Wharton@Work

November 2021 | Finance

Return to Normal? Commercial Real Estate Investing Now

Recent headlines reflect the volatility in commercial real estate: pandemic rent discounts are vanishing, business travel remains in a slump, and betting on big-city comebacks is still a gamble. We asked Professor Todd Sinai, chairperson of Wharton’s Real Estate department and academic director of the Assessing Commercial Real Estate and Markets program, for his perspective on the current state of the market and its future.

Wharton@Work: To say that the pandemic caused severe disruptions to the commercial real estate market is an understatement. But there’s a lot of capital right now that investors are looking to spend. Overall, should they be looking for opportunities or waiting it out?

Todd Sinai: One of the big themes of the moment, like it was a year ago, is trying to separate in our minds the current market from what the world is going to look like in a more normal time. Currently, we’re looking at dislocations, mispricings, and other responses during COVID-19 and immediately post-COVID. But real estate investors need to think about how the world will look longer term, and keep the separation clear. Don’t get caught up in what is happening now. Invest with an eye on your long-term prognosis.

W@W: In the year since we last spoke, the housing sector has been incredibly volatile. How should investors respond to trends like population shifts away from cities and price surges?

TS: Housing and apartments are doing tremendously well. Newspapers say we are having an issue with affordability, but the flip side of high prices for houses and rents is high revenue. The shortage of single-family detached houses combined with what I believe is a short-term movement out of cities has put a real push up on prices. That typically leads to more building, and I believe, with high rents and relatively easy access to capital, we can and should be building apartments. Add to that the places where people are “COVID fleeing”: areas with more open space make building even easier. What worries me when we are out of this moment is that as the greater apartment supply comes online it will beat back the growth on rents. We will see where that one settles out. The good news is that typically the apartment sector doesn’t tend to get catastrophically overbuilt. It’s self-limiting: you can’t build enough fast enough.

W@W: What about retail?

TS: It’s interesting. Retail was doing poorly pre-COVID, and the pandemic didn’t help for many in this sector. Traditionally, big malls have fared the worst, but the malls that have a grocery store are doing pretty solidly. They have a resilient tenant base, with business up for grocery stores because restaurants were either closed or just not frequented like they were. People also continue to go to strip-mall staples like Starbucks.

That said, there is just too much space available, which means no retail will do tremendously well. Even with the retail pendulum that swung hard to ecommerce now swinging back, it’s not enough to fill up the available space. Everyone is grappling with this problem. It’s going to take a while for the market to puzzle it out, but generally, there is no future I can see where we will need more retail space.

But warehouses are another story — a bright spot in terms of demand and collecting rent. As economic activity moved online, we needed warehouses to support it. Investors came in, prices went up, and supply continues to increase as more warehouses are built. It’s expensive, but a great sector for people who already own it.

W@W: COVID-19 didn’t just affect sectors differently. We saw and are still seeing how some geographies were hit much harder than others, based on local and state government responses to the pandemic and the move out of cities. Are these changes going to be long lasting? How should investors think about the pandemic-induced urban exodus?

TS:  It’s easy to get caught up in the moment. Right now, at one-third full it’s horrible for office space. The forward-looking investor has to ask where this will settle out. There will be teams and entire companies that will work virtually. Others will experiment with hybrid models until they figure it out. And there will always be people who would rather live with more space, and with a pandemic, their number grew.

But the market on average believes cities are going to recover, and as a scholar, I definitely think that’s true. For every young professional or family that leaves a city, there will be more coming in. There is something about human nature that wants to be near each other. We are social creatures and that isn’t going to change.

But urban recoveries must be synergistic. A vibrant city requires people working there, viable retail, tourists, restaurants, and activity on the streets. When the people aren’t there to work, shop, and eat, when it’s dark and empty at night, there’s a downward cascade. That “live-work-play” experience of a city is a fundamental driver of real estate value, and each piece of that trio is important. It makes it an interesting disruption.

W@W: Where are the best opportunities for investors today?

TS: Today’s market is not cheap. Most sectors are priced above their peak after the financial crisis. There’s a relatively low yield on cash flow, but it’s still better than corporate bonds, which makes it appealing. That said, there is no wind at your back in this market — you need to create value. One way to do that is to look for distressed properties coming out of COVID-19. For example, this past summer leisure travel was way up and hotels did tremendously well, so you might look at hotels that had enough capital to carry them through the downturn but now need rescuing.

In terms of office buildings, if you’re looking for a bargain you have to consider what it would cost to make that building more attractive to tenants. After 9/11, tenants wanted buildings that were resistant to terrorist attacks. Now we are changing how offices are built, ventilated, and laid out in response to COVID-19. Buildings that can be made more pandemic resistant will be more desirable, but that conversion takes money.

Another way of creating value is doing the hard work to create the synergies we talked about to make a location appealing. Beyond being pandemic resistant, an office building is going to be appealing because it’s in a location where some people might also prefer to live and play. But we can’t fool ourselves that it’s easy to create that kind of synergy around a suburban office park. You need people coming back to their apartments at the end of day to overlap with those who work there during the day to economically support retail and restaurants. Real estate development is really trying to make sense of that — can you blue sky a live-work-play location? It’s really hard. You need the right activities, retail, and restaurants. If you can pull it off, you can create a lot of value.

W@W: In general, what are your thoughts on COVID-19’s effect on real estate? Where do we go from here?

TS: Although I don’t believe COVID-19 was an existential threat to real estate, that doesn’t mean many people didn’t lose a lot of money. When you invest in real estate, it is only ever in one location — and the relative value of that location can change dramatically. Whether you think that change is temporary or not will affect your decision to hold onto a current investment, sell, or look for another opportunity. I believe the current situation is temporary, but the human desire for proximity to others is permanent, which is why I believe cities will rebound. As an investor, work at keeping an eye on the long term instead of focusing on present disruptions.