Commercial

What’s Driving Strong Investment Demand In the Multifamily Sector During COVID-19?

by Nathan Adkins, Jing Ren, Neil Blake
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CBRE Econometric Advisors (EA) Analysis of the Strength of the Multifamily Asset Class by Nathan Adkins, Jing Ren, and Neil Blake The multifamily sector’s share of overall transaction activity has grown steadily over the past 15 years. Starting from a quarter of all transactions in the mid-2000s, multifamily expanded to a third of all transactions by 2016, overtaking the office sector, and giving multifamily the largest share of any property type by investment volume. It remains the preferred sector in 2020 with its share reaching a 20-year high of 36%, underscoring investors’ confidence in the sector. In 2021Q1, the share increased even further, to 38%. A combination of recent robust historical performance, resiliency during the pandemic, and expectations of stable future rent growth are fueling investors’ confidence in the multifamily sector. Supported by demographic trends and a growing preference for urban living, multifamily provided high and stable cash flow yields compared to other CRE sectors over the past decade. In the post-pandemic future, investors see multifamily as a safe, stable asset with less volatility and uncertainty than other sectors. Degree of resilience of multifamily sector varied by class, type and region From Q1 2020 to Q1 2021, the U.S. Sum of Markets multifamily vacancy rate increased by 50 basis points (bps), while rents fell 4.2%. This is a milder response than that experienced during the Global Financial Crisis (GFC), when, within a year, vacancy rose by 180 bps, and rents fell by almost 7%. The Sum of Markets statistics are dominated by large, dense, expensive metros which have been harder hit by COVID-19. These large metros saw many of the urban amenities that attract renters to higher priced markets shuttered in the interest of public health, while simultaneously, the prevalence of remote work made it possible to migrate to cheaper, less dense markets. These smaller metros were only lightly affected by these demand issues and most are well on their way to recovery. Additionally, suburban, Class B/C and mid-size Midwest, West and Southeast multifamily markets have all fared better during the pandemic than Class A apartments in urban cores on the East and West coasts. Performance differences in urban and suburban markets Urban core submarkets, like large, expensive markets, lost attractions such as walkable restaurants, bars, and entertainment venues due to pandemic-related shelter-in-place orders. Meanwhile, unemployment from hospitality and service industries put more pressure on urban core already stretched thin for affordable housing. Consequently, the worst-hit submarkets this year have been the urban cores in San Francisco and New York City, where effective rents fell by more than 15% year-over-year. This disparate impact of the pandemic on urban core and suburban submarkets is most starkly illustrated in their recent divergence in vacancy rates. Urban core and suburban vacancy converged in 2015 and have been essentially the same for the past five years. The flight from the shuttered, expensive urban cores is evidenced by a 180-bps jump in vacancy after Q1 2020, reaching 6.1% in Q4 2020, its highest level since Q2 2010. While, in suburban markets, vacancy has remained on its pre-COVID trajectory. As for multifamily rents, urban core submarkets’ year-over-year rents declined by 12.7% from Q1 2020 to Q1 2021, worse than the 11% peak-to-trough contraction during the GFC. Suburban submarkets have been much more resilient, with rent slipping by only 0.1%, compared to 6.7% during the GFC. Performance by Building Class Social distancing measures also disproportionally affected employment in the services and hospitality businesses, which tend to pay lower wages. In theory, disproportional impact on low-income categories of workers should negatively affect demand for Class B and C multifamily housing, but this wasn’t the case. Higher unemployment rates in the low-wage service industry did not translate into higher vacancy rates in Class B and C. Due to supply constraints, Class B and C have been outperforming Class A since 2015. Rather than seeing this gap shrink with the onset of the pandemic, we saw them diverge further, as vacancy rates for Class A units jumped to 6% in Q1 2021, a 130-bps increase from the year before, while Class B and C vacancy rates stayed relatively stable. One possible explanation for the relative underperformance of Class A in light of these labor dynamics is that high-income renters are more able to work from home, and therefore have more flexibility in choosing where to live and whether to buy or rent housing. Recently enacted government policies, such as eviction moratoriums, also contributed to Class C overperformance. According to a recent U.S. Census Bureau Household Pulse Survey, about 14.5% of all renter-occupied households were behind on their rent payments. For households with an income of less than $50,000 a year, 20.3% were falling behind on rent payments. Performance by Market Despite the ongoing pandemic, out of the 69 multifamily markets tracked by EA, 51 recorded positive rent growth from Q1 2020 to Q1 2021. While some renters chose the suburbs over downtowns within the same metro area, others went further and moved away from gateway cities to secondary and tertiary markets, often to be closer to family. Consequently, markets with the highest annual rent growth in Q1 2021 were mid-tier markets: Riverside, Sacramento, Albuquerque, Tucson, Memphis, and Richmond, where rent grew over 6% year-over-year. With downtown commercial activity severely affected by the pandemic, rents fell furthest in major U.S. metropolitan areas, such as San Francisco, San Jose, Oakland, New York and Boston, where rents fell by at least 6% from Q1 2020 to Q1 2021. We expect this trend will reverse starting in 2021 and throughout 2022, with demand shifting back to major metros. Economic outlook and multifamily forecast According to an advance estimate of the Bureau of Economic Analysis, the U.S. economy grew at 6.4% (annualized rate) in Q1 2021. The April 2021 unemployment rate was at 6.1%, a considerable decline from 14.8% recorded in April 2020, but still above 3.5% recorded in February 2020. We expect the U.S. economic recovery to accelerate throughout 2021 with new household

Offices Face Quantum Shift Post-COVID

by Paul Fiorilla
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The Metamorphosis of the Office Market by Paul Fiorilla No sector of commercial real estate faces more uncertainty going forward than offices. Companies found during the pandemic that work can be accomplished productively from home, and many workers found that they prefer shorter commutes and more flexibility. Demand for office space will be reduced, and workspaces will be redesigned. The only question is how much of a disruption will occur. Offices have taken quite a hit from COVID-19, even though the measurable cost has been obscured by the long-term nature of office leases. The U.S. office vacancy rate climbed to 15.9 percent as of April, up 280 basis points year-over-year, while sublease space has more than doubled during that time, according to Yardi Matrix. That bump, however, is just the tip of the spear. Only about a quarter of downtown office workers nationally reported to an office as of April, with the percentage closer to 15 percent in New York City and San Francisco, according to security firm Kastle Systems. The question is not whether companies will reduce their office footprint post-pandemic, but by how much. Demand for space barely scratches the surface of the considerations faced by owners and occupiers. The industry must come to grips with a host of factors, including when workers can safely return; how many people will use offices and how often they need to be there; where offices should be located; how offices interact with lifestyle preferences such as commuting and walkability and, how to re-design space to attract and maintain talent while meeting functional needs. The industry is facing a “quantum fundamental shift,” according to Jeff Adler, vice president of Yardi Matrix. “The sector is at the beginning of a wrenching multi-year rethinking of the nature of work. Everything is in play.” Where to Work? The primary question hanging over the industry is how office utilization will change after the pandemic ends. “Every tenant is asking the same questions about how and when to get back,” said Benjamin Breslau, chief research officer at JLL. Breslau said that the percentage of workers reporting to an office is expected to triple by year-end, to 75 percent, and that work-from-home will double to 20 percent of workers from 10 percent pre-pandemic. Many companies have found that workers can be productive from home, but to what extent can it be done without impacting corporate culture and collaborative efforts? A consensus has formed around the idea that most companies will adopt more flexible arrangements, but what that means for office space demand depends on the details. In terms of how much space is needed, there is a big difference between giving employees a choice to be fully remote or requiring them to be in an office part-time. Those decisions are complicated not just by employee preference but by the nature of the job and the industry. Some types of knowledge work (such as programming) can be performed well anywhere, but others are more productive in a collaborative environment. Daniel Ismael, a senior analyst at Green Street Advisors, said the average office worker’s time in the office will likely drop to 3.5 days a week from 4.5 days a week pre-pandemic. While a part of the office space decision will be driven by the type of jobs and corporate culture, companies will also have to bear in mind the preferences of employees, which is another complex issue. If proximity to an office is no longer important, how will that change workers’ preference for where they want to live? In the years leading up to the pandemic, the default assumption was that young knowledge workers wanted to live in an urban environment. Job growth over the last 20 years has been concentrated in urban areas,even in secondary and tertiary metros. However, the pandemic prompted a drop in population in urban submarkets in gateway metros. Young families moved to suburbs to get more space while others who were suddenly unmoored from the need to commute moved to different parts of the country. Some moved to lower housing costs, but part of the movement was driven by the closure of entertainment and cultural venues. When those venues re-open, some will move back to urban areas, but others have left permanently. Companies could deal with this by shifting offices to the suburbs or moving to less expensive metros, or by adopting a “hub-and-spoke” model with a city headquarters and outposts in the suburbs. Mark Grinis, hospitality and construction leader at EY Global Real Estate, said during ULI that a more distributed workforce is at odds with the need for collaboration. Studies done by EY of workplace productivity found that secondary locations—the “spokes”—had the worst performance. Lifestyle Changes COVID-19 has prompted many people to think about lifestyle and where they want to be. Many workers were relieved to avoid long commutes of more than 30 minutes, but “walkable” neighborhoods with access to shopping and other amenities remains popular. Diane Hoskins, co-chief executive officer of design and consulting firm Gensler, said that many are choosing smaller cities and inner-ring suburbs, especially in the technology sector. “There’s a real appetite for reconsidering how cities work,” Hoskins said. “When you look at real estate as an investment in people, you say how do you do it in a way that optimizes … competitiveness to be able to thrive in a global environment.” One difficulty for picking a location is that few metros are configured to meet conflicting worker preferences. Lifestyle considerations mean that office buildings themselves need to be re-thought to meet the new paradigms. For example, workers may demand less density for health considerations. If workers come to the office less frequently, then more collaborative space is likely needed to make efficient use of the time they are together. Companies may have to redesign space to add amenities to retain workers and/or entice them to come to the office. The myriad redesign changes, and even downsizing, are likely to require costly capital expenditures at a

Navigating the Commercial Real Estate Market in the Post-Pandemic Period

by Rick Sharga
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Is the COVID-19 pandemic beginning to have an impact on commercial real estate? First quarter sales data from First American DataTree suggests we might already be seeing a glimpse into what’s likely to be a difficult year for commercial real estate (CRE) sales in 2020. At first glance, sales volume appears relatively stable, if uninspiring. Three sectors—apartments, industrial and hotels—actually showed modest year-over-year increases in the total dollar volume of sales, while the office and retail sectors showed fairlysignificant declines. But a closer look at the number of units sold probably offers more insights into what’s likely to be a trend for the rest of the year. Only the apartment sector was able to eke out a small increase in unit sales. The industrial, hotel and senior living sectors showed modest declines. Both the Office and Retail sectors showed a significant drop-off in the number of properties sold. How the CRE Market Has Already Changed The COVID-19 pandemic has had devastating consequences for the U.S. economy. Entire industries, mostly in the service sector, were shuttered. The implications for the CRE market were ominous, particularly for commercial properties that hosted sports and entertainment events, housed restaurants and retail stores, and supported travel and lodging. These were the types of businesses that most often closed in an attempt to “flatten the curve” and minimize the spread of the virus. For an economy where consumer spending accounts for 70% of its gross domestic product, shutting down these businesses effectively put an end to the longest period of sustained economic growth in U.S. history and sent the country into a recession. GDP dropped by 5% in the first quarter. Analysts are forecasting a drop of 25% to 42% drop in the second quarter GDP. Unemployment jumped from 50-year lows to over 15%, andnew jobless claims continue to exceed 1 million a week in July. It’s no surprise that an economic shock of this size has had an effect on every sector of the CRE market—some more than others—and each with a different outlook for the post-pandemic future. The good news is that transactions and development haven’t completely stopped, although they have slowed dramatically. The unanswered questions the industry faces are making financing new deals more difficult: When will consumers feel confident enough to spend again? How many businesses won’t survive the downturn and how many jobs will be permanently lost? And what sort of behavioral and structural changes will have an impact on the utility of commercial space in the years ahead? Until we have answers to those questions, it’s hard to predict whether the CRE market will experience the kind of crash it did in 2008. It’s not hard, however, to see some of the short-term implications from the pandemic. For example, the office sector may see the most long-term changes due to COVID-19. The segment is likely to see two countervailing forces at work. On one hand, there will be a need for more space-per-employee and modifications to entrances and points of egress to facilitate social distancing. Apparently jamming employees into crowded cubicle farms or setting up coworking facilities where workers sit shoulder-to-shoulder aren’t great ideas during a pandemic. On the other hand, it’s likely that many companies will need less office space in general, since work-from-home productivity was better than expected. Will companies move toward a more distributed workforce, with employees working from home some or all of the time, and/or offices set up in less expensive markets across the country rather than in the more expensive major metro areas? Anecdotally, these conversations are already happening in Silicon Valley. Twitter has announced a permanent work-from-home policy, and Facebook executives have discussed the benefits of having employees in other, less expensive states. The pandemic may well have already changed the size, location and the very structure of tomorrow’s offices. In the short term, the hotel sector will probably suffer most. The outlook for travel is bleak. Consumers seem unlikely to travel in large numbers until the pandemic is under control or there’s an effective vaccine available. The major brands like Marriott and Hyatt will certainly weather the storm (albeit not without some pain). But many of the limited service hotels are owned by smaller investors, and they may not have the financial wherewithal to survive the downturn. In the long run, the retail sector is likely to be the biggest casualty as we exit the pandemic. This sector was already struggling before COVID-19, with vacant suburban shopping malls and big box retailers like Macy’s, Sears and J.C. Penney Co. shuttering stores across the country. Since the pandemic hit, many other well-known brands (e.g., Brooks Brothers, Neiman Marcus, GNC, Pier 1 Imports and JCrew) have all filed for bankruptcy. The weakness of the retailers themselves, the accelerated growth of e-commerce and questions about how quickly shoppers will head back to the stores all weigh against a strong recovery. It’s very likely that the most successful resolution for the retail sector might be the repurposing of existing shopping centers into multiuse facilities. On a more positive note, the industrial sector seems poised for post-pandemic growth. As mentioned, the pandemic has fast-tracked the country’s already growing shop online habits. To accommodate this growth, we may see Amazon and other major online retailers invest heavily in warehouse and distribution hubs across the country. A distributed workforce will likely create the need for more cloud computing facilities. And it seems likely that we’ll see investment in more flex manufacturing facilities, since the inability to produce the kind of personal protective equipment needed by health care providers and first responders shined a light on that weakness in our manufacturing ecosystem. All three of these trends should drive industrial growth. The apartment sector may experience some short-term pain. Most unemployment claims were likely filed by renters, and there appears to be an accelerating trend among millennials to abandon urban apartments for suburban homes, in search of a healthier environment to raise their families. But the sector is well-positioned

Zoning Isn’t Your Problem

by Nick Labadie
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Looking at the potential issues a project may face and taking the steps to minimize them early will help keep you on budget and on schedule. When developers, investors or builders look at a new project, everyone knows to consider the zoning and the entitlements necessary for the project to happen. What often gets pushed down the priority list, or not thought of at all, are the corollary issues that may have a bigger impact on the project than the zoning itself. It is not enough to simply confirm that an appropriate zoning district is available and apply standard estimates for timing and costs for processing the applications for those entitlements. There is almost always a zoning district that will accommodate the desired use. But the zoning district itself is not what poses the greatest threat to the ultimate approval. Instead, it is often politics; neighborhood opposition; the property’s history; general, comprehensive or specific plans (where applicable); or even traffic concerns. Any one of these can derail your schedule, budget or both—and in a big way. You don’t haveto leave them up to chance though. Each one can be researched and planned for well before any money goes hard. Politics One of the first steps in considering the viability of any project is having a meeting or discussion with the local elected official of the district where the project is located. This may be either a councilperson or county supervisor—or the most influential—if the local elected officials serve at-large. This meeting isn’t about just giving a polite heads-up. Local elected officials must balance a complex and interwoven pile of issues, agendas, goals, stakeholders and problems, many of which were inherited, all while trying to responsibly reflect the desires of their constituents. Many factors that won’t turn up in any research but are within the elected official’s realm of responsibility can impact your project. For example, there may have been significant community discussion about the property you are looking at, and plans laid for it despite it not being owned or even tied up by the jurisdiction or community. That is something you need to know before making an application for a project that may be completely different. Elected officials themselves may have plans for municipal projects that are not yet on paper but will impact your project. These kinds of projects may range from large open space plans to significant infrastructure upgrades or studies in progress for specific area plans. They may also have strong personal preferences on certain aspects of development that can be easily incorporated into a project early on. You must also consider the interrelation of the elected officials’ interests, concerns and agendas. The balancing act elected officials must perform and the fact they may be elected by different demographic groups can put them at odds on various issues. Analyzing how this will impact your project is a critical component of the research you should be conducting before committing to a project that will require city, town or county approvals. Neighborhood Opposition You’ve likely seen a project get absolutely destroyed by opposition from neighbors, neighborhood organizations, or other interested and organized parties in the community that may or may not be geographically close to the project. Of course, you believe your project will benefit the community. It very well might, but it is difficult to foresee how everyone in the community will view it when you cannot know what is tinting the lenses they are viewing it through. What may seem like an obvious and eminently appropriate change of zoning from a technical, professional and societal perspective may seem like the end of the world to neighbors or community groups. Often, such opposition is due to misconceptions, miscommunications or fears associated with past experiences. As the applicant for an entitlement, you are often unfairly greeted with distrust and skepticism rather than the benefit of the doubt when it comes to the quality of the project, true intent and willingness to communicate with the community. Likewise, the community often forgets that projects like yours are the only way cities and counties improve infrastructure, build roads, extend utilities, construct and maintain parks, and generally create progress and growth that is a critical component of a healthy city. With a good project, neighborhood opposition can almost always be overcome through communication and open dialogue. Most often, community outreach involves treating the community as one large group and hosting multiple public meetings, conducting focus groups, sending surveys and attempting to identify and solve problems. That may be appropriate in some cases, but there are rarely issues in a community that apply across the board. Embracing a multifaceted approach that includes research, required notification, meetings with key players and individuals and continuing communication is much more effective. At the earliest stage of your project research, you should investigate the history of neighborhood opposition to projects in the area. Your zoning consultant should have some idea of the larger issues in the area, but specific research should be done to identify projects in the immediate vicinity that have had significant neighborhood participation—both positive and negative—to identify key issues and players. City or countywide research can also be helpful if the project is more unique and there are comparable projects elsewhere in the city or county. This research does not need to take forever or blow out a budget. You can often find and identify issues quickly. The jurisdiction will typically have requirements for public notification and outreach that you must conduct. Follow up with all responses from this step. Either identify the issues and work to resolve them or thank the respondents for their support and request they voice that support in an email or letter to the jurisdiction, or better yet, attend a hearing. When someone supports a project they likely will not participate in the process unless they are asked. However, you can be sure that folks who aren’t happy will engage. It is important for everyone’s voice to be

Away From the Office—Permanently?

by Aaron Block
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How working remotely is changing real estate A corner office isn’t what it once was. No office is. Technology has made it easier than ever for people to work remotely, handling their jobs from wherever they happen to be at any moment. That flexibility affects more than just how people schedule their lives and work assignments. It also has a large impact on real estate. Technology at Work The ways in which real estate gets bought, sold, leased, managed and so on have already changed dramatically in recent years because of technology. For example, the rise of telecommuting is one more way in which technology is changing how people work, and that affects how much office space a company needs, possibly the length of their lease agreements and other factors that the commercial real estate world needs to adjust to. The challenge for the real estate industry will continue to grow as more people, and their employers, discover the flexibility and cost savings telecommuting can provide. Changing Demographics Already about 40% of the American workforce works remotely at least on occasion, according to an analysis that GlobalWorkplaceAnalytics.com conducted using the U.S. Census Bureau’s 2005-2017 American Community Survey. Part of this is driven by changing demographics, with millennials now the largest generation in the workforce. Millennials are the architects of the so-called sharing economy, and they are fine with spending their workdays in coffee shops or coworking spaces. Impact on Commercial Real Estate Some of the ways all this impacts real estate include: What companies expect from an office is evolving. In fact, the whole notion of office space—how it looks, where it’s located, how it’s valued, the services it offers—is shifting. A number of tech-enabled firms, such as WeWork, Convene and TechSpace, are not only changing the way office space is leased, managed and configured, but also how it is conceptualized. To remain competitive, commercial real estate firms will need to offer space that has more services and has flexible leasing terms. Many businesses and workers today do not want to be tied to long leases and oppressive space with cubicles, fluorescent lights and bad coffee. If workers spend much of their time elsewhere, companies no longer need the amount of space they once did, so sharing conference rooms, kitchens and other facilities with multiple businesses just makes sense. Yes, There Are Apps for That Whether a worker is a freelancer or part of a large team, they can book workspace through apps, rather than going through more traditional methods such as responding to a newspaper advertisement or contacting a property manager or a broker. Spaces are available in all shapes, sizes and locations for any length of time. People can book space for a month, a year or even by the hour, depending on their needs. Technology already has had an enormous and lasting effect on numerous industries, such as taxi companies and the newspaper business, in some cases upending companies that once were very profitable. Unless real estate practitioners want to follow in the footsteps of some of those businesses, ignoring the ways in which technology is remaking the industry is not an option. Instead, make sure you keep tabs on the tech trends likely to affect your business. Building a realistic strategy that takes emerging threats and opportunities into account is more critical than ever.