A Secular Shift in Real Estate?

Weizhen Tan of CNBC reports banks may have to brace for heavy losses as commercial property prices plunge:

Commercial real estate prices have plunged this year as people stopped going into offices, and retail businesses were disrupted. That could lead to a significant amount of losses for banks, according to a recent report.

In previous downturns, commercial property loan losses were “heavy” and there are worrying signs that such a trend could be repeated this time during the coronavirus-induced slowdown, Oxford Economics’ Adam Slater said in a report.

In a worst-case scenario, Slater said these loan losses would “materially erode” bank capital.

“Large (commercial real estate) price declines generally translate into big losses for banks. Write-offs of (commercial real estate) loans made a big contribution to overall bank losses in the last two major downturns,” wrote Slater, an economist at the firm.

During the 2008 great financial crisis, for example, such loan losses accounted for between 25% and 30% of total loan write-offs in the U.S.

This time those risks look highest in the U.S., Australia, and parts of Asia such as Hong Kong and South Korea. In these economies, lending growth has been high, with “significant” loan exposure. But commercial property prices are already sliding, especially in Hong Kong, the report said.

In Singapore, office rents had their steepest decline in 11 years in the third quarter, official data showed on Friday. Rents for office space fell 4.5% in the latest quarter till September.

The firm’s index of global commercial real estate prices based on seven large markets show they are down 6% from last year.

“Could the coronavirus crisis lead, via the commercial property sector, to long-term problems for the banking and financial systems? … we think it is a genuine concern,” Slater wrote.

“Currently, hotels are running at very low occupancy rates, retail units have seen sharp declines in customer footfall, and many offices are closed or running with very low staffing levels,” he said. “In these circumstances, rental income and debt repayments from affected sectors are in grave doubt.”

Oxford Economics analyzed 13 major economies and found that write-offs of 5% of loans would amount to the equivalent of a loss between 1% and 10% of banks’ tier 1 capital, their primary funding source including equity and earnings. The biggest impact would be felt in Asia, it said.

Bond investors may also be at risk.

In the U.S., around half of the lending by this sector is not made through bank loans, and that includes the issuance of bonds in the sector, according to the report. In parts of Europe and Asia, that proportion of borrowing through the non-bank sector has risen to 25% or more, in recent years.

“In the case of property funds, (commercial real estate) downturns could see a rush by investors to redeem their holdings leading to fire sales of assets — amplifying price declines and broader loan losses,” said Slater.

But there’s one bright spot. Banks are in better shape to absorb them as compared to a decade ago. Their capital and leverage ratios are around double the levels a decade ago, Slater said.

Following the financial crisis, reforms were introduced to mitigate risk and improve the resilience of the global banking sector, by maintaining a certain leverage ratios and levels of reserve capital.

Big banks are definitely in better shape now to "absorb" major losses in commercial real estate and bank loans that go along with the sector.

But don't be fooled, banks are still petrified of a significant downturn in commercial real estate and so are pensions and sovereign wealth funds

Back in September, JPMorgan warned about a "troubling" sign: productivity of its youngest employees working from home was slipping.  

Of course, to me, this was all nonsense. The real reason JPMorgan wanted people back at the office wasn't because productivity was slipping among younger staff (we're in a pandemic, productivity is necessarily slipping as people deal with it as best as they can), but to set a precedent so other companies would follow (and fight the rising tide of office vacancy rates).

Some did but then we got the second wave of COVID-19 and that put a stop to plans to bring employees back to the office.

These days, it seems like there are vested interests arguing against working from home (WFH) and for working from the office (WFO).

Show me where someone works and I'll tell you where they stand on this ongoing debate.

For example, Brookfield posted some research on why the future of the office isn't what you think.

Great research from one of the best real estate funds in the world but in the back of my head I kept thinking they're talking their book and some others who I shared the research with told me they're "grossly arrogant and need a good dose of humble pie".

On LinkedIn, I've been tracking postings and comments from Jonathan Pearce, EVP Leasing & Development, Office & Industrial at Ivanhoé Cambridge, CDPQ's massive real estate subsidiary. 

Jonathan is a very smart guy and has huge responsibilities, especially now in a very difficult environment. 

I'd say he's more careful and balanced in his views but even he lets people know where he stands posting articles like these:

Three tips avoiding WFH burnout? What about WFO burnout? Here's my tip for that: avoid the office as much as possible to avoid toxicity and you'll be fine.

In all seriousness, here is what I posted on LinkedIn:

Good article but let me give you all some tips since I have plenty of experience. WFH has its drawbacks and it’s advantages. Focus on the advantages and take advantage of them. No, you don’t have to wake up at an ungodly hour to catch a train to work but get up early, go for a brisk walk in the morning to get blood flowing and clear your mind. Do your house chores first thing in the morning (if you want to change the world, start off by making your bed). Next, eat a healthy breakfast, make a delicious shake, enjoy your coffee, as you watch morning news and plan your day and take shower to wake up. Never mind wearing a suit (unless you have to), stay disciplined, stay focused, stay engaged and do what works for you. I like research and reading in morning, watching and trading markets and my productivity increases as the day goes by, hitting its peak in afternoon. That’s me, others are morning busy birds, then they wane off early in the afternoon. Respect diversity and realize people have children or other responsibilities and things going on in their lives. We aren’t all the same but obviously you need to make sure you deliver your work on time and in a professional manner. 

Even when I was working at the office, I was going in at 9 - 9:30 and never leaving before 6:30 or 7 p.m. at night. Why? Personal health reasons, mornings were always brutal for me (still are but a bit less so since now I wake up early naturally) and to be honest, I loved it when everyone left the office so I can sit and focus between 5 to 7. 

I found that was my productive time, no useless meetings to take up my time, no distractions from colleagues, I can just sit, read and produce. 

That's why I take all these arguments that WFH is detrimental to your well-being and very unproductive with a grain of salt. It's nonsense, people know what is expected of them, they are disciplined and know how to structure their day and can accomplish a lot more working from home.

In fact, there is a danger that you go overboard but all you need to do is communicate your boundaries firmly to your boss and colleagues and if they're understanding, they will accommodate you.

I don't know if you have noticed but the nature of work is changing. It's not just the pandemic, it precedes it.

Last year, I did a brief stint at KPMG. To be truthful, the job was a nightmare because they didn't think things through properly and didn't know what they wanted but the people were nice (for the most part, a few special cases there too). 

Anyway, what I realized being gone from an office environment for so long was that millennials are very different from my generation as we were from the one that preceded us.

For them, it's all about work-life balance, not stressing out too much, let's all be collegial, take our coffee breaks, chat about the latest vegan restaurants and health trends, and so on. A bit self-absorbing on one level but refreshing and honest on another (they've got their priorities right).

At one point, I told a buddy of mine "I feel like I'm in the Twilight Zone" and he laughed and said "welcome to the millennial and Gen-Z generations, they demand work-life balance, want to change the world but also want to get paid big bucks for doing so". 

I'm being a bit facetious and obviously there are plenty of younger folks who work their tails off and we shouldn't generalize but the culture shock really hit me hard, felt totally out of touch, like a dinosaur from another generation (back in our day, you were lucky you had a job, were expected to suck it up and earn your stripes by working like a donkey and drink your problems away, lol).

Where am I going with this? The nature of work is changing, the lines between working from home and at the office are totally blurred and I suspect the younger generation is totally fine with this. 

In fact, if you did a poll, most people would say they miss some office interactions but if you had to put them on a polygraph, they'd unequivocally tell you they prefer working from home.

What about building culture? What about it? The younger generation builds culture via Instagram, Tik Tok, YouTube, Twitter, LinkedIn. They don't need to physically be in one location to "build culture".

What about mentoring? There, I agree, it's tough mentoring someone via Zoom and Teams but when I was working at the office, there wasn't as much mentoring going on as I wanted (only lucky few had real mentors). I pretty much had to get into people's faces to learn things I needed to learn and most of the time, had to figure things out on my own.

The younger generation is a lot more versatile than my generation and they are much more adaptable and flexible.

Leading tech companies know exactly what I'm talking about which is why they're being more flexible with their workforce, allowing them to work from home, in some cases forever.

What do I make of Google's announcement to expand its San Francisco office despite shift to working from home during pandemic?

Well, to be honest, not much. It's normal given that San Francisco office rents are plunging and showing no signs of bottoming as big tech firms explore cheaper cities or allowing employees to work from home. 

I would caution people not to read too much into such actions, look at the bigger picture, which is giant tech firms are setting aggressive goals to lower their carbon footprint over the next decade and like it or not, one way to do this is by allowing their employees to work from home, wherever that is.

And Big Tech sets major trends in commercial real estate. They're not the only employers but their impact is huge, they tend to be leaders and everyone else follows.

In a world where companies are competing for top talent, especially top tech talent as the economy goes digital, it's impossible to ignore what Big Tech is doing to attract talent, including offering more flexible work options.

Even Ivanhoé Cambridge's Jonathan Pearce notes the following: 

"As many of us continue to solely WFH due to the pandemic, the future that seems to be resonating most with many looks to be an agile hybrid where employers must give choice, and employees will demand it. But whether it’s WFH or WFO, the office will need to continue to evolve to support this flexible way of working."
He's right, offices need to evolve to reflect evolving demands of clients. 

Over the weekend, I saw a friend of mine, Elias Retsinas, a top real estate lawyer and partner at Fasken’s Montreal office. 

Elias mostly (but not exclusively) deals with big developers. He told me AAA offices are seeing more and more solid tenants renovating their offices, adding a few conference rooms, making the office spaces more spread out and adding space where needed (landlords get fees when tenants renovate so they're fine with it, especially if these tenants sign longer leases).

He said some smaller companies are opting for WFH but others are gearing up for the post-pandemic world where they want their revenue generators in the office a few times a week and will likely allow support staff to work from home. 

He emphasized, however, "we are not heading back to pre-pandemic levels any time soon, that will take a while."

And in Retail real estate, which is getting massacred, he said if pensions adopt the long view, they can make a killing because the land is worth a lot to developers who can build multi-family residences and have a few anchor stores at the bottom like a pharmacy, a grocery store or a gym.

I was driving through Marché Central this weekend and then cut through Rockland shopping center to go home and was shocked at how busy the malls were (people are fed up being cooped up).

Marché Central is owned by BCI's QuadReal and the land is a developer's dream. Rockland used to be owned by CDPQ before it started shedding its massive retail portfolio. Great spot but the traffic around there is horrendous and the Quebec Government needs to redo the highway juncture (let's see how the new mega mall project goes).

The point is Elias is right, many retail real estate locations offer pensions that own them tremendous long-term opportunities to develop them, if they team up with the right developers, especially now that construction costs can be easily absorbed (borrowing costs are low given prevailing interest rates, however, the costs of construction are actually going up but the low financing rates are offsetting that to some degree).

But the pandemic has also impacted multi-family residences in big cities as people look to get out of apartments and condos to buy single family homes in the suburbs.

In fact, the Wall Street Journal reports a housing crisis centered on the vast apartment and home-rental markets is emerging in the US, threatening to send millions of renters into eviction and leave landlords short billions of dollars:

When you think about the effects the pandemic has had on Retail and can potentially have on Office and Multi-Family, you begin to understand why big pensions are very worried.

Retail typically makes up 15-20% of a real estate portfolio, Office & Multi-Family can make up 40-60% and Industrial the rest. That's a big chunk of assets that can potentially be impacted since Real Estate typically makes up 15% of a large pension fund's total assets.

Real Estate used to be the best-performing asset class at CDPQ and other large Canadian pensions in terms of risk-adjusted returns over the long run (private equity is best in terms of absolute returns).
The best way to view Real Estate is like a leveraged bond, offering you steady returns between stocks and bonds, but the pandemic has changed this in a very big way and it's also impacting other big transportation infrastructure assets (airports, toll roads, etc.).
But it's the long-term and lingering impact of the pandemic on real estate that worries me more than other assets. 

Let me blunt, back in May, I discussed whether a paradigm shift is going on in real estate, but now I'm more worried of a secular shift in real estate with long-term effects on the portfolios of global pension and sovereign wealth funds. 
To be sure, many pensions will use the pandemic to write down underperfoming retail assets but I worry this is only the tip of the iceberg.   

Leo de Bever used to tell me: "Real Estate keeps me up at night." Back then, he was worried of an unanticipated inflationary shock sending rates soaring.

Very few pensions were prepared for the unanticipated deflationary shock of the pandemic and if unemployment starts climbing again, Real Estate will keep everyone up at night for other reasons.

It's not a lost cause. The current environment is great for the Blackstones and Lone Stars of this world which love buying distressed real estate assets on the cheap:

But buying distressed assets here isn't going to deliver the same returns as in the past, the landscape has changed irrevocably, we aren't going back to pre-pandemic levels even if we introduce a new vaccine and better testing.

Alright, I better wrap it up here. Once again, this and other comments represent my views and I don't hold a monopoly of wisdom on pensions and investments.

If you have anything to add, feel free to email me your thoughts at LKolivakis@gmail.com.

Below, Jeffrey Sherman, Deputy Chief Investment Officer of DoubleLine Capital, moderates a discussion by four experts in these asset classes, their capital markets and real estate-related market securities. Participating in the discussion are Bill Hughes of Colony Capital, Ryan Simonetti of Convene from DoubleLine Capital Morris Chen and Ken Shinoda and Jeffrey Sherman (embedded Part 1 and 2). Great insights into real estate market.

Third, Ryan Simonetti, CEO and cofounder of Convene, joins “The Sherman Show” to discuss the future of commercial real estate, particularly in the office and hospitality sectors. Convene designs and services premium places to meet and work. Founded in 2009, Convene has transformed the workplace and meeting place by bringing together trends in technology, service and amenitization, which is the lifestyle movement that transformed hotels and luxury fitness clubs. Great insights here too.

Also worth noting, Ivy Zelman, CEO and co-founder of Zelman & Associates, spoke with “The Sherman Show” hosts Jeffrey Sherman and Samuel Lau on the state of the multifamily and single-family housing markets and her outlooks for these asset classes. Founded in 2007, Zelman & Associates provides research, analysis and advice about the U.S. housing market and related sectors to investors and business leaders. This edition of the podcast was recorded Oct. 12, 2020 and not available on YouTube yet but you can listen to it here. Take the time to listen to it and the other views above.

Fifth, Dave Seymour, the star of the show "Flipping Boston," gives his thoughts and predictions about the commercial real estate market. Take the time to listen to him, very interesting insights.

Lastly, recent video footage of how London has fallen. Scary stuff and it's happening all over the world across major cities (h/t, Lisa Lafave)