A New Norm
BACKDROP
On February 12, 2020 the Dow Jones Industrial Average reached an all-time high of 29,551.42. With the backdrop of three interest rate cuts in 2019 by the Federal Reserve, the era of easy money policy, “lower for longer”, persisted. Easing trade war tensions with China, moderating job growth and consumer spending added to the overall complacency in the market. Corporations borrowed as much money as they could and bought back stock while investors came to expect low levels of volatility subsequently taking on more risk in search for yield.
Fast forward to March 9th, the Dow fell a record 2013 points followed by two more record breaking point drops by March 16th. With the market off more than 20% from the previous months’ highs, the impact from the COVID 19 Coronavirus pandemic ended the 11-year bull market that began in March of 2009.
At what I consider to be the first few plays of a double overtime game, there is little we know for certain at this point except that this will be the sharpest global economic contraction in history. Unemployment in the U.S. could easily top 30%, levels not seen since the Great Depression. Businesses, and entire countries, have become insolvent, with ripple effects felt throughout their supply chains. The distress is evident in every corner of the global economy.
REFLECTIONS
While each crisis in our history is marked with catalysts specific to that moment in time, research has shown that one can find several common themes. Looking back to 2008-2009, debt was cheap, there was massive liquidity in both the equity and debt markets fueled by enormous capital inflows from all over the world, driving asset values to historical highs. Naturally during exuberant times, investors underestimate risk and overestimate growth subsequently leading to a complete re-pricing of risk and a painful period of deleveraging, balance sheet repair, illiquidity and significant declines in asset values.
The GFC started as a financial crisis that bled into the real economy. Property owners had trouble getting new loans from capital deprived banks but tenants still paid their rent, allowing landlords to meet their mortgage obligations. Transaction volumes dried up. Real estate valuations ultimately saw cumulative declines of approximately 30-40% from the period of August 2008 through June 2010, putting upward pressure on cap rates as property fundamentals deteriorated, capping revenue growth. Because cap rates lag economic cycles, they peaked in 2010, several quarters after GDP growth resumed.
For many of us who lived through the Global Financial Crisis, we can draw many parallels to that period in time. It is only when we look back that we can begin to draw a framework for what’s ahead.
OPPORTUNITY
With the markets in freefall and at the very early stages of this downward economic cycle, Sponsors are struggling to assess the risk in their portfolios, which assets and which tenants will perform. No amount of scenario analysis could’ve modeled out a complete global economic shutdown that would lead to a whole host of new acronyms, many bearing resemblance to those of the GFC, the PPP, MLP, PMCCF, SMCCF, MLF, TALF etc. all established to quickly bring aid to the 22 million newly unemployed, undercapitalized lenders, struggling or bankrupt small businesses and insolvent state and local municipalities. However, the moratorium on evictions and foreclosures has left property owners and lenders alike with an opaque picture of the risks that lie ahead, leaving Sponsors uncertain of where cap rates will end up once we settle into the new equilibrium.
As is the case with all financial crisis’, a dichotomy emerges between companies with strong balance sheets ready to take advantage of low costs of capital, fire sales and depressed valuations whilst on the other end, owners and lenders rush to raise cash to meet obligations. Albeit necessary, industries consolidate and those resilient enough to survive benefit from fewer competitors, reduced operational expenses and the one thing property owners can control, purchase prices.
The other group that benefits from extreme market dislocations, arguably the most valuable, the entrepreneurs. Those with the fortitude to create and innovate, to force change in a world where so much of what we do is repeat what we’ve done before. Think of all the companies that were born out of 2008-2009, UBER, WhatsAp, Instagram, Airbnb, Spotify, the list goes on. In technology, the focus is on speed, efficiency, innovation, progress and measurable performance. These are hardly the first adjectives that come to mind within the real estate sector. The current market dynamics and the emergence of several new themes created by the COVID pandemic could finally be the catalyst necessary to turn the real estate market on its head. An opportunity exists to not only invest in what may be one of the greatest buying opportunities of our generation but to incorporate in our investment thesis the new paradigm that is emerging with the confluence of living, working and socializing in a singular location. Several themes support this theory.
Renting For Longer
With affordability as one of the main drivers behind the significant reduction in homeownership over the last several years, a behavioral shift towards more flexible, amenitized, urban-style living has helped support this trend. Millennials and Baby Boomers encompass a large majority of the rental market today, placing significant emphasis on health, wellness and environmentally friendly living spaces. The COVID pandemic and the subsequent recession that will ensue will no doubt reinforce the rent vs. own debate and prolong any first time home buying decisions.
Decentralized Business Models
COVID has sped up the path towards decentralization and simultaneously made us examine the future of work. To contextualize how quickly this has happened, ATT reported US mobile device, audio and web conferencing increased 400% MoM and the “Zoom Boom” has taken Zoom’s valuation from $9bln in April 2019 to $32bln today. As companies and employees prove the ability to work and be productive remotely, workers will challenge how and where that work gets done in the future. Technology and connectivity have allowed for this trend to quickly take hold. That’s not to say the traditional use of office space will disappear however the implication is such that every space, be it your home, a coffee shop or a common area in your building will need to be designed to accommodate this new multi-use and promote productivity.
Digital & Technology Adoption
Venture Cap has poured $80bln in the past decade into more than 1800 prop tech companies with the goal of bringing innovation and efficiency to things such as investment management, asset management, construction tech, property related fintech, digital improvements in sustainability, smart home technologies to streamline operations and improve resident experiences, home fitness and entertainment, advances in commutability options etc. The adoption of these innovative technologies have both tangible benefits with measurable ROI reflected in revenue enhancement and cost reductions, as well as intangible value with overall increased tenant satisfaction, brand recognition, community good will and most importantly, it has allowed for a better understanding of the consumers of space on a micro level, which ultimately improves utilization and retention.
Eco-Conscious and Wellness Focused
Never before in our lifetime has the importance of health and wellness been brought to the forefront as it has right now. With lives essentially grinding to a halt, transportation all but stopped and industrial production frozen, as the dust settles, we notice ourselves and the environment are better on a large scale. What long-term behavioral impact will this have? On an individual level, people have come to appreciate life and their surroundings more. We have learned to live with less, utilize space differently, use time more efficiently and perhaps changed our perspectives on how we think about living, working and socially interacting. On a professional level, companies have come to focus on human capital, corporate culture, customer service and quality and safety at the asset level. The “S” factor in ESG has come into focus as a way to drive performance. Equally, sustainability practices are being reprioritized by tenants, employees and investors alike.
