[Exclusive Research] Real Estate Investors Adopt Divergent Strategies Amid Uncertainty[Exclusive Research] Real Estate Investors Adopt Divergent Strategies Amid Uncertainty

Falling sentiment reiterates caution, but many see opportunity ahead.

More than six months into the 2020 recession caused by the global health crisis, questions at the forefront for commercial real estate are how much investors dial back their economic outlook, property performance expectations and their plans to invest more capital. Yet the latest edition of the NREI / Marcus & Millichap Investor Sentiment Survey yields a surprising mix of both positive and negative views.

The Investor Sentiment Index has proved to be a reliable barometer for views on the commercial real estate industry across its more than 16-year history. Investor sentiment dropped sharply from 166 just ahead of the pandemic in the first half 2020 survey to 140 in the current second half survey that polled industry participants in late-August [Figure 1]

Although the Index now stands at a 10-year low, it remains well ahead of sentiment during the 2008-2009 recession when Index levels fell below 100. The decline in sentiment was expected given the havoc the coronavirus pandemic has wreaked on the U.S. and global economies. However, the Index remains surprisingly high given the severity of the impact. In fact, the current level is just slightly below the peak of 148 reached during the last cycle in 2005.

Digging into the granular survey results suggests that it is difficult to paint the entire commercial real estate market with a single brush. “The factor weighing most heavily on sentiment is the uncertainty surrounding the pandemic and the economy, and these issues are affecting some property types a lot more than others,” says John Chang, senior vice president of research services at Marcus & Millichap. Survey respondents continue to have a favorable outlook for some sectors and more pessimistic views on others. Specifically, property values over the next 12 months are anticipated to rise by an average of 5.7 percent for industrial, 5.6 percent for self-storage, 5.1 percent for apartments and 3.0 percent for seniors housing. At the same time, there is greater concern for eroding values in other sectors, with hotels expected to see the biggest weakening of 7.7 percent, followed by retail at 6.8 percent and office by 5.0 percent [Figure 2].

“There is a lot of variance by property type and also by geography,” says Chang. At the same time, survey responses regarding whether it is a better time to buy, hold or sell assets indicates that many investors see new opportunities, he adds. Views were widely mixed when all respondents were asked whether they thought it was a better time to buy, hold or sell properties across different sectors. In most cases, a bigger number of respondents said it was better to hold. However, several sectors demonstrated strong buyer sentiment including industrial at 49%, office and seniors housing each at 41 percent, and apartments at 38 percent. Those property types that rated low for buyer interest were self-storage at 12 percent, retail at 13 percent and hotels at 19 percent.
When the same question was asked only of those investors who already actively invest in the particular property type, favorable views on buying increased for industrial and seniors housing to 60 percent and 59 percent respectively. Views on buying apartments or office were comparable with 42 percent for each who thought it was a good time to buy more. Fewer thought it was a better time to buy hotels (27 percent), retail (16 percent) or self-storage (13 percent). “Investors see opportunities ahead for several property types, but there is still a lot of caution surrounding others. So, the real estate market is a very fragmented right now,” says Chang.

Survey Methodology: National Real Estate Investor’s research unit, Informa Engage, and Marcus & Millichap emailed invitations to participate in this online survey to public and private investors and developers of commercial real estate. Recipients of the survey included Marcus & Millichap clients as well as subscribers of NREI selected from commercial real estate investor, pension fund, and developer business subscribers who provided their email addresses. The survey was conducted between August 20-30 with 691 completed surveys received. Survey respondents represent a broad cross-section of industry respondents that include private investors, developers, advisors, lenders and REITs among others. The largest percentages of respondents are private investors at 38 percent, developers at 12 percent and private partners and financial advisors each at 11 percent. Respondents are invested in a variety of property types with a majority of 63 percent invested in apartments, followed by retail at 36 percent and office and industrial each at 32 percent. On average, respondents have $41.4 million invested in commercial and/or multifamily property.

Uncertainty and the impact from economic fallout related to the coronavirus has weighed on transaction volume and shifted strategies.

Investors are well aware of the severity of the economic crisis. Two-thirds of respondents believe the 2020 recession caused by the global health crisis could be as severe or even more severe that the 2008-2009 recession. National economic data certainly supports that view with a GDP loss in second quarter that amounted to roughly $2.1 trillion and an unprecedented 22 million jobs lost during the first two months of the pandemic.

“From an economic losses standpoint, this recession is worse than the Global Financial Crisis. However, it appears to be short lived, and it didn’t hit us the same way,” says Chang. The previous recession was characterized by a freeze in financial markets, a prolonged downturn and a slow growth cycle coming out of it. “In this case, we fell into a very deep hole very fast, but it looks like we may be coming out of it, and with a vaccine or some type of medical solution that better protects people from the virus, we could have a comparatively quick recovery,” he says. In addition, investors are benefiting from good liquidity at exceptionally low financing rates.

Uncertainty and the impact from economic fallout related to the coronavirus has weighed on transaction volume and shifted strategies. According to Real Capital Analytics, second quarter transaction activity fell 60 percent compared to the same period in 2019. A majority of respondents (62 percent) said that the spread of the coronavirus and declining interest rates have impacted their 2020 real estate investment plans in some fashion. Specifically, 29 percent plan to buy more real estate than they previously expected; 23 percent stated that they are likely to hold instead of buying more; 14 percent now intend to hold instead of selling more real estate; and 3 percent said they will sell more than previously planned [Figure 3].

 When asked how the spread of the coronavirus has changed their outlook on job creation in 2020, a majority of 87 percent said their outlook is now weaker. Specifically, 29 percent said that job growth will be negative in 2020, 28 percent believe there will be short-term softening and then recover, 20 percent expect job growth to be weaker, yet still positive and 10 percent think job growth will be weaker and turn negative in 2021 [Figure 4].

Investors still have ample access to capital, a healthy appetite to increase holdings in the coming year and confidence that interest rates are likely to remain low in the near term.

Several positive findings were also revealed by the second half survey, notably that investors still have ample access to capital, a healthy appetite to increase holdings in the coming year and confidence that interest rates are likely to remain low in the near term. The number of respondents who say they have abundant capital to spend dropped back only slightly from 63 percent in the first half survey to 58 percent in the second half survey. “Many investors have dry powder and are well positioned to capitalize on the market. We should see that come into play in the fourth quarter,” says Tony Solomon, senior vice president, national director of Marcus & Millichap Capital Corp.

More than half of survey respondents (54 percent) said they plan to increase their commercial real estate holdings over the next 12 months. Although that is a step back compared to the 63 percent who expected to increase investments prior to the outbreak of the pandemic, it still represents a high level of confidence given the uncertainty surrounding the economic recovery. Thirty seven percent anticipate no change to holdings, while 9 percent said they are likely to decrease holdings in the coming year [Figure 5].  The average increase expected is 11 percent, which is fairly consistent with previous surveys. Cash flow was rated as the primary real estate investment priority by half of survey respondents, followed at a distance by asset appreciation at 27 percent.

“People continue to believe in real estate and the long-term nature of this asset class,” says Alan L. Pontius, senior vice president, national director of the Office & Industrial divisions of Marcus & Millichap. There has been a lot of uncertainty in the past six months and questions about what is around the next corner. “However, when you look a year or two years or five years ahead, a lot of that uncertainty goes away, because the root of our headwinds stem from the COVID-19 health crisis, and that will – hopefully – be a relatively short-term phenomenon,” he says. Once some sort of medical solution is in place, business will recover, which is a key factor supporting investor confidence in real estate. They are looking beyond the short-term turbulence and seeing the longer-term demand drivers, he adds.

As the survey indicates, numerous investors have adopted a hold strategy. On the other hand, many investors are focusing on the attractive yield premium cap rates now offer compared to the cost of capital, notes Solomon. Interest rates have held steady at or near a record low, with the 10-year Treasury as of September hovering in the 70 basis point range. Similar to the first half survey, more than half of respondents (54 percent) anticipate no change in interest rates versus 39 percent who were expecting rates to increase, and 7 percent said rates could decline [Figure 6] . Only 17 percent of respondents believe the 10-year treasury will go negative in 2020.

The low rate environment has also spurred increased refi activity. Half (50 percent) plan to refinance at least some if not all of their real estate in 2020 due to the impact from the coronavirus and falling interest rates, while the other half had not changed their plans related to financing [Figure 7]. Yet despite those low rates, investors’ ability to access capital depends on the individual situation. “A couple years ago, virtually any property could be financed within a relatively tight band,” says Solomon. “Right now, there is much more variance depending on the location, type of property and borrower strength.”

Investors remain bullish on improving industrial values and a majority think now is a good time to buy.

The current climate highlights key differences between different property types. Survey respondents have disparate views on their outlook for property values in the coming year, as well as their view on whether it is a good time to buy, hold or sell. Survey respondents are more optimistic on their outlook for stable or improving values in industrial, self-storage, apartments and seniors housing, while views are more mixed on where better buying opportunities exist.

Investors remain bullish on improving industrial values and a majority think now is a good time to buy. Confidence in the sector is backed by solid fundamentals. During the second quarter a dip in absorption nudged vacancy rates 30 basis points higher to 5.5 percent, while rents continued to grow at an annual rate of 2.8 percent, according to Marcus & Millichap. Seventy two percent of industrial investors believe property values will continue to rise in the coming year with an average increase expected of 5.7 percent. Additionally, 60 percent think it is a better time to buy versus those who said it was better to hold (31 percent) or sell (9 percent)  [Figure 8].

Industrial properties benefit from pandemic-driven structural changes, notably accelerated growth in the use of e-commerce. Shelter in place orders and fears about contracting the virus have kept people at home and pushed many online to buy essentials ranging from groceries to pharmaceuticals. They set up online accounts, they became comfortable with using the technology, and in many cases, they were happy with the convenience, which is going to result in permanent behavior shifts, notes Pontius. Industrial space demand has also been spurred by retailer’s need to store increased safety stock of key items such as paper products and hand sanitizer to accommodate waves of consumer demand. In addition, elevated grocery sales, both online and in-person, are driving more demand for cold storage space. As such, changes to supply chains and a focus on reshoring manufacturing of critical products and safety equipment may spur industrial space needs going forward, he adds.

Confidence in the apartment outlook is still positive, but distinctly more muted in the second half survey.

Confidence in the apartment outlook is still positive, but distinctly more muted in the second half survey. Nearly half (48 percent) expect values to rise over the next 12 months with an average increase of 5.1 percent. Those results mark a sizable shift compared to past surveys where an overwhelming majority predicted rising values. In fact, the 48 percent is the lowest level in the past decade of survey results. One-third of investors think values will remain stable in the coming year, while 19 percent anticipate a decline.

Government policies will continue to play an important role in the housing outlook. While stimulus such as expanded unemployment benefits played an important role in supporting tenant’s ability to pay their rent, moratoriums on evictions have created increasing rent collection headwinds in several regions. According to Marcus & Millichap, multifamily vacancies rose 30 basis points to 4.7 percent in second quarter, while annual rent growth remained marginally positive at 1.0 percent. “Rent collections for multifamily have been very good at close to 95 percent through the initial stages of the health crisis, but a critical piece of that has been the government stimulus package,” says John S. Sebree, senior vice president, national director of the National Multi Housing Group at Marcus & Millichap. That stimulus, and whether or not it will be replaced with a new aid package, is an enormous variable that could influence the near-term outlook, he adds.

More apartment investors (46 percent) think it is a better time to hold assets. However, it is significant that 42 percent still consider it a good time to buy. That percentage held firm compared to the first half survey results and it also reflects the highest level who favor buying since 2013. Those who believe it is a better time to sell are in the minority at 12 percent. “It is a perception of strength for the sector over the long term, in part because there is still a macro-level housing shortage. In addition, the bulk of the millennial generation is still in their prime-renting years,” says Sebree.

Despite the negative headlines surrounding COVID-19 cases in senior care facilities, investors still hold a relatively good outlook for seniors housing.

Despite the negative headlines surrounding COVID-19 cases in senior care facilities, investors still hold a relatively good outlook for seniors housing. According to NIC MAP® data, senior housing occupancies fell 2.7 percent in the second quarter to average 85.5 percent, while average annual rent growth slowed to 2.0 percent. Forty three percent of investors think property values will rise over the coming year with an average increase of 3.0 percent expected.

“Most investors see seniors housing as a long-term investment, and they are more focused on future demand as baby boomers age. So, short-term sentiment wasn’t impacted as much because of the long-term nature of that asset class,” says Todd Lindblom, national director of Marcus & Millichap’s Seniors Housing division. Fifty nine percent of seniors housing investors believe it is a good time to buy more, while 37 percent think it is better to hold and 4 percent said it was a good time to sell.

Self-storage investments have grown in popularity over the last several years, and survey respondents have a favorable view of improving property values.  Over half (58 percent) predict that values will rise in the coming year with an average increase of 5.6 percent expected. “We saw a lot of demand for self-storage in the second quarter,” says Steven Weinstock, first vice president and national director of Marcus & Millichap’s Self-Storage division. In particular, storage benefited from people in transition, such as students coming home from college and people reorganizing homes to make space for a home office, he notes.

Self-storage vacancies improved from 10.1 percent in first quarter to 7.8 percent in second quarter, according to Marcus & Millichap. That strong performance may be why nearly half of investors (48 percent) said it was a good time to sell assets. However, the self-storage sector is still digesting a heavy load of new supply, including an estimated 67.8 million square feet that was completed in 2019. Increased competition coupled with owners who have been reluctant to raise rents during the pandemic contributed to average annual rent growth of -4.3 percent in second quarter.

Investors are more pessimistic in their outlook for improving values in office, retail and hospitality.

Investors are more pessimistic in their outlook for improving values in office, retail and hospitality. Although a bigger number of property owners who already own assets in these sectors said they prefer to hold, there is still a healthy number who see buying opportunities. Notably, 42 percent of office investors said it was a good time to buy. That represents a significant jump from 30 percent in the first half survey, and it also represents the strongest views on buying since 2013. Forty seven percent consider it a better time to hold office properties and 10 percent believe it is a good time to sell.

“There is a lot of perceived risk associated with urban core properties, while the flip side of that is that the outlook for suburban office is improving as companies consider shifting to low-rise buildings with ample parking and private entrances for employees,” says Pontius. That shift is amplified by aging millennials that have started moving to the suburbs. There are likely several more granular differences in investor sentiment related to views on urban versus suburban office, as well as their appetite to buy assets in primary versus secondary and tertiary markets, he says. “We are seeing more investors focusing on suburban office properties, whereas I think there is more caution and more holding patterns when it comes to the urban core,” he adds.

During the second quarter, office vacancies rose 60 basis points to 13.6 percent, while annual average asking rent growth remained relatively stable at 3.7 percent, according to Marcus & Millichap. Views are split on whether office values will fall (42 percent) or hold steady (41 percent) in the coming year. An additional 17 percent believe values could rise over the next 12 months, and the overall change averages -5.0 percent. “That negative 5 percent was a bit surprising. I think it may be driven by a belief that companies will reduce their footprint and have more remote workers. However, respondents are likely overestimating the impact,” says Pontius. He adds that most workers have indicated that they prefer to work in an office but want added flexibility to work remotely 1-2 days a week. Beyond this employee feedback, companies fear the loss of collaboration and culture as a key risk to a heavy weighting to remote work. Finally, the need for increased physical distancing will likely raise the average square footage needed per employee. Again, there likely is going to be more softening in some of the urban core markets, while suburban markets could perform very well due to new demand drivers, he adds.

Hospitality and retail have taken the brunt of the economic impact from the coronavirus-spawned business disruption, and this has clearly weighed on the outlook for property performance and investment strategies.

Hospitality and retail have taken the brunt of the economic impact from the coronavirus-spawned business disruption, and this has clearly weighed on the outlook for property performance and investment strategies. Almost half of retail investor respondents (47 percent) anticipate that retail property values will decline over the next 12 months by an average of -6.8 percent. Overall, half of respondents who already own that property type said it is a better time to hold compared to 34 who believe it is better to sell and 16 percent buy.

“At a macro level, many investors see a grim outlook for retail, but there are several segments within the retail category that are performing well,” notes Daniel Taub, senior  vice president, national director of the Retail and Net Leased Properties divisions of Marcus & Millichap. Shopping centers that have fitness centers, movie theaters and a lot of sit-down restaurants are struggling more than grocery-anchored centers that have a drug store, dollar store or other essential retailers. In addition, some single tenant net lease assets are still doing quite well, he adds. Although the retail sector saw negative absorption of 9.7 million square feet in second quarter, the sector is still reporting relatively low vacancy, with just 5.2 percent available for lease, according to Marcus & Millichap.

Despite the fact that hotels have been the most negatively affected sector with occupancies and cash flows that virtually dried up at the height of health crisis shutdowns, nearly one-third of investors (27 percent) think it is still a good time to buy hotels. Forty eight percent believe it is a better time to hold, while 25 percent said it is more favorable to sell. “In general, hotels face the highest level of distress, and there are investors out there who view this as a buying opportunity,” says Skyler G. Cooper, national director of Marcus & Millichap’s Hospitality division. These prospective buyers tend to have strong management teams that can operate efficiently during the downturn, and they may be well positioned to take advantage of opportunities that arise, he says.

Although hotel occupancies and revenue per available room have improved from the extreme lows experienced in the first three months of the pandemic, fundamentals remain well below the record-high pre-crisis levels. According to STR, metrics from the last week in September show occupancies averaging 47.9 percent. That is down 20.1 percentage points on a year-over-year basis, with the average daily rate (ADR) down 26.3 percent to $95.63 delivering a 48.1 percent decline in the revenue per available room (RevPAR). Hotel investors are bracing for the pain to continue through the remainder of the year. Fifty seven percent believe that property values will drop versus 43 percent who anticipate stable or even improving values. Overall, the average decrease expected is -7.7 percent.

Respondents continue to agree that commercial real estate offers favorable returns compared to other investment.

Respondents continue to agree that commercial real estate offers favorable returns compared to other investment. However, that sentiment has edged lower since the survey taken prior to the onset of the pandemic when 74 percent favored real estate over other investment classes. Part of the decline may be attributed to the significant rally the stock market has experienced through much of the summer months. Yet real estate continues to present a compelling alternative for investors, especially when considering the ability to leverage very low financing rates. “The yield spread between the 10-year Treasury and the average cap rate for commercial real estate is at its second widest level on record,” notes Chang, offering investors some of the strongest levered yields on record.

Views were mixed on whether the worst of the economic downturn is in the past or still ahead, and how long it may take to achieve full recovery. Half of respondents do not think the worst has occurred, while 24 percent were unsure and 26 percent thought the worst had already occurred. “We may have already started the economic recovery, and we are expecting a pretty sizable economic bounce in the third quarter of 2020,” says Chang. “However, based on current economic forecasts it’s likely that we won’t get back to pre-crisis GDP until 2022.” A majority of investors believe that a full recovery to the economy will come after 2021. Nearly half, 46 percent predict that recovery will come in 2022, 19 percent said 2023 and 12 percent said 2024 or later [Figure 10].

It is no surprise that survey respondents expressed elevated concerns related to a variety of issues over the next 12 months. Chief among them are containment of the coronavirus at 56 percent, state of the U.S. economy at 54 percent, high unemployment at 53 percent, rising vacancy rates at 51 percent and changes to taxes at 50 percent [Figure 10]. Respondents don’t seem overly concerned about the upcoming presidential election. Similar to the first half survey, most respondents (58 percent) report the upcoming presidential election will not impact their 2020 investment plans [Figure 11].

Looking ahead, there are a couple of very big unknowns that could impact commercial real estate performance and further shift investor sentiment and strategies. One is how long it will take to get a vaccine or some type of medical solution in place to better protect the public from health risks associated with the coronavirus. Second is whether Congress approves another stimulus package and how substantive it is in terms of providing relief to individuals and businesses. “The themes that will continue permeating the commercial real estate industry will be fragmentation, uncertainty and caution until we come to terms with these bigger issues that overshadow everything,” says Chang.