2021 Market Preview Real Estate - Marquette Associates
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2021 Market Preview
Real Estate
FINDING THE NEW NORMAL
On the backdrop of low interest rates, economic growth, and
low inflation, real estate thrived over much of the past decade.
For many investors, the asset class was a “set it and forget
it” allocation that generated consistently high returns and
attractive yields. However, as we moved later into the cycle,
performance dispersion across sectors increased as a result
of technology disruptions and evolving societal trends. At the Will DuPree
onset of COVID-19 this became more visible than at any other Senior Research Analyst,
point in the cycle. While COVID-19 was the catalyst that ended Real Assets
the previous market cycle, it also pushed real estate markets
further in the directions they were already moving.
Real estate performance as measured by the NFI-ODCE open-end core real estate
index is on pace to deliver flat to slightly positive returns for the calendar year 2020.
Performance continues to lag due to declining property types experiencing further
distress during the pandemic.
Within the ODCE, Industrial continues to be the best performing sector, having
outperformed all others since 2016, with a rolling one-year return (as of 3Q20) of
10.1 %, followed by office at 2.8%, apartments at 2.3%, and retail at -6.3%. However,
apartments have significantly outperformed office since the onset of the pandemic
and year-end return figures should reflect this trend.
Geographically, the top performing region is the West, with one year rolling returns
(as of 3Q20) of 3.3%. The South and East have had modest returns of 1.5%, while
the Midwest continues to lag with returns of -1.1%. The top performing markets
across most property types are Austin and Seattle, while secondary markets such as
Nashville, Phoenix, Raleigh, and Denver have continued their 2–3-year rallies on the
backdrop of 1.5–2.5% annual population growth. On the other side of the spectrum,
previously thriving gateway markets with limited tech-based job growth such as
Chicago and New York continue to struggle.
INDEPENDENT INVESTMENT CONSULTINGAt present, the National Council of Real Estate Investment Fiduciaries (“NCREIF”) projects average returns
over the next four years to be in the 5.0–6.5% range. While income and capex are projected to remain
steady, Net Operating Income (“NOI”) growth is projected to be significantly below the 4.6–5.6% range of
the previous cycle.
ASSESSING CAPITAL FLOWS
Through September 30 th, capital flows of the NFI-ODCE are -$817.3 million,2 indicative of an overall reduction
to real estate investments on behalf of investors. However, redemption requests had been trending upward
in recent years as late cycle observations compelled many investors to lock in gains; this trend accelerated
significantly after COVID-19. At this point, the vast majority of NFI-ODCE funds now have entry/exit queue
ratios less than 1.0, though a large share of these redemptions appear linked to rebalancing. In the prior
cycle, redemption requests also increased significantly following the Global Financial Crisis, but a large
number of these were canceled following declining market volatility and favorable government intervention.
Nonetheless, this is an issue worth monitoring in coming months if redemptions are not recalled and funds
are forced to liquidate properties in a low transaction volume market, as these dynamics will create headwinds
for real estate returns.
PERFORMANCE DISPERSION
A TALE OF TWO SECTORS
At the onset of the pandemic, performance dispersion across sectors became more pronounced than at any
other previous point in the cycle. In the second quarter, the percentage of NPI properties that were written
up in value fell to 20%, while the number of properties written down in value jumped to 80%. This is the
greatest disparity in value that markets have seen since the Global Financial Crisis.
Exhibit 1: NPI Write-Ups vs. Write-Downs
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
1990 1993 1996 1999 2002 2005 2008 2011 2014 2017 2020
Write-Ups Write-Downs
Source: NCREIF as of September 30, 2020
Nothing tells the story of this dispersion better than the retail and the industrial sectors, as the two have been
on polar opposite ends of the performance spectrum since 2016. E-commerce has been the primary catalyst
of this trend. As the convenience benefits of e-commerce have boosted its popularity, demand for industrial
warehouses that store and ship goods has surged and retail traffic — mainly within brick and mortar mall
2types — has dwindled. Since 2000, e-commerce has doubled its share of retail sales every five years, causing
demand for industrial and retail properties to rise and fall, respectively.
Exhibit 2: The Inverse Relationship Between Retail and Industrial Demand
3%
Retail Absorption
(% of Inventory)
2%
1%
0%
-1%
2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020
4%
Industrial Absorption
3%
(% of Inventory)
2%
1%
0%
-1%
-2%
2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020
Sources: NCREIF, DWS
This pattern had led investors to wonder if the retail sector of real estate is dead. Our answer to this question
is no, but continued contraction is inevitable. A recent study by the International Council of Shopping Centers
found that automotive and food/beverage categories have the lowest level of e-commerce penetration,
while over 20% of apparel sales today are made online. Accordingly, grocery-anchored retailers have held
up well during the pandemic, as these retailers have successfully integrated e-commerce platforms such as
Instacart and curbside pickup into their business models in ways that do not detract from profitability.
But the high costs of implementation and other factors have prevented many brick and mortar retailers from
successfully integrating e-commerce platforms in ways that support mall properties. Today e-commerce
penetration is now forecasted to rise to 25% by 2023.3 Once a convenience, buying online became a necessity
during the pandemic, and the preferences of many consumers are likely forever changed. Therefore, retail
allocations that feature a larger weighting to grocery-anchored retail properties are poised to outperform
more traditional allocations to malls and other stores which have seen sales decline as a result of growing
e-commerce.
THE FUTURE OF OFFICE REMAINS UNCLEAR
The challenges for the office sector are more ambiguous. Like retail, office has also been challenged by its
own technology disruption, the increased number of professionals working from home (“WFH”). Since 2010,
the percentage of office employees working from home has gradually increased (Exhibit 3); the pandemic
has forced the vast majority of white-collar employees to conduct a full-time WFH experiment.
3Exhibit 3: E-commerce and Working from Home Surge in Popularity
15% 20%
Work-From-Home Share of
19%
13%
E-Commerce Share of
Office Employment
18%
Retail Sales
11% 17%
16%
9%
15%
7% 14%
13%
5%
12%
3% 11%
2010 2012 2013 2014 2015 2016 2017 2018 2019 2020
E-Commerce Work-From-Home
Sources: Census Bureau, DWS
Since the first quarter of 2020, leasing activity has been suppressed and transaction activity has been non-
existent, as tenants patiently contemplate whether to eventually renew leases or permanently embrace WFH
and reduce their office footprints altogether. YTD the values have declined by 2.16%. However, total returns
remain positive at 1.1% on the backdrop of 90+% rent collection and longer lease terms. Lease rollover
percentage, a primary driver of value and future demand, will be a key data point in coming quarters. In 2021
we expect landlords to pursue lease renewals more aggressively in order to protect property values, but
negotiation power has thus shifted from landlords to tenants.
We believe the rumors of a massive office exodus have been exaggerated, but a smaller yet significant
percentage of tenants may reduce office footprints. While WFH has introduced its own set of advantages,
such as no commute and more time with family, it has also introduced new challenges including burnout,
communication barriers, and declines in mentoring, collaboration, and creative thinking.4 In a recent survey
of 317 companies, 95% said they plan to bring over 50% of employees back to the office eventually, however,
25% planned to shift ~20% of on-site employees to permanent WFH positions, and 13% claimed to have
already cut reductions in real estate expenses.5
Moving forward, we expect demand for the sector to modestly contract, however, gateway markets are
expected to see sharper near-term declines. Factors such as the difficulty of implementing social distancing
on public transit, larger suburban workforces, and increasing corporate tax burdens imply that gateway
tenants are more inclined to reduce their office footprints. Markets that lack significant tech employers — such
as New York and Chicago — will be the most challenged. Suburban and sunbelt offices will also experience
some vacancies but are likely to see more favorable cap rates in the near future, per accelerating population
growth and millennial migration. Additionally, properties in all markets should see some tailwinds from the
new need for de-densification — meaning an increased need for appropriate space between employees —
but will also see future NOI pressure from tenant improvements associated with improved ventilation and
higher sanitation standards.
4ASSESSING RELATIVE VALUE
Despite the multitude of headwinds, relative value is apparent. The spread between core real estate cap rates
for major property sectors and the 10-year Treasury yield has significantly widened to +392 bps, while the
spread vs BAA corporate bonds and BB High Yield bonds has widened to +116 bps and +20 bps, respectively
(Exhibit 4). In a market of increasing yield scarcity, core real estate offers some of the most attractive income
distributions.
Historically, large cap rate spreads have preceded periods of strong real estate returns. However, if the
trends of performance dispersion continue, more attractive valuations are more likely to be observed by
property types that are in more favorable points of their respective market cycles.
Exhibit 4: Current Cap Rate Spreads Over Treasuries and Corporates Well Above Prior Peaks
12% 12%
10% 10%
8% 8%
6% 6%
4% 4%
2% 2%
0% 0%
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
Spread (right) NCREIF Cap Rate (left) 10-Yr Treasury (left)
10% 8%
8% 6%
4%
6%
2%
4%
0%
2% -2%
0% -4%
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
Spread (right) NCREIF Cap Rate (left) Baa Yield (left)
20% 8%
15% 3%
10% -2%
5% -7%
0% -12%
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
Spread (right) NCREIF Cap Rate (left) BB Yield (left)
Sources: Bloomberg, NCREIF, Clarion Partners, DWS, Blackrock
5OPPORTUNITIES IN CORE REAL ESTATE
Alternative Sectors Continue to Grow and Exhibit More Core-Like Characteristics
While a significant share of core real estate assets is in a period of price discovery, esoteric property types
such as data centers, cold storage, medical office, and self-storage are gaining popularity. Towards the end of
the last cycle, ODCE managers began modestly increasing exposure to these “other” or alternative property
sectors, as these assets began to exhibit not only diversification benefits, but also core asset characteristics.
Since 3Q18, alternative sector exposure has increased from 3.3% to 4.4% of the index (Exhibit 5). Prior to the
pandemic, many of these property types were experiencing tailwinds that have since accelerated.
Self-storage absorption increased in 2020 on the backdrop of many employees temporarily abandoning
gateway market apartments and living at home until the end of the pandemic. Demand for medical office
and life sciences properties had been increasing in recent years, per the aging population coupled with
increasing R&D spending and technological innovations. The pandemic-driven demand for self-storage
implies that it may be approaching a cyclical peak, while the demand for life sciences and medical office
properties was strengthened by the pandemic and should continue to grow.
Demand for data centers and cold storage also increased in 2020, however, future demand for these
properties is less clear. Demand for data centers has accelerated significantly with millions of white-collar
employees working remotely. While most employees are expected to return to the office, the increasing but
to be determined number of future remote workers should create long term structural growth. Demand for
cold storage also accelerated significantly per health concerns associated with in-person shopping. While
many will return to in-person shopping post pandemic, others have fully embraced the convenience of online
grocery shopping, creating enough structural change for future growth.
As traditional sectors continue to contract, we expect alternative sectors to gradually become a larger part
of the core real estate universe.
Exhibit 5: The Growth of Alternative Property Sectors
45%
NFI-ODCE VW Sector Weightings
40% 38.3%
35%
33.5%
30%
25.1% 26.8%
25%
20.3%
20% 20.4%
15% 12.8% 14.8%
10%
5% 4.4%
0.4% 2.3%
0.0%
0%
2013
2014
2015
2016
2017
2018
2019
2020
Apartment Industrial Office Retail Hotel Self-Storage Other
Sources: NCREIF, Clarion Partners as of September 30, 2020
6OPPORTUNITIES IN VALUE ADD AND OPPORTUNISTIC REAL ESTATE
A Magic Bullet or a Mirage?
Because chaos creates opportunity, the temporary demand shocks of COVID-19 have likely created investment
opportunities for value add and opportunistic real estate portfolios. Many of these currently depressed
property types could see major positive demand shocks and thus appreciation in value after successful
vaccine distribution and society returns to levels of normalcy. However, we must be prudent in assessing
the current opportunity set. Because the pandemic has created and accelerated several behavioral shifts —
some of which are likely permanent — it is highly unlikely that all property types will return to pre-pandemic
demand levels.
We are observing value add opportunities originating from the combination of pandemic-driven occupancy
declines and credit stress. Senior living, student, and luxury housing opportunities offer much potential, and
we are cautiously optimistic on post pandemic return projections. Furthermore, with the credit curve likely to
steepen, prudent underwriting is imperative.
We are also seeing attractive opportunities for opportunistic strategies. Sharp declines in valuations and the
second wave of COVID-19 may create meaningful liquidation scenarios and recapitalization opportunities
in properties most dependent on foot traffic. However, it is imperative to temper expectations and not
expect vaccine implementation to have a magic bullet effect. While leisure travel properties are likely to see
immediate spikes in demand, per vaccine fatigue and increased American savings, post pandemic corporate
cost savings strategies will likely limit business travel from reaching previous levels.
CONCLUSION
Years from now when we reflect on 2020, we may see it as the year that permanently impacted real estate
markets for years to come. However, the medium to long term outlook for the asset class is not all doom
and gloom. While much of real estate sits in price discovery, the combination of lower borrowing costs, yield
scarcity, and attractive cap rate spreads imply that markets could see attractive returns in the medium to long
term. However, because sector dispersion is likely to continue, property types at more favorable points in the
cycle are more likely to be accretive to investment portfolios than those at less attractive entry points. Moving
into 2021, we believe real estate should continue to play an important role in portfolios. However, we are likely
to continue seeing an environment of winners and losers across both property types and asset managers.
Prudence in both property selection by managers and manager selection by fiduciaries is more imperative
now than it has been in many years to ensure a successful real estate investment portfolio.
NOTES
1
2020 annual returns have not been released as of writing date
2
NCREIF Fund Index – ODCE Quarterly Detailed Report, Q3 2020
3
Prologis
4
Harvard Business School, April 2020
5
Gartner, Inc. (3 Apr 2020).“Gartner CFO Survey Reveals 74% Intend to Shift Some Employees to Remote Work Permanently.”
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The sources of information used in this report are believed to be reliable. Marquette Associates, Inc. has not independently
verified all of the information and its accuracy cannot be guaranteed. Opinions, estimates, projections and comments on
financial market trends constitute our judgment and are subject to change without notice. References to specific securities are
for illustrative purposes only and do not constitute recommendations. Past performance does not guarantee future results.
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Registration does not imply a certain level of skill or training. More information about Marquette including our investment
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focused client service approach and careful research. Marquette has served a single mission since 1986 – enable institutions
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