thirds of homeowners currently have a fixed mortgage rate under 5%. I think if you go under 4%, it's still like 60% and so obviously there's a huge reluctance, on the part of existing homeowners to list the house even if they wanted to, or even if they wanted to buy a bigger house or move to a different location, they're just not willing to give up their 3% mortgage rate that they have locked in for the next 20 plus years so it's an amazing phenomenon. I think certainly the agencies in the home market lenders were not ready for this situation that we find ourselves in. It's almost like a deep freeze. I think the forces that Ant brought up, those three forces would certainly change the market. But right now it's hard to see crates fall that much, our home price is going to fall that's going to be hard to see and can we really realistically kick-start a lot more building? I think Zillow's latest data says we're still short, something like 4.3 million homes, [laughs] given the demand and it just feels like since the financial crisis. We've never been able to close that gap. Gosh, it's hard to see it closing any time soon.
Deidre Woollard: It's not just the lock in effect, it's also those who've paid off their mortgage is a huge part of this. Almost around like 40% of homes don't have a mortgage right now and about over half of those people are in retirement age. Maybe they move at some point, but I think the other factor, not to be really grim, but the other factor here that's going to shake this out eventually is the aging of America, the demographics that shift that eventually people will have to leave their homes and people want to age in place, but that's not always possible.
Anthony Schiavone: It's certainly got to happen at some point. How fast can it happen and will it happen soon enough to resolve this incredible supply demand gap that we're seeing right now on the market? Probably not, but it'll happen.
Deidre Woollard: Well, that supply and demand gap has been good news for home builders. You and I have talked before about the fact that, at one point about a third of the houses on the market were new homes which just like never happens, that's usually around 10%. You've got the situation that should be good for home builders, but as we mentioned, they're not really building. They're building but they're not building maybe as exuberantly as they could because they're still cautious. But what's your thesis for home builders right now?
Anthony Schiavone: My thesis is a simple one. I think it's for everything we've talked about which is just a, they're pretty much the only game in town, really. Because like we said, the existing home market is frozen. What you have is a situation where home builders can come in, build new homes, offer financing to new home buyers, oftentimes down payment terms and rates that are a lot better than what you can traditionally get from a lender. If no existing homes are for sale and all you have are new homes being built by home builders, they are in a position where they can charge whatever they want, but at the same time, while their margins are great they're interested in protecting those margins and they don't want to overbuild in a situation where there's less demand or uncertain demand. Like you said, it's a perfect environment for them, but they're also being very cautious. If this is the status quo for the next year or so, home builders are going to do great. Because they're going to pick their spots, they're going to work through their backlog, they're going to earn incredible margins, the highest margins they've ever earned on home building. But they've got other forces they have to worry about. They've got uncertain demand, uncertain economy, they've got higher costs, labor costs and input costs and they're just going to manage those as carefully as possible. To answer the larger question, homebuilding isn't a solution to the housing crisis that we face in this country, the affordable housing crisis. But as an industry they are certainly in a great position right now. If you're an investor in home builders you've seen the results of that over the past 18 months. It's been a great place to be invested.
Mary Long: As always, people in the program may have interest 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 Mary Long. Thanks for listening. Whether this is your first time with us or you're a seasoned Fool. Our team is taking a break these next few days to enjoy the end of the year. We'll be back next Friday, December 29th, for a 2024 preview show. See you then, Fools. From all of us at Motley Fool Money, we wish you and your loved ones a very happy holiday season, a wonderful end to 2023 and of course, a foolishly fruitful New Year.
