An Uneven Race to Recovery

Located at 8 Spruce St. in New York’s Financial District is the New York by Gehry. The 76-story apartment tower sports one of Manhattan’s most interesting designs, with the exterior appearing to be crinkled halfway down the south façade. Built in 2011, the 800-unit building, which also houses an elementary school, was praised in the New York Times by critic Nicolai Ouroussoff as “the finest skyscraper to rise in New York since Eero Saarinen’s CBS Building went up 46 years ago”.

And yet, according to Trepp, first-time servicer watchlists indicate that the tower’s occupancy has fallen by more than 20% since 2019.

The $550-million loan backing the apartment has remained current throughout the pandemic and the owner has not requested COVID relief. Still, the loan is in trouble. In 2019, it posted a debt service coverage of 1.93 when occupancy was 98%. The loan was put on a servicer watchlist after its DSCR fell to 1.84x and occupancy dropped to 74% in the first nine months of 2020.

On one hand, the plight of New York by Gehry could be a story about Manhattan’s struggles during the pandemic. The borough has nearly 16,000 empty rental apartments— its highest vacancy rate in at least 14 years.

But in a larger sense the complex is also representative of the recovery in commercial real estate. It is well-known that many economists have described the recovery as a K-shaped one, with some sectors of the economy performing better than others. That is doubly true within CRE, which has seen certain asset classes, such as multifamily and industrial, outperform certain hard-hit sectors, such as hotels and retail.

What has been less examined is the shifting fortunes within these asset classes. Multifamily, for instance, is not without its weaknesses, which could have an effect on its recovery.

Indeed, the New York by Gehry is a story with national, not just New York City, legs.

Inspired in part by the New York by Gehry, Trepp searched for all multifamily loans from private-label, US CMBS deals where occupancy had fallen more than 15% from 2019 through partial-year 2020. It found about 50 loans totaling almost $1.5 billion in outstanding balance. That total represents about 3.8% of the loans that have reported partial-year 2020 occupancy.

Since apartment tenants have one-year or two-year leases, Trepp has previously warned that dips in apartment occupancy were expected to emerge much more slowly than in the hotel sector. And even with this data in hand, Trepp still believes “it’s too early to make a call as to whether these loans are a harbinger of more bad news to come or that the relatively small number is a hopeful sign for the market.”

Still, it cannot be ignored that the vacancy rate increased 10 basis points in Q3, according to Moody’s REIS, which put it at 5.0% at quarter’s end. The long-term average vacancy rate in the sector ranges from 5.2% to 5.4%.

VACANCY, BUT NO DISTRESS

In particular, class A apartment deals are facing a double whammy right now. Before the pandemic, there was a softness in some urban areas as construction deliveries rose. Then, COVID hit. With office employees free to work from wherever they wanted, many have decided to leave urban core apartments in places like New York and San Francisco for cheaper housing with more space. “The markets that are going to struggle are very tourist-driven or the urban cores, like downtown San Francisco and downtown Manhattan,” says Sam Isaacson, president of Walker & Dunlop Investment Partners. “It’s going to be soft.”

Even after a vaccine, Isaacson isn’t convinced that things will go back to normal.

“This might just be the new normal,” he says. “Urban class A is going to be impacted for sure.”

But vulture buyers may want to look at other places for opportunities. “It doesn’t look like it’s going to be so severely impacted that there’s going to be true distress in that sector,” Isaacson says.

Isaacson doesn’t see many apartment developers handing their keys back to the bank, which could happen in other sectors. Even if there isn’t real distress in the market, he thinks a lot of developers will want to get out of deals because “their equity is wiped out.”

“You’re sitting at 95% of the [capital] stack, and you’re just going to move on and build the next deal,” Isaacson says. “You’ll make it up on the next deal or 10 deals or whatever the case may be.”

A STORY THAT APPLIES EVERYWHERE

Multifamily is, of course, just one of the asset classes that make up the CRE community, but its story is being writ large across the industry as the 2021 recovery gets underway. For most of these sectors it will be two steps forward and one step back as they deal with not only troubles that arose during the pandemic but also disruptive trends that had been emerging before the world had even heard of COVID. Retail, to name the most obvious example, will greatly benefit as the economy reopens but it is still dragging its pre-pandemic baggage behind it. In many cases, special servicers have been stricter with retail loans seeking forbearance compared to hospitality ones because of the structure issues the sector is facing. Even industrial, which has been surging all year is not without its own conundrum.

“Industrial is doing really well but there may also be some softness there,” Isaacson says.

Specifically, Isaacson thinks industrial properties with small business tenants could struggle if more of those organizations go out of business. There is also the risk that investors could overpay for assets as bidding gets even more intense.

Industrial, of course, is currently regarded as the crown jewel of CRE. So if there are issues in that sector, there are potential problems everywhere.

“There really is an interesting dynamic going on across commercial real estate,” Isaacson says.

THE SINGLE-FAMILY RENTAL HOME SECTOR RISES

For some lucky asset classes, the skies ahead are blue and cloudless.

At the start of 2021, JLL revealed it had formed a team dedicated to the single-family home sector. The move was a direct response to increasing institutional interest in the sector, it said. The sector had the wind at its back before the pandemic, but as the effects of COVID became clear to renters, fundamentals in single-family rental homes really took off as people fled apartments in the cities to live in houses in the suburbs.

According to the Single-Family Rental Market Index produced by the National Rental Home Council and John Burns Real Estate Consulting, 59% of new single-family rental home residents relocated from urban residential environments in the third quarter of 2020.

The index is designed to measure the single-family rental home market’s relative health by evaluating key leasing activity, household occupancy and anticipated demand. Fueled by growing numbers of individuals and families transitioning away from urban residential locations, the index hit 74.4 in Q3, the second-highest level on record after the 2Q 2020 reading of 76.3.

These properties make sense for renters as the average rental rate for single-family rental homes remains below the average monthly mortgage cost for owner-occupied, single-family entry-level homes. “Fifty-three percent of owners reported homes leasing more quickly than one year ago, with overall market occupancy reaching 97%,” said David Howard, executive director of NRHC, when the report was released.

While SFRs are a growing asset class, institutions with more than 100 homes still own less than 3% of total stock. That provides new entrants with a lot of runway for growth, according to JLL.

Since the pandemic has begun, a number of large transactions have occurred as institutions looked to scale up. JLL points to a recent $133.7 million capitalization that it closed on behalf of Haven Realty Capital with an institutional equity source for a six-property portfolio of new and to-be-built homes in the greater Atlanta area.

In November, RangeWater Real Estate revealed plans to deploy $800 million in Sunbelt markets to build 15 build-to-rent single-family communities over 18 months. The single-family rental communities will be called Storia.

In October, Invitation Homes and Rockpoint Group formed a $375 million joint venture that will acquire single-family homes to operate as rental residences. The JV will deploy a total of more than $1 billion, including debt, to acquire and renovate single-family homes in markets within the Western US, Southeast US, Florida and Texas, where Invitation Homes already owns homes.

Perhaps most significantly, over the summer, a syndicate of investors led by Blackstone Real Estate Income Trust re-entered the market with a $300 million preferred equity investment in Toronto-based Tricon Residential, with BREIT acquiring $240 million of the preferred equity.

2021 RETAIL WILL CALL FOR PLUCK

The industry is well aware of the burdens that retail had as we entered the pandemic last year, as well as the additional pain the shutdowns and social distancing brought to the category. Late last year, Moody’s Analytics REIS examined the servicer commentaries for both the hotel and retail industries. It found that there was a clear leaning towards forbearance on lodging properties versus a leaning towards foreclosure for retail.

“These comments and data support the economic narrative that while hotels have a better chance of ‘returning to normal’ over the next few years, retail is going through a structural change,” according to REIS.

Servicers, therefore, are being less supportive with retail workouts, and appraisers are harsher with longer-term cash flow projections, REIS concluded.

But retailers can find opportunities in the nooks and crannies of the recovering economy. Consider the example of bank branches, which have been closing and consolidating for years now as banking moves online. Enter COVID, which highlighted the value of having a drive-thru and related zoning.

“Once you figure out how to work around the bank vault and the installation of restaurant equipment and fixtures, the existence of a drive-through will help the permitting process for a retrofit to a restaurant,” says Noah Shaffer, senior director of asset management for Confidant Asset Management.

If banks don’t become restaurants, they can also work as medical or general office and retail space, such as cellular stores or funeral homes, according to Shaffer. Regardless of the use, they are usually attractive options for tenants.

“Somebody else will want to be in a decently well-profiled location,” Shaffer says. “They’re usually in a nice-looking building, with high-quality building materials, in a retail corridor, but the new tenant is just not going to pay the same rent as the bank would. But we typically see some restaurants and then maybe general retail, such as a cellular store or something along those lines move into those spaces.”

This is not to say that there is a wholesale rush to drive-thru space.

“We’ve had a lot of conversations with tenants who are beginning to think along those lines, but they’re just not making that call yet,” Shaffer says. “They aren’t actively reaching out and saying like, ‘Hey, we’ve figured out that this is what we’re going to do. Let’s sign the lease because we’re going to do a drive-through mattress pickup store now. I think every tenant who is contemplating a shift in real estate strategy still has seven or eight ideas on the chalkboard, but they haven’t figured out exactly what strategy to execute going forward, and there is going to be a lot of speculation.”

But Shaffer expects a lot more interest in drive-thrus over the next few years.

Other restaurant chains are also rolling out more drive-thrus. “Panera was doing a pretty big roll-out plan, moving from stores to drive-thrus,” Shaffer says. “Those are different stories and are on the fast track. Maybe they were trying to do drive-thrus at 10% of their stores a year. Now it may be 25%.

Regardless of what tenant moves into retail space, many landlords who lease to banks will soon need new tenants. They might be pleasantly surprised at the range of options.

BLACKSTONE’S INTEREST IN SELF-STORAGE

In October,  Blackstone Real Estate Income Trust announced it would acquire Simply Self Storage from a Brookfield Asset Management real estate fund for approximately $1.2 billion. Simply Self Storage is one of the top five private owners of self-storage and operates a portfolio totaling eight million square feet across the US. BREIT, for its part, owned a $300 million portfolio of self-storage facilities, and with the acquisition it became the third largest non-listed owner of storage in the US.

As is usually the case with Blackstone, the acquisition caused investors to give self-storage a second look. What they found was an asset class that shone throughout the pandemic.

One of those investors is Buchanan Street Partners, which launched a self-storage investment platform with plans to buy $350 million to $500 million over the next five years. “As we expected, self-storage has continued to perform very well during the pandemic, further reinforcing our investment strategy,” according to Timothy Ballard, president and CEO at Buchanan Street Partners. “The pandemic reaffirmed the belief of self-storage being a recession resistant sector.”

The demand is driven by heightened consumer interest in storage facilities, which have led to strong occupancies. “With consumer demand at an all-time high, the sector appears to have proven that it is a need among consumers,” says Feerooz Yacoobi, VP at Buchanan Street Partners. “That’s why in terms of occupancies, we’re seeing same store pools among the REIT operators at an all-time high, in the mid-95% range. We think this sector will continue to weather the storm.”

“Many of these self-storage facilities are coming available as developers, merchant builders or shorter-term capital are looking to sell early and realize gains, or they’re struggling with short-term oversupply that is causing them to miss pro forma projections,” says Yacoobi.

These problems are actually not due to slowing demand during the pandemic but rather overbuilding issues throughout the last two years. “We’ve seen overbuilding as a lot of new product was delivered in 2018 and 2019. That has negatively impacted market rates, but rents are now starting to pick back up in certain trade areas,” says Yacoobi. “As noted, we think those are interesting opportunities to come in and acquire class A newly-built product.  Our patient capital doesn’t need immediate cash flow, which enables us to invest in institutional-quality assets in strong locations.”

LET THE GOOD TIMES ROLL

It is hard to overstate how well the industrial asset class has performed during the pandemic, but here is one measure: John Chang, director of research services at Marcus & Millichap, says that now is a good time to buy in almost every sector—except industrial. For industrial, caution is advised, and it might even be a good time to sell with prices elevated in some areas of the country.

Industrial pricing is up 7.4% year-over-year and 1.9% from Q2 to Q3 2020, according to Real Capital Analytics. In Q3, industrial rents reached a historic high of $6.32 average per square foot nationally, which is a more than a 36%  increase over the previous cycle record set in 2007, according to JLL. Rent collections hit 99.4% in July.

With COVID delaying development pipelines by two or three months, new deliveries will be limited in the second half of 2021, according to JLL. That could lead to bidding wars for new properties, which would only increase values, JLL cautioned.

Jonathan Needell, president and chief investment officer of KIMC, though, notes that people shouldn’t assume that assets across the industrial sector are trading at those frothy prices. “The reality is that not everybody can get a tenant like that, and not every property deserves a cap rate backed by those kinds of tenants, such as Amazon and FedEx,” he says.

Needell says the Amazons of the world demand features that aren’t found in even reasonably new buildings. Fifteen years ago, buildings had a 32-foot clear height, and there were deep truck courts for turnaround. These buildings also had one per thousand parking.

But today’s high-tech users have different demands. He says they have advanced beyond what was once the lowest technology and innovation level within real estate.

“Now, if you lease to someone like Amazon, you have to have three per thousand parking,” Needell says. “They’ve done a mezzanine triple deck in the middle of the large industrial building that is essentially a small office building.”

Instead of having just docks and a turnaround court, industrial buildings now need one-third more space in truck courts for storing trucks that are not being docked or turned.

“They’ve got a whole extra third of depth that they’re adding for the containers and trailers,” Needell says. “So, instead of two depths, because you need to turn around, it’s three depths.”

Between the need for more storage trailers, parking requirements and the sophisticated processing power through the same infrastructure demanded inside the building, not every warehouse can serve high-tech users.

“It is a different building than the majority of industrial, even the stuff that is only 10 or 15 years old where there was 32-foot clear height and one per thousand parking,” Needell says.

Needell says the traditional investment-grade industrial user, who represents a deeper part of the market than the Amazons of the world, doesn’t need properties with super low cap rates.

“You have essentially everyone jumping into a sector thinking that their alternative tenant case is going to be a sophisticated e-commerce user or at least an omnichannel user, like a Walmart,” Needell says. “Those people are way more sophisticated and not going to take the traditional industrial building from five or 10 years ago. So there is a bit of a trap there.”

Right now, Needell says there is bifurcation in the market between the traditional industrial and high-tech properties for e-commerce users.

“There is also a need for both,” Needell says. “The industrial user who is shipping parts is not going to be needing the same kind of systems that an Amazon, Walmart or FedEx would.”

PANDEMIC HIGHLIGHTS LIFE SCIENCE’S ALLURE

Interest in life sciences was heating up before COVID-19. But the pandemic has accelerated that trend for obvious reasons. However, while investor interest has been fueled by the arrival of a vaccine, the problems in hotel, retail and even office are also playing into life sciences’ strength.

“Buyers are looking for other market segments subject to the same structural tailwinds enjoyed by industrial and apartments in which they can deploy capital,” Tom Leahy of Real Capital Analytics wrote in a blog post.

In addition to the search for a vaccine, Leahy writes that advancements in technology, data capture and analysis and a rapidly aging population in the developed world are attracting vast amounts of capital to the life sciences sector, which encompasses pharmaceuticals, biotech and medical technology industries.

Examples of investor activity proliferate. Alexandria REIT, which is the largest player in the space, made a significant acquisition with the purchase of the Karlin Palmer portfolio in the Research Triangle Park in Raleigh/Durham, North Carolina for $615 million late last year. In October, Ventas acquired a three-building portfolio in San Francisco for around $1 billion.

While other sectors struggle with falling rents and rising vacancies, rents are continuing to increase in life sciences. “It’s a function of basic supply and demand, and supply has not kept up with demand in many areas, so rental rates keep chasing the supply,” according to CGS3 attorney Dawn Saunders.

Traditionally, life sciences companies tend to form in hubs around universities like Oxford and Cambridge in the UK, Munich in Germany and San Francisco and Boston in the US. However, there is some evidence that life science hubs could emerge in new markets due to high costs and the fact that employees are moving away to take advantage of telework policies implemented during the pandemic. “This has created the perfect storm for life sciences companies to re-evaluate their real estate footprint and look at tier-two cities that have some of the factors essential to their success in a market,” Mark Hefner, CEO and shareholder of MGO Realty Advisors, says.

WHITHER THE OFFICE?

By now it has become an exhausting exercise trying to determine what role the office will play in companies’ operations once the economy reopens and employees have no safety fears to keep them at home. The consensus is that there is still a place for the office, though remote work productivity will likely remain strong.

But recent research from Cushman & Wakefield suggests that the work from home trend may eventually lose its luster.

In a focus group with 32 owners, occupiers and placemakers, Cushman & Wakefield found that not only were both management and professional staff able to do their work remotely, but administrative and non-exempt workers were also able to execute at a high level.

“It was an ‘aha moment’ that we can actually be very productive when you put 90% of your colleagues fully remote,” one executive told C&W.

Still, the occupiers in C&W’s focus groups indicated that increased remote work has created a perceived cost in long-term productivity, corporate culture and innovation and creativity. They shared that employees wanted to go back to the office to connect and collaborate. In fact, work-from-home fatigue is setting in, which is partially driven by video conferencing. The technology has led to “meeting sprawl” as meetings have increased for many people.

While employees surveyed by C&W were comfortable with remote work today, there was a feeling that this might not be sustainable once employees return to the office. C&W pointed out that it could be a much different experience for a worker if they’re on video in a meeting where everyone else is in a conference room.

Developments in overseas markets also gives office owners a reason for hope. An owner with locations in Korea and China indicated that as of October 2020, businesses were back in the office at pre-pandemic levels in those countries. It is encouraging to note that they too had slogged their way through Zoom fatigue.