As economic uncertainty swirls, some commercial properties show resilience
As investors remain focused on protecting and growing their wealth, many see 2024 as another year of continued market uncertainty. Conflicts in Ukraine, Gaza, and potentially Taiwan cast an ominous cloud over the global economy that could disrupt domestic and international markets.
The direction of future Fed action to reduce rates remains unknown and can often change course based on a few simple words uttered at a Federal Open Markets Committee meeting. And while consumer confidence appears to have rebounded early this year, a looming $5 trillion credit card debt is hardly a reassuring measure that we are out of the woods from a potential recession. Even if a recession is avoided, a best-case scenario might point to a lower Gross Domestic Product (GDP) growth environment.
Rethinking Portfolio Allocation
Amidst these current uncertainties, you may need to boost your allocations to life-event-driven asset classes if the stock or bond markets turn sideways. 2022 – when many saw their 60/40 stock and bond portfolios drop double digits – is not too far removed from investors’ minds.
In the alternative investment space, commercial real estate is often viewed as a preferred asset class due to its low correlation to publicly traded securities. However, commercial real estate is a broad asset class composed of many sectors that often perform quite differently. So, the type of real estate strategy used is more important than ever.
Commercial Real Estate Challenges?
You may be aware that high interest rates and stubborn inflation have taken a toll on many commercial real estate properties as the valuation gap between buyers and sellers widens and owners grapple with refinancing expiring loans at today’s much higher rates that can quickly make a property uneconomical.
These challenges are real and, we believe, not likely to go away any time soon, but it’s important to know that, much like the broader economy, commercial real estate experiences its own market cycle, and a repricing phase of assets is simply one stage of the cycle that not all sectors will experience at the same time.
The Commercial Real Estate Cycle
Cycles can influence transaction activity, property values, occupancy, and rents and are dependent on location, property type, and quality. As illustrated here by the work of Glenn Mueller, Ph.D. at the University of Denver, Daniel College of Business1, each phase of the market cycle has unique characteristics that influence the performance of real estate. It’s important to know that not all property types experience the cycle at the same time or in the same way.
Mueller: Real Estate Finance 1996
And while today, we believe it is reasonable to assume most sectors are either in the Hypersupply or Recession phases, some property types are less sensitive to the cycle’s influences and can be supported by demand drivers that enable a smoother transition from one phase to another.
Life-Event-Driven Property Types
Life-event-driven sectors often exhibit resiliency and continue to perform well even when other properties may not. Some of these include lesser-known commercial real estate sectors like:
At first glance, you may recognize these property types as those that have intersected with your life at one time or another. This is why they are considered life-event-driven asset classes. Most of us will encounter one or more of these at one time or another in our lives, highlighting why there is typically a strong demand for these property types.
Consider the current strength and dynamics of just a few:
Student Housing. According to recent industry research reports:
Self-Storage. According to industry-stalwart Storage Cafe4:
Outpatient Healthcare. According to data research specialist, Resourcemed:5
Post-pandemic, outpatient physician-office employment is growing faster than underlying supply of space. As of Q3 2023, physician office employment grew 3.3% annually while the outpatient or MOB inventory grew by just 1%. Interestingly, during this period we have seen occupancy rates for the outpatient sector growing consistently as absorption of space has been outpacing completions.
Meeting Consumer Needs Throughout Life
This chart may help illustrate how life-event-driven assets are often needed throughout consumers’ lives and shows how the demand for certain real estate sectors is positioned to continue for decades to come thanks to the growth and aging of different generations.
Source: U.S. Census Bureau
A Case Study: Off to College
Perhaps the best way to show how life-event-driven properties can readily touch several needs in our lives is to provide a sample case study:
Robert and Sue Farrington have been married for forty years, have three daughters (two now in college; one a senior in high school) and have lived in the same home in Milwaukee, Wisconsin since the very beginning. Robert is a patent attorney who remains as active today as when he started, and Sue works part-time at a pediatrician's office.
With their two oldest daughters, Nora and Grace, now in college, and Sara soon-to-be, the Farringtons find themselves in full “spend mode” covering expenses for tuition, room and board, and activities. They knew the cost would be high, just not quite this high!
Nora and Grace live in off-campus student housing while attending the University of Wisconsin-Madison. They currently share an apartment but have decided to split up next year and live with friends. The sisters were able to sign, with their parents as co-signers, a 12-month lease which is the typical term for off-campus housing. The assurance of consistent annual income, despite a few months of summer vacancy, is an attractive advantage for student housing investors.
Nora and Grace’s furniture will need to be moved once the spring term ends, so the Farringtons will rent a self-storage unit in Madison for the summer months.
Meanwhile, back home, Sara, who is an elite soccer player with pending offers at several Division One schools, just tore her ACL which will require surgery and several months of physical therapy. And while the unfortunate event wasn’t an expected expense for the Farringtons, fortunately, all of Sara’s medical treatment will be accommodated at a renowned orthopedic outpatient surgery clinic near their home.
While the Farrington’s hypothetical situation might not accurately reflect your own family experience, it highlights how common it can be for many of us to use life-event-driven properties, often more than one at a time, throughout our lives.
Some of the risks related to investing in commercial real estate include, but are not limited to: market risks such as local property supply and demand conditions; tenants’ inability to pay rent; tenant turnover; inflation and other increases in operating costs; adverse changes in laws and regulations; relative illiquidity of real estate investments; changing market demographics; acts of God such as earthquakes, floods or other uninsured losses; interest rate fluctuations; and availability of financing.
1https://daniels.du.edu/assets/Cycle-Monitor-23Q2.pdf
2https://www.realpage.com/analytics/november-2023-student-housing-update/
4https://www.storagecafe.com/self-storage-industry-statistics/
5https://revistamed.com/demand-for-outpatient-space-growing-faster-than-supply/