The pandemic has forever changed the face of business and industry in America. Listen to our special podcast series to hear how three hard-hit areas are evolving as a result.

How has COVID-induced working from home changed commercial real estate? Tony talks with Kelly Rush, CIO of Principal Real Estate Securities, on the future of real estate.

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Kelly Rush, CIO of Principal Real Estate Securities

Please listen to important disclosures at the end of the podcast.

Wilmington Trust’s Capital Considerations with Tony Roth

Episode 22: 2021 Capital Markets Forecast: Who will be left standing—The outlook for real estate
Tony Roth, Chief Investment Officer, Wilmington Trust Investment Advisors, Inc.
Kelly Rush, CIO of Principal Real Estate Securities

Tony Roth: Welcome to Capital Considerations, the podcast that takes complex ideas from the investment world and makes them accessible to everyone. I’m your host, Tony Roth, chief investment officer of Wilmington Trust.

Today, we are exploring one of the key themes from our 2021 Capital Markets Forecast: Pivoting the Business: Who Will Be Left Standing, which focuses on the evolution and future outlook of industries in the wake of COVID-19.

I’m very excited for our first industry focus today, which is on commercial real estate and joining us is an eminently qualified guest, Kelly Rush, chief investment officer of Real Estate Securities at Principal Global Investors. Kelly has been managing real estate equity portfolios since 1997 and is co-portfolio manager on Principal’s U.S. and global real estate securities funds. Kelly, thank you so much for being here today.

Kelly Rush: Well, thanks for inviting me, Tony. Looking forward to the conversation.

Tony Roth: Yeah. And I think it’s very timely. Let’s get going.

Kelly, one of the very personal observations that I can share to kick the conversation off is that we recently opened a new facility in Radnor, Pennsylvania for our investment team. And we all spent a lot of time and effort putting together a great plan for a collaborative work environment, not a lot of walls, 20-foot ceilings. And we were in there for about two or three weeks and we were just loving it. It was just the best.

Then, we were all sent home and it’s looking like it’s probably going to be over a year before we get back. And so, yes, we continue to pay the rent because, A, we’re a good tenant and we’re a big bank and that’s what good tenants and big banks do; B, we do expect to get back in there at some point and I believe that human interaction is not only sort of fundamental to the human condition but also important to doing well in a company like ours from a collaborative standpoint.

But it’s hard not to miss the message, if you will, in the fact that all these office buildings all over the country are close to empty in some shape or form. And I know it’d be easy to dismiss commercial real estate and say, oh well, there goes that sector of the economy. But, of course, it’s a lot more complicated than that. Maybe you could kick us off. Just give us some overall perspective on sort of the haves and have nots if you will in the commercial real estate space.

Kelly Rush: Sure, Tony. Real estate has been under pressure this year. It’s been an underperforming group as an industry within the stock market. The stocks that we invest in have generally been underperforming and that’s been driven by a couple of reasons. One, they’re just part of this very large universe of companies that, frankly, are not part of the FAANG group.

So, the FAANG stocks, as we all know, have just been ripping and as a result they’ve really helped, they’ve really been the primary driver of why equity markets have recovered and done better than probably what many would’ve expected in the year of a pandemic this year where the economy’s been shut down the way that it was. So, that’s been part of it.

But, part of it as well is just all this uncertainty as to what are going to be the long-lasting impacts of the pandemic and what’s it going to mean for real estate and, particularly, what’s it going to mean for sectors that maybe in unforeseen ways that one couldn’t have seen previously. And really, it boils down to this, as I relate it to your experience, Tony. We’ve been forced to work from home as a result of the pandemic and in being forced to work from home, we’ve also come to realize, hey, this works pretty good. This is—this works better than what we expected.

So now, the big question that’s coming, you know, into focus is the question of how are companies going to react, how are workers going to react when they’re no longer tied to a location that—when work can be done from anywhere. It can be done from home. It can be done from anywhere in the country, anywhere in the world. And so, no one quite knows the answer to that just yet. That’s going to literally take years to play out and that’s creating a lot of uncertainty regarding the companies that own real estate that I invest in.

Tony Roth: Kelly Rush:
Tony Roth: But there are a lot of distinctions to be made within the commercial real estate space. Are there areas that are doing well and areas that are doing poorly? Is all office space doing poorly? Is some doing well?

Kelly Rush: If you narrow the focus to real estate, we can see that within real estate it’s been a bit of a microcosm to what’s gone on in the broader equity market and insomuch that we have our own group of sectors that have markedly outperformed in this environment and we’ve had some that have lagged. So, the big outperformers have been companies that own large logistical warehouse facilities that are supporting the e-commerce industry, so our industrial sector. Owners of special-purpose space that’s used for the life science industry and the biotechnology industries, that’s been a very popular in favor sector and those stocks have done quite well. Owners of data centers, owners of mobile cell towers, owners of single-family residential homes that they own that they rent that are largely in suburban areas, these have all been groups of stocks that have been part of the haves if you will.

And in terms of the have nots, now we already mentioned office. Likewise, lodging’s been under a lot of pressure and then retail with the already-in-place trend toward increased e-commerce. With that only accelerating as a part of the pandemic, we’ve seen the need for physical stores be reduced and those have been among the group of stocks that have been in the have not group.

Tony Roth: All right. So, let’s just parse some of these out even more specifically and let’s stick with office for a moment. We have what I see as this tension, if you will, if I was an owner of those kinds of assets where, on the one hand, it would seem that they’re somewhat immunized from the immediate impacts of the lockdowns and the closures, because most commercial real estate are going to have, of course, very long lease terms with that. So, unless the lessee is actually going to go bankrupt, the property owner is going to be able to continue to collect rent in most cases I would imagine.

But then, on the other side of things as you noted, Kelly, so many people are, in fact, recognizing, whether you’re on the employer or the employee side of the divide, that people can work from home successfully and maybe will never get back to the sort of full in-office employment that we had prior to the pandemic. How do those two forces play against each other and where are they going to shake out do you think over the longer term?

Kelly Rush: Well, the good news is that if you’re the owner of an office building, you have a bit of a reprieve provided that you’ve got good credit quality in your building today in terms of your tenants and so you have these enforceable contracts where they’re obligated to make good on their rental payments. And so, it essentially buys you some time as a landlord to weather the storm to see how this all plays out in the end. And no one really knows the answer to that today. It’s going to take some time to sort that out. So, it buys you time as an owner of an office building.

However, in the public markets, which is where I am active, the markets are very swift in reacting and they’re anticipating what they see the future to be, which helps to explain why office stocks have been under as much pressure as what they’ve been under this year having fallen by about, oh it depends on which stock you’re talking about, but they’ve lost roughly a third of their value this year.

Tony Roth: And while there are certainly companies like Microsoft that have already been quite public around their commitment to allow, in the new normal, post-pandemic employees to work from home permanently, not all of them of course, but some population. So, do you have any sense of what percentage of their business the providers of this commercial office product are going to be losing?

Kelly Rush: It’s really too early to tell. I mean any number I would give you, and I can give you a range. But it’s highly speculative. It’s just too early to tell.

But I think, I would suggest to you that most industry observers would suggest to you that one could say with a fair amount of confidence that in terms of long-term demand that we would estimate that it’s been diminished anywhere from let’s say a range of 10% to 20% and that’s a pretty conservative estimate. Some would tell you that’s too low, that it’s going to be even more than that. And, frankly, no one really knows at this time.

Tony Roth: Yeah. But certainly, very material in terms of margins

Kelly Rush: Yeah. In the end, it’s material. There’s going to be a material diminution of demand for office as a result of this. The only issue is how much. And from my perspective then, you know, my challenge then is what’s being embedded into the stock prices and those are the judgments I and my team are having to make.

Tony Roth: Staying within the office space, Kelly, one of the areas that I see somewhat of a trend is that we’re seeing a lot of folks that live in the suburbs that had erstwhile commuted into the city to go to the big office tower. And perhaps after the pandemic they will have the ability to go to a more localized suburban office, maybe smaller, maybe less people. And it’s something that employers might have to do in order to accommodate employees to get them into an office at all or it may be something that just makes sense in terms of smaller groups working together successfully.

And New York City is an area in particular that a lot of folks are worried about, Midtown Manhattan real estate. What’s the long-term impact there? A lot of folks moving out to the Greenwiches and the Summits of New Jersey and so on and so forth But then on the other hand, you’ve seen the Amazons and Apples and Googles take up massive space within Manhattan recently. So, maybe you could just sort of flesh it out for us a little bit.

Kelly Rush: Well, first one I’ll grab onto is your comment regarding the Manhattan leasing that’s occurred recently. Those were all trends that were in place pre-pandemic. So, really you can almost disregard that in terms of what implications that has for the future.

What the situation today is we’re in a very, very dynamic environment today where we’re all trying to sort out what’s going to be the impact of the pandemic and what’s going to be its long-lasting impact. And we’ve just come through a period of time where there’s been this trend over the past, say throughout this century to date, the past 20 years, where we’ve seen this shift toward moving toward the most popular, call them 24/7 cities, 24 hours, seven days a week, active, chance to work, live, and play, entertainment opportunities, nightlife opportunities, restaurants and whatnot, just people being very much attracted to those types of cities. And so, what’s occurring today that arguably in some ways being caused by the pandemic, but there are other factors contributing to it as well is have we reached an infection point where we’ve seen a zenith in terms of the popularity of this move of—that’s been occurring over the last 20 years and are we now going to start to see that reverse somewhat, somewhat as a result of no longer being tied to a location as a worker.

So, you can increasingly work from anywhere, as you mentioned earlier. But then, also contributing to that is just the rising cost of living in some of these locations and by moving outside of them you can offset that and gain more space in terms of where you live. And so, what many would suggest, and I would tend to subscribe toward is we probably have seen the peak of that shift that had been going on the past 20 years.

What’s difficult for any of us to gauge is, is it completely reversing now, or does it just mean that that growth of … somewhat? My guess is the truth is somewhere in between there, that it’s not just going to be a complete reversal. And then what we’ll have to sort out is, is this a shift toward the suburbs? Is this a shift toward secondary cities in the U.S.? Which are going to be the beneficiaries? And those are all issues that we’re having to work through.

Tony Roth: Yeah. It’s fascinating, isn’t it. Certainly, it looks like the pandemic and some of the social stress we’ve had in the country in the form of various riots and racial issues and whatnot, coupled with the perception that cities may be more dangerous from a health standpoint, at least the short-term forces that are acting on the real estate market as people do somewhat migrate out of those top-tier cities into burbs and second tier cities. What impact does it have on the multifamily residential real estate market?

You know, when I think about the Millennial, it was always the case that Millennial was going to live in the big city, never buy their own home, live in an apartment forever. And we’re seeing a big resurgence in the housing market, particularly for first-time homes. We’re seeing Millennials sort of shifting their behavior pretty radically. It would suggest perhaps that multifamily residential, at least in big cities, may not be as attractive or do you see it differently?

Kelly Rush: Observers have long anticipated that Millennials were going to start to increasingly shift toward wanting to own larger space, live in suburbs, starting families. And so, that’s been anticipated for some time. Arguably, the pandemic’s been a bit of an accelerant there in terms of more of that occurring. As a result, somewhat because of that factor, but then it really ties back to this bigger issue that we mentioned earlier, this key question of when we’re no longer tied to an office space, where will they choose to live? Where will companies allow them to live?

And so, if you have a reduced propensity to live in a large urban center, then you’re going to have reduced needs as it relates to housing in those centers. And so, it’s really been brought into question what’s the value going to be, what’s the earnings potential of a large luxury apartment building in Manhattan? And that’s really been brought into question as a result of the pandemic and that’s part of the dynamic environment that we exist in today is that people are trying to sort that out.

But I can tell you that the stock markets quickly voted by saying we’re really concerned. This looks like this could be, could have a very negative impact on those types of properties.

Tony Roth: So, let’s maybe get into some other areas of the commercial real estate space.

You mentioned industrial warehouses. We’re all aware of the big trend to e-commerce and digital consumption for goods that has only been accelerated with the pandemic. And we had actually brought to market, Kelly, a couple years ago or so a industrial warehouse fund with one of the, we think, best sponsors in the country in that space and it’s done phenomenally well for us. Is it an area that is overbaked at this point or is there still opportunity do you think in the, sort of that ecosystem that supports the distribution chain for e-commerce?

Kelly Rush: Well, one of the things that we do when we’re making our judgments when at Principal Global Investors is, we spend a lot of time talking with our people that manage … assets for our investors that want to be in the private markets. And we just had our most recent meeting with that group, and I walked away from that meeting just even more convinced about just the enduring nature of some of these trends and investor interest in industrial properties going forward.

So, we have a very positive outlook as it relates to industrial and feel quite good about it going forward. And part of the issue behind that is that there’s a lot of money out there looking to find its way into alternatives. There’s a lot of money looking to find its way within the alternative space into real estate and as a private investment, yet that money is very reluctant to buy its way into things like office buildings, into retail properties, into lodging properties.

If you just watch some of the headlines, there’s large groups such as Blackstone that’s a big investor that really isn’t looking to make contrarian investments in those assets and instead into those types of assets. So, increasingly, you’ve got more money funneling its way into things like industrial, property types such as industrial. And so, as a result we think … very supportive for that sector going forward. And so, no, we don’t judge it to be overbaked at this time, see nothing but very strong supportive tailwinds for that sector going forward.

Tony Roth: And it’s interesting, Kelly, one of the other areas of focus for us is, in fact, the retail space within this theme in our Capital Market Forecast. And one of the observations that we note there is that with all of the acceleration that we all feel in our own lives, if you will, in consuming through our computers and our phones as a percentage of total retail spend, e-commerce has moved from around 13% to maybe 16% or 17%. So, it’s still a fairly modest percentage of the overall pie and there’s a lot of room for growth there, which all needs to be supported by industrial warehouse.

And then, of course, their models are changing too. As they move to more immediate delivery, they need smaller spaces that are closer into the populace. So, lots of trends supporting that area, I think.

You mentioned lodging. So, lodging is an area that, boy, I wouldn’t want to be a hotel owner right now, right, because hotel owners, airplane owners, etcetera, they’re not assets that people are comfortably utilizing for the most part. How do you think about the future of lodging? There are important distinctions to be made around business versus more vacation type of properties. What’s your take there?

Kelly Rush: Sure. Well, first, I’ll just mention upfront that we do study lodging very carefully. It is worth noting that within our universe that we have to invest in, whether you’re talking the U.S. or global, it’s a pretty de minimis portion. It’s really not a large portion of our universe that we have to invest in. But, having said that, we do follow it very carefully.

Within the lodging space, you know, the big issue is around, now that we’ve all gotten accustomed to doing more and more meetings via Zoom, via Teams, that will there be diminished need for business travel going forward? Will companies see that as a potential area for cost savings? Now that it’s become customary, will it become more acceptable business practice, if you will?

Well, the question is just how much, you know, in the end still that first, that face-to-face interaction is going to matter and we don’t think that’s going away entirely. And then the second consideration around this is that not only will business travel likely be reduced, but there’s likely going to be not just for meeting purposes but also in terms of conferences, we expect that there will be fewer conferences going forward. We’ve found as a team, my own team, that we’re actually attending more conferences now that we’re able to do so using Zoom technology.

And so, our suspicion is that we’ll probably move toward more conferences that are done in some sort of hybrid fashion where some will travel, and some will not. But that will enable those that don’t travel to attend more conferences. And so, as a result, again, less need for hotel space as a result of that.

In terms of leisure travel, we really see that as being a short-term phenomenon. We—it’s been diminished, of course, this year. But we think that that will come back. It’s just a matter of time and it’s just more a question of when do people feel safe to do so again. And again, we expect that to be a short-term phenomenon.

Tony Roth: So, from an access and investment exposure standpoint, Kelly, if you’re a retail investor or maybe even have access to some private REITs, are there vehicles that have historically made that discrimination between vacation hotel property, lodging property versus business and have focused on one or the other so that going forward people looking to put money to work in the real estate space in the—specifically in lodging can direct their money towards the kinds of opportunities that we think are going to come back hard once we get the vaccine, and sort of stay away more from the business focused hotels?

Kelly Rush: Within our universe of publicly traded lodging companies, those are choices that are available to us. We have some companies that focus very much on the leisure traveler and some that focus on the business traveler and some that do a mix. So, within the public universe, that’s very much a choice that one can make.

Now, you had asked me about private REITs that’s really an area that I don’t study carefully. But I would suggest that I know just enough probably to indicate that there is probably—there are probably limited options available for doing that sort of segmentation within that universe. In fact, most private REITs tend to be a little more diversified in nature where they’re not single property type specific. But, again, I’m not the expert in that area, so I’ll defer to others who know more than me there.

Tony Roth: All right. Fair enough. I did want to ask you as well that, most owners of these commercial assets, whether it’s an office building, a hotel, a retail mall, even retail, smaller retail storefront-type of properties, certainly industrial warehouses, most of these things are financed and we’re in an environment now where we’ve moved from record low interest rates to more record low interest rates, new records. How significant is that further shift to essentially almost a zero-rate environment on the front end of the yield curve for property owners? Does it give them an opportunity to refinance and is it really material to their overall income statement when they look at their expense side of that?

Kelly Rush: It’s really helping them in two ways. One, it’s it is helping from a refinancing standpoint. To the extent that they’ve got a maturing loan on a property, they’re able to refinance at a lower cost. Or if they’ve got, you know, limited prepayment penalties, then they can take advantage of that as well.

So, in some modest ways it is helpful to property owners. Within our space of public real estate companies, many of them are fairly conservative as it relates to the amount of leverage that they carry, and rightfully so. And so, while they do gain some benefit from it, it’s not a big, big material benefit that they’re deriving that in a big way is changing our future earnings forecast for these companies. So, on the margin helping a bit but not a big, big difference maker.

It is also supportive in terms of real estate value. A low rate world is supportive of lower required rates of returns or what are known as capitalization rates on purchases or when you’re valuing properties, much akin to when people talk about looking at stocks and the valuation of stocks and it being supportive of low discount rates for stocks that both of the—that a low rate world is supportive for risk assets such as real estate. And so, it’s, you know, supportive for real estate values and those are the two ways in which the low rate world has had a positive impact on real estate owners.

Tony Roth: I mean certainly as investors we’re always looking for income streams and we’re looking for income streams to replace bonds now more than we ever have. And to the extent that we can find real estate assets that continue to have good income streams associated with them, they, they’re especially valuable in diversified investment portfolios. Kelly Rush: Tony Roth:

Kelly Rush: That’s one of the interesting things about what’s going on in the market today is that you’ve got a group of stocks, real estate among them, there are other stocks as well that offer a pretty healthy dividend yield in such a low-rate world. Yet, they’re largely being disregarded by the market simply because they’re not offering the growth that those select few FAANG stocks, that they’re offering. And so, investors could be well-served to look at making sure that they have diversified portfolios with exposure beyond the most popular, you know, just buying more Amazon stock if you will, and looking to buy something that’s been out of favor that’s not been performing as well but yet still offers a reliable and secure dividend yield, which real estate does fit into that group.

Tony Roth: Yeah. Couldn’t agree more. And that’s exactly what we do in our portfolios. We do have a hard real estate allocation in our portfolios and we work hard to find those opportunities. So, the last question, Kelly, is because the commercial real estate universe is just so incredibly broad, I thought I’d just throw it open to you to ask are there other areas of commercial real estate that we might not have touched on that you think, even if they’re a bit specialized, perhaps that you think our listeners should just be aware of that may continue to present opportunity and do well notwithstanding the environment we’re in.

Kelly Rush: So, of our universe, we’ve spent a disproportionate amount of our time talking about roughly a quarter of our universe that I have to invest in. We’ve talked a lot about office and retail and lodging stocks and that’s certainly a part, a big part of our real estate universe that we have to invest in. But it’s still roughly it represents about 25% of our universe. We still have a number of other areas, some of which have been very, very much in favor. We’ve seen very strong price performance. And I mentioned some of those earlier.

But then there’s also been other sectors where they’ve seen nice steady, resilient demand as well. We’ve seen the self—owners of self-storage do have reasonably strong fundamentals, consistent demand there for that sort of space. We’ve seen other sectors that are large, notable sectors that have been under pressure I would suggest primarily for short-term concerns but longer-term should end up standing up and doing well. And specifically, I would highlight the multifamily sector in that area. Eventually, people do need to have a place to live and so this is a necessity-based sector that we believe that’s been punished quite a bit that does represent some good value opportunity that we have to look at in our universe.

Likewise, owners of health care facilities, they’ve been under a lot of pressure this year as well as the pandemic has certainly torn through in a very, you know, very negative way in terms of their population, resulting in death in many and just increased costs in terms of running these facilities. And so, just as a result, as a result of the pandemic there have been a lot of pressures there. But as we all know, that there’s a long-term demographic shift of an aging population for the need for health care facilities. So, over time that will eventually recover, and we’ve seen some of these stocks, we’ve seen the stocks be under some pressure this year.

And so, there’s a large percentage of our universe, some of which has been under pressure for short-term needs that will recover, some sectors that have really actually done reasonably well that have been thriving as a result of the pandemic, and then there’s this third basket that we’ve spent a disproportionate amount of time on today that have been under a lot of pressure. There’s some companies that are poised to do well longer-term once we come out on the other side of this pandemic. And then there’s a group of companies that are, you know, there’s kind of a fog around that only time will tell how they perform and those are the ones that we’re having to, you know, that we’re going to have to be patient on to see how that all unfolds.

Tony Roth: Well, certainly it’s an area that requires deep expertise in all of the various nuances and distinctions of these types of hard real estate assets. And we could go on. There’s so much more to cover. But unfortunately, we’re out of time.

So, I’m going to summarize the three key takeaways, as I always do. And I’m going to start with the idea that while there are some subsectors of the commercial real estate space, like office in particular in urban settings, maybe storefront retail, malls, etcetera, that are under a lot of pressure right now. We really have to find out what the long-term impact is going to be on some of the underlying trends, like working remotely, etcetera. We know there’s going to be an impact, but we don’t know how profound the impact is going to be.

And in the meantime, there is some headwind, excuse me, tailwind for these assets through the ability to have longer-term leases if you have high credit tenants and maybe some refinancing options to help a little bit on the margin as well. So, those particular areas, while not probably set up for a swift recovery, over time there may be some really good value there.

Second is that those demographic trends around working from home rather than being in the office are going to play out in lots of different and interesting ways, not just from urban to suburban, but also tier-A cities versus tier-B cities perhaps, continued what we’ve seen for decades Northeast to Sunbelt states. And those trends will present their own set of opportunities. We are here at Wilmington Trust looking very carefully at bringing an opportunity for qualified clients to invest in just that, which is multifamily residential real estate in primarily what we have historically thought of as B-tier cities, but which are for many younger people the choice cities to live in these days.

And then lastly I would say that in a diversified portfolio it continues to be critical to structure income into those portfolios, not only to provide income to the beneficiaries of the portfolios, but also to provide some shock absorbers, some certain sources of return in a lower return environment going forward. And lots of different kinds of real estate continue to be very sound sources of income and continue to comparatively be much more interesting than the traditional sources of income, which are bonds. And so, we think that in building good, diversified portfolios here at Wilmington Trust, and Kelly, you’ve helped us corroborate this, that real estate, carefully selected, really, has a very important role to play.

So, with that, Kelly, I want to thank you so much again for being here and helping us understand the commercial real estate space today.

Kelly Rush: Thanks for having me, Tony. I’ve enjoyed it.

Tony Roth:
And I want to remind our listeners how important it is to have their portfolios and wealth plans stress tested to see how they stack up, particularly during this very uncertain period in the COVID pandemic and the slow economic recovery that we continue to undertake here in the economy in the U.S. and globally.

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Listen to other episodes from our 2021 Capital Markets Forecast series:

The outlook for travel & tourism  with Axel Hefer, CEO of Trivago

The outlook for retail with Mark Mathews, Vice President of Research Development & Industry Analysis, National Retail Federation