real estate and the US stock market

Real estate is very important for the US economy. There’s comparatively little direct stock market exposure, however. This is in contrast with most other major world stock markets, where real estate development and real estate investment firms have major index weightings. In smaller, but historically important, markets like Tokyo, Hong Kong and Singapore, real estate has overwhelming influence.

Perhaps as a result of this, the US finance literature on real estate that I read in business school and over the first ten or fifteen years of my investing career (after which I stopped) was underwhelming The basic idea was the real estate was the king of asset classes. The reasoning? …real estate produces not only a larger return than other asset classes but much smaller volitility of return (the academic measure of risk) than stocks or bonds.

How embarrassing for the finance PhDs who wrote this–and who presumably never owned a house or an apartment. As any homeowner soon becomes aware, real estate transactions dry up in an economic downturn. There are few potential buyers, because they can’t get financing at a reasonable price. No one wants to sell in a downturn, either, at the steep discount the few active buyers will demand. So there are basically no transactions. The academic world of the 1980s-90s dealt with this lack of liquidity and the resulting dearth of actual price data by ignoring it, and assuming that prices remained at their boom time highs. This false assumption of price strength during downturns is at the root of the academic coronation of real estate as a superior investment.

The real world has always known better.

There are a number of listed homebuilders in the US stock market, as well as hotel companies. And of course there are REITs. But most exposure is indirect–financial institutions that service borrowers with real estate collateral or whose investment arms manage real estate portfolios for others; or building materials, equipment or maintenance providers.

Around the world, prime office space in urban centers has been regarded as the best–highest-return and most secure–type of real estate investment. That’s followed by upscale hotels and resorts (the main drawback here is sensitivity to the business cycle), with commercial real estate and housing bringing up the rear.

The factors favoring prime office space are:

–tenants are typically large, financially sound corporations

–contracts are for large amounts of space and usually extend for five years+

–landlords can mitigate risk by staggering the lease periods for different tenants

–the amount of available class A urban space is usually limited

–moving costs for tenants are high, and alternatives usually limited

–pre-pandemic, overall demand for office space has been rising, making existing projects increasingly valuable.

There is business cycle movement within office space. Typically during expansions, demand for office space expands from the city center into the outskirts of a city, but contracts back toward the center during recessions. And the overall long-term movement has been expansionary.

The peak of a cycle is typically marked by the completion of a mega- project, like Hudson Yards in Manhattan right now, that supplies massive amounts of new office space into a market that is levelling off and just about beginning to contract.

I was listening to a Bloomberg interview of the owners of Hudson Yards over the weekend. Management spoke of huge demand for office space in the complex. The New York Times tells a somewhat different story and points out that NY state is proposing large increases in office space around Penn Station, a few blocks away. What the HY owners didn’t talk about is the other big variable in evaluating real estate, the rental rate. Typically during a downturn, office buildings may keep the official rental rate unchanged. But they either offer deep discounts or other offsets like rent-free periods to lower the effective rental rate to induce tenants in older buildings to trade up.

The overall effect is that while the prime areas may do little more than break even, older buildings, especially in marginal areas, get clobbered. Some may never recover and will need to be repurposed. One issue is that it may be prohibitively expensive to convert bespoke office space into residences (the traditional solution).

The elephant in the room, of course, is the reluctance of remote workers to return to the office.

more tomorrow

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