Occasionally, I get questions from people about whether they should invest in real estate. Many of them have read bad news reports about the high cost of debt, low office occupancy and the like. The quick answer is yes, if you have done your homework and all the boxes check out.
Instead of giving a one-size-fits-all answer, I will give a multifaceted, nuanced take on what I think about the real estate sector, including where you should and should not invest. Take note, however, that this is not investment advice but more for your own input. Any investment decision should be made in consultation with registered investment professionals who you trust.
First, let me start off by saying that because most real estate projects are very expensive, most are typically financed by debt. The developer puts up a certain amount as equity, but most of the financing is really debt. Hence, real estate is very sensitive to interest rate changes.
Traditionally, whether it is a house for a home buyer or a condominium or office development project by a developer, banks and other financial institutions have traditionally not hesitated to give loans to real estate because the asset is very tangible. There is often an expected future cash flow, and the law allows them to foreclose and confiscate the property if the borrower fails to pay after a reasonable amount of time.
Sure, those disputes are also subject to legal appeals processes, but in general, the law has upheld the right of banks to foreclose on unpaid mortgages and real estate developer projects. Real estate is a major component of the assets held by banks on their balance sheets.
Lower cash flow from office space rentals
Particularly to office space, the unlucky combination of maturing real estate loans that need to be refinanced at higher interest rates, plus the fact that many companies now allow employees to work from home at least a few days of the week mean that the cash flow from office space rentals and leases from tenants is now less than what it used to be. The Fortune 500 company that used to lease three floors might need only one floor for the next few years.
This means that over time as the loan is being paid out, the money that the developer was expecting is much less than what they computed, and it now appears to be a losing proposition. That’s why you see some developers, even the high-end ones like Blackstone, just returning the buildings to the banks.
This has implications as well for the retail space, particularly those that were built to serve the working office population in downtown areas. The working transient high-income populace was the one that retail shops and restaurants normally counted on for their revenues. The residents who live in those areas are important but often do not generate enough business without the transient workers.
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Some developers have had some success repurposing excess office capacity into residential condos or apartments. However, that has a lot of challenges. The footprints of office buildings are often huge, and any residential space in the middle will not have window access unless the units are extremely large. Plus, you would need to add kitchen and toilet plumbing to each unit. Often, it is simply easier to tear down the old and build a new, properly designed residential building in its place.
The banks do not want to acknowledge the problem too much because they know that their stocks will get hammered. It does not help that the low interest rates prior to the Fed rate hikes encouraged real estate developers to borrow and build commercial real estate projects, which are now at an oversupply relative to current demand.
Now you see a lot of boarded-up office spaces or high vacancies in many buildings. The so-called Class A office spaces that are environmental, social and governance (ESG) compliant are fewer in number and are still popular with their Fortune 100 and high-end professional office clients. But the older-style buildings often have less luck attracting tenants.
High interest rates challenge home buyers
With respect to housing, the high debt rate and the pandemic construction pause have created an artificial shortage of housing. New home buyers, used to 3% mortgages for 10 to 30 years, are now faced with 7% to 8% on those loans, which adds up to a huge difference. There is hesitance on the part of buyers to sign up for mortgages, and sellers also hesitate because they may also need to take out a similar loan to upsize to a larger home. However, for those with adequate financial means, this means that buying a home that they want for cash and flipping it is quite lucrative, if they are able to pick a home in a desirable fast-turnover neighborhood.
While office space may be to some extent optional for some companies, owning or renting a home is not. Many people want to own a home, and if they cannot, they will be forced to rent. So long term, as younger people mature in their careers, many will want to buy a home.
Government regulation also plays a part in whether real estate is a good investment. For example, if rent control laws are too strict, there is no incentive for developers to improve older residential apartments, as the artificially low rent will not cover the cost of those improvements.
Other aspects of real estate, including commercial real estate, are quite healthy. Online shopping warehouses, senior care, self-storage and other kinds of properties are doing quite well.
One cannot generalize the real estate sector. Demand and supply depend on the particular area, the type of property and function and legal and economic considerations. The only thing you can do is to educate yourself on the risks and rewards of each property type and area, do the computations and decide on a case-by-case basis if the rewards outweigh the risks.
