Shopping for commercial real estate

Good morning. Yesterday featured a stronger than expected retail sales report and an Atlanta Fed GDPNow update which put fourth-quarter real growth at 2.4 per cent. If we are in a slowdown, it’s a very gentle one. Or are we missing something? Email us: robert.armstrong@ft.com and ethan.wu@ft.com.

Where to find deals in US CRE

As the great commercial real estate valuation reset rolls on, the ominous headlines keep coming. “The bill is coming due on a record amount of commercial real estate debt”, The Wall Street Journal blared this week. Fair enough. The sector is genuinely challenged, especially in offices, and distress is almost certain to rise. But all the same, CRE presents a classic moneymaking opportunity for risk-tolerant investors. The dangers are well-telegraphed, fear is high, and many underlying properties are in fine shape.

Many of the scary-sounding recent headlines come out of the slow-moving, illiquid private market. Public markets, conversely, have already priced in a lot of distress. An index of US CRE real estate investment trusts sits 35 per cent below its highs:

Compare that to what forecasters expect for CRE more broadly. Kiran Raichura, property economist at Capital Economics, projects a peak-to-trough price decline across property types of about 20 per cent. Even in offices, Raichura’s forecast for a 43 per cent decline falls well short of the 63 per cent drawdown in office Reits since 2019. 

“Generally speaking, the public markets have overcorrected, potentially pricing in everything and then some,” says Cathy Marcus, co-chief executive at PGIM Real Estate, which invests in public Reits as well as private real estate. She notes public markets’ tendency to sell indiscriminately, without a close analysis of each property a Reit owns. For example: “In my view, [public markets aren’t] differentiating enough between office Reits that hold B-tier assets and office Reits that hold A-tier assets.”

So where to buy CRE in dislocated public markets? The first thing to say is that generic all-property Reits (or CRE ETFs) are probably a bad buy. CRE is very diverse. Returns differ markedly by property type and by metro area. In the past decade, you really wanted to own data centres and really did not want to own malls:

So we asked three CRE-watchers what they think looks interesting out there.

Uma Moriarity, who sits on the investment committee at real estate asset manager CenterSquare, likes senior living facilities. This is a demographic play, banking on an ageing US population and impending wave of baby boomer retirements lifting demand for comfortable retirement homes. Senior housing supply, meanwhile, has been slow to respond. 

Marcus and Moriarity both like “necessity retail”, meaning high-traffic supermarkets in well-off suburbs. These have the appeal of acyclicality; people keep going to the grocery store in a recession. There are demographic tailwinds, too, namely a rising number of millennials moving to the burbs. The biggest risk is a supply response, new stores swooping in to compete for suburban dollars. Yet since the great financial crisis, fears of ecommerce disruption to the grocery business have kept construction in the retail sector subdued. Moriarity’s chart:

Marcus made this case for further outperformance in global data centres:

We made our first data centre investment around 2012-13, during what I would call the Netflix generation. All of a sudden, there was a growing interest in streaming. The investment thesis was the need for data centres was only going to grow. Then the next wave was Covid-related working from home, where everyone needed to be on Teams [or Zoom]. Now it’s the AI revolution driving [outperformance] in data centres.

At each point [of data centre growth], even in 2012-13, there was the question: how much more can the need for data centres grow? And we’ve seen the answer is that it seems almost infinite.

Finally, Lonnie Hendry, head of CRE at data firm Trepp, offered a sanguine take on the apartment market, another sector that has received poor press lately. The metro area matters a lot here, as some markets (Phoenix) face oversupply while others (New York) have shortages. But the bigger picture remains a strong economy and national housing shortage supporting rent growth combined with preferential government financing via Fannie Mae and Freddie Mac. That makes it hard to bet against apartments in the long run, even if a short-term pullback is likely, Hendry argues. 

These are only starting points. Real estate is “hyperlocal”, as Hendry puts it, so property-level analysis (or rock-solid conviction in a Reit’s managers) is a must. But a widespread valuation reset is bound to lead to excessive bearishness, and reward those who put in the work. (Ethan Wu)

Unhedged’s 2024 stocks of interest (part 1)

It’s time for the Financial Times stock picking contest. So Unhedged is going to pick some stocks!

First things first: the following is not investing advice. Boy, oh boy, is it ever not investing advice. Regular readers know that at Unhedged we spend little time thinking about individual stocks. We write about broader market trends and the interplay of markets and the economy. Real stock picking, the kind that has an outside shot at consistently outperforming the overall market, is a full-time job. Sometimes it looks — to Unhedged, at least — like trying to beat the market using fundamental analysis is a waste of time. At best it’s satanically hard.

Regular readers will also know that our picks in last year’s contest, which amounted to an all-in bet on recession, were an absolutely spectacular failure. The same approach had worked very well the year before, when our portfolio was five short positions. All-in bets, while fun and quite logical in stock picking contests (where the point is to win rather than to minimise risk) go wrong sometimes.  

So what is the right bet for 2024? We don’t have a ride-or-die bet about macroeconomic conditions, as we did last year. We are not going to bet that inflation or growth or rates are going to be higher or lower than expected. But we are going to gamble that the biggest trend in the market is going to reverse: that growth stocks generally, and specifically the Magnificent Seven tech stocks, are not going to lead the market.

That is not to say we are going to pick value stocks — that is, stocks that are very cheap because their businesses are either financially levered or highly sensitive to economic growth. Value does best in a true economic recovery, and we don’t seem to be in one. Nor are we going to short the Mag 7 (too scary!). Instead, we are going to look for stocks that have reasonable valuations and solid secular (as opposed to cyclical) growth profiles. We talked a little bit about these sorts of stocks last week, and we mentioned our first pick, Everest Group, then.

Everest is a property casualty reinsurer and primary insurer based in Bermuda. It is very cheap on a forward price/earnings basis (6x) though a bit less so on price to book (1.4x). But reinsurance stocks are usually cheap as their earnings are not easy to predict (see: hurricanes). The real appeal of Everest’s stock for 2024 is threefold. Property casualty reinsurance is not cyclical, so it’s not a bet on a confusing economy; pricing and contract terms in reinsurance in particular are better and tighter now than they have been in years; and the company has a strategy for profitable growth, led by a credible management team which has delivered decent shareholder returns over the past few years.

Reasonable valuation; a solid secular, rather than cyclical, growth story; and a strong record. That’s the kind of stock we’re betting can do well in the most uncertain year of 2024. More on Everest, and four more picks, next week. If you have ideas, please send them along — and enter the contest, which closes on January 28. 

One good read

How Ecuador fell apart.

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