With summer wrapping up, we wanted to post an update on what we’ve been up to. It’s been a busy summer catching up with friends and family where we left off in 2020. We’ve also been busy building our new brand and I’m happy the new website is now live. We also created a ton of great resources that you can find on our Insights page, and much more will be coming out in our blog and on social media. Read on to find out what is in our pipeline, what’s happening with the economy, and how it’s shaping the real estate industry.
What We’re Doing
We’re working diligently to identify fantastic operating partners for our first fund. We think we’ve found some great opportunities and we’re very excited about it. Stay tuned for an announcement soon.
Our first fund will focus on diversification and provide access to several operators that have been in the business for decades. With this fund, we wanted to answer the question: “What is the best way to grow and protect our capital?” In other words, how do we ensure we are not taking on too much risk in one area of our portfolio, endangering our principal? Overwhelmingly, our research pointed towards diversification.
As a result, we set a course to identify and invest with several long-tenured operators (~20 years) who are active in multiple markets. We will create diversification within one investment by selecting operators who:
- Have extensive experience through multiple market cycles.
- Operate in leading metros across the US.
- Are individually focused on different real estate sectors: multifamily, self-storage, manufactured housing, industrial or light manufacturing/industrial office parks, and suburban life science offices.
- Have high minimums or better terms with higher investment amounts that are not available to most investors.
We are targeting operators that offer funds so that our investors will own 20-30+ assets with a single investment. The fund is intended to provide diversification from the stock market and within the real estate market itself. We believe an investment in our fund provides a strong foundation for private real estate investing without exposing an entire portfolio to the risk of single assets, operators, or markets.
We Closed Our First Full-Cycle Passive Investment in June
98Fifty was our first passive investment to go full cycle. Although the returns did not quite meet the projections (~20% IRR), the results were still good at 15.1% IRR and 1.6x equity multiple. A $100,000 invested in 98Fifty in 2016 turned into a total of $160,000 in 2021 (including preferred return distributions). Over the same period, a $100,000 investment in the stock market would have produced ~$153,000, an ~11% IRR before fees. We learned a few lessons but are generally happy with this outcome.
This summer saw strong engagement from consumers driving a robust recovery. Baseball games were back in swing, restaurants were booked up, and airline travel was approaching pre-pandemic levels. Nearly every economic indicator tracked by JP Morgan’s Pandemic Indicators is above pre-pandemic levels, with only a few notable exceptions: office and public transportation utilization. We’ll talk more about those later, but if you like charts, look at that report from JP Morgan. America is back!
Retail sales remain well above pre-pandemic levels even as recent data shows increases in spending slowing down and shifting from goods to services. Although spending at restaurants, bars, and other venues had outpaced grocery store spending earlier this year, hesitancy has stalled further increases in spending there. But there still seems to be a lot of gas in the tank (or bank) for American consumers to tap into as overall retail spending continues to rise.
Meanwhile, workers are scarce, and offices remain largely vacant. The unemployment rate has continued to drop to 5.2% now, but at a slowing pace except for June and July. The busy summer months brought about renewed hiring above 850,00 jobs each month. Through the first half of the year, hiring seemed to have plateaued and the trend was starting to look more like a typical economic recovery. With August’s hiring numbers retreating to 250,000 jobs, there still seems to be lots of hesitancy to hire. But one bright spot in the labor market is that more workers are quitting their jobs, boding well for workers’ confidence in finding a better job.
As a result of the increased spending and constrained supply of goods and services, inflation has become the investment world’s word of the year. The thought of inflation is scaring a few pundits who are used to the low inflation norm. But most economists believe the current situation is a temporary, transitory condition. This appears to be supported by the plateau in inflation over the summer months. For now, supply and demand imbalances appear to be driving inflation rather than broad-based price increases. In fact, the example du jour, lumber prices, have already declined back to basically normal prices as supply catches up with demand. The rest of the year’s inflation numbers will be keenly watched by every trader, pundit, and Fed watcher to determine what’s going to happen with interest rates.
For now, the Fed is standing tight on interest rates. But Jay Powell has moved swiftly this year from his stance of “not talking about talking about” changes to the Fed’s monetary policy to doing more than just “talking about talking about” it. In fact, this week, the Fed indicated that they are ready to start tapering its bond-buying, signaling the end to monetary stimulus. This is faster than many predicted early this year. Still, the Fed does not see a rate hike soon and projected little change until 2023. And there is still much uncertainty around that timing. Yet inflation is stalking. And although it does not appear as serious a concern as earlier this summer, it can’t be ignored.
So, the Fed will continue to hedge its bets and remain vague about timing. But it is worth noting that the chaperones to this party are keeping a close eye on the punch bowl and moving ever closer to snatching it away if needed.
But wait, there’s one area of concern that always rears its head this time of year. Congress. The usual dysfunction around the debt ceiling and the annual budget is just around the corner. And if there is no agreement this time around and the government shuts down, it could have a more detrimental impact due to the fragility of the recovery at this point. The one thing politicians seem to agree on is that America’s infrastructure needs some tender loving care. How much? If asked, you’d get a different answer from every member of congress I presume. Whether a huge spending bill gets passed is a completely different story. Let alone a massive budget with even more spending beyond physical infrastructure. If directed to the right infrastructure projects, theoretically the spending should provide a boost to the economy today and maintain or improve productivity growth for years to come. Both are good things for the American economy. But Congress must get it right, and that’s a tall order.
This leads me to our take on what all this means for investing and the real estate market.
Real Estate Market Updates
The real estate market is gliding along now that there is a much more certain path to economic recovery. That means there are more buyers and sellers willing to come to an agreement on pricing. As the future becomes clearer, there is better alignment on a property’s financial prospects and pricing. As a result, deals are happening. With interest rates at rock bottom and buyers flush with capital to deploy, prices are high, and yields are getting driven ever lower. To most investors, a 5-8% yielding property is still more attractive than a negative-yielding government bond, adjusted for inflation. Until the Fed changes its policy, expect prices to remain elevated, cap rates to stay low, and competition to continue to be fierce.
Although the real estate industry avoided a melt-down, it has changed dramatically over the last two years. There are two notable areas to examine: core business district office utilization and suburban vs. urban living. Where we were once concerned about residential renters, the new area to watch is office space occupancy and utilization. And as evidenced by the utilization of public transportation, far fewer people are traveling downtown. More people are moving to the suburbs, buying cars, and driving. Naturally, traffic has exceeded pre-pandemic levels, meaning people aren’t staying home, they’re just driving more. But not to the office.
Offices are the real estate industry’s biggest concern. Office vacancy surged to 15% but has been stable through the summer months. However, office leases are usually rather long, and therefore office income has remained somewhat steady. The true utilization of offices appears to be much lower, as shown in JP Morgan’s Eye on the Market report. No major market shows office utilization over 50%. That is an important statistic to monitor. If 50% or more of all office space remains empty, owners will be wrestling with what to do with all that extra space. There will be major changes to how this space is used or significant adjustments to valuations. Either will be costly if workers stay away for good.
Some workers have begun to go back to the office but the question over the next year to two will be how many and how often workers show up. There are also big shifts in core business districts versus suburban office utilization trends. These trends will determine how big of an adjustment is coming as leases expire or are renewed. It’s too early to determine where the office market is headed, but there could be significant losses if workers stay home even 2-3 days a week and office vacancies remain elevated.
Outside of the office sector, so far, there is no evidence of significant trouble in the general commercial real estate market. Residential real estate has emerged relatively unscathed due to government support, even in the face of eviction moratoriums. Single-family home sales have been on a tear, but it does appear some of the low supply constraints are easing. The big change in residential markets has been the move to the suburbs and to single-family homes. Although that trend seemed to have peaked over the summer as core business district apartment rentals recovered, it’s clear there is a lot of demand for more space. Residential investors should monitor migration trends and changes in occupancy and vacancy of sub-markets carefully to see where demand is heading.
Similarly, self-storage and industrial assets are performing very well. As the e-commerce demand continues to increase, warehouses and fulfillment centers are in high demand. Well-located industrial assets are likely to continue to appreciate under increasing demand well into the future. Retail on the other hand continues to struggle overall. Although this is a very broad category from main street to suburban shopping malls, most retailers face the same pressures driving growth in industrial assets. But there are pockets of strong performance within retail, especially in grocery-anchored strip centers. But Covid-accelerated shift to e-commerce will continue to have a large impact on the retail sector.
We continue to believe in the diversifying power of real estate investments. It’s simple, diversification from the stock and bond market reduces risk and increases long-term returns. We’re not the only ones who believe this. Just read the advice from great fund managers like David Swensen and Ray Dalio. Properly diversified real estate investments provide one important avenue to achieve better results in your investment portfolio.
Find out how Cira Capital Group can help you diversify your investment horizon.