Hosts Joe Muratore and Ryan Swehla discuss how COVID-19 has affected their portfolio and what they're doing to strike a balance between being supportive of tenants while preserving cash flow for investors.
Learn more about Graceada Partners at graceadapartners.com
Hosts Joe Muratore and Ryan Swehla discuss how COVID-19 has affected their portfolio and what they're doing to strike a balance between being supportive of tenants while preserving cash flow for investors.
Learn more about Graceada Partners at graceadapartners.com
Start Transcript:
Joe Muratore:
The smartest companies will bifurcate. They'll have the creative, competitive people in the office, as required, working together, and the more process-driven, less competitive ...
Ryan Swehla:
Less collaborative.
Joe Muratore:
Yeah, those things will be done remotely.
Ryan Swehla:
Yeah.
Joe Muratore:
But understanding those two things and getting the amount of office space in the location that serves that purpose is crucial
Speaker 3:
From Graceada Partners, this is Durable Value: An Investor's Podcast, where hosts Joe Muratore and Ryan Swehla demystify commercial real estate with safe, sound investment strategies to help you balance your portfolio.
Ryan Swehla:
On this episode, Joe and I discuss how the pandemic has impacted our investment portfolio and what we expect for post recession recovery.
Ryan Swehla:
So we're in some pretty unusual times right now. How has this pandemic and the economic fallout affected our portfolio?
Joe Muratore:
Well, our portfolio is 91% professional office right now and 9% retail, which is excellent. It turned out retail was impacted heavily during the pandemic and professional office, not so much. On the office side, about a third of our office is government, about 15% is medical office, and the remaining is professional office, so engineering, law, that sort of thing.
Joe Muratore:
On the retail side, we have three or four restaurants that we've worked out deals with. Generally, it's partial relief one month, a little bit less the following month. But we're working to be very supportive, they're not open, but we're also working to protect investors, and protect our investments, and strike that right balance of being supportive, but also preserving the cashflow of the properties. On the office side, we've had very few complaints or requests for paying less rent, one or two, and we've worked through those. But all in all, it's gone pretty well.
Ryan Swehla:
I think, also, we'll see how the economic repercussions play out over time as well. With the office tenants, they tend to be delayed response, and that's partly why we focus on, I hate to say this, but kind of a worst case scenario when we're doing our initial underwriting. That's why we focus on being cost competitive in any environment. We focus on multi-tenant properties so that we have that risk mitigation as well.
Ryan Swehla:
I do anticipate that as this plays out, we will see some more impact to our office tenants, but we've underwritten a healthy amount of vacancy and lease-up time initially, we've kept strong cash reserves, and in the meantime we've been able to add new tendencies as well. So I think we're in a good position to be able to navigate through that existing portfolio.
Joe Muratore:
On the office side, this is interesting. Well, the larger question is, how does real estate change as a result of this sort of pandemic, and one of the first things that comes to mind is I'm on a Zoom call almost every day now, and a month ago I'd never heard of Zoom. But now Zoom has become a part of our lives, so the natural question is, what impact does that have on office space?
Joe Muratore:
The first answer is, people are working from home so they're getting a sense of why they would want to be in offices. You can only be so productive when the dog's barking in the background and the kids are calling, and so that sort of gives a compelling reason for why you might want to be in office space. But at the same time, it also has given people a chance to practice being productive outside of office space.
Joe Muratore:
Personally, what I think this means is that this will have some impact on demand for office space. I think that footprints will become a little bit smaller, maybe 10 or 15%. Maybe a portion of that workforce works from home one or two days a week. Maybe not. But certainly, they're getting more comfortable with that.
Joe Muratore:
What's interesting about that, though, is because rental rates have not reached a point in our geography that justifies new construction, in about the last 10 years very little new supply has been built, and so demand's stayed pretty strong. I think what this does is set us back a few years, maybe five years in that demand cycle. I suspect over the next 10 years, more office space also won't be built because working from home alleviates some constraint.
Joe Muratore:
So, all in all, I see just being set back a few years, but until there's new buildings being built, there's going to be continued growth on demand. What do you see?
Ryan Swehla:
I think that this virus has accelerated underlying trends that were already there. I mean, we've all heard about the demise of the office space and that telecommuting is going to take over, and all this did was add emphasis to that. But what's interesting, to your point earlier, is that emphasis has been good and bad. How many times have we been on a Zoom call and there have been either weird technical difficulties, or we've kind of checked out because we're just not at that level of engagement and interaction?
Ryan Swehla:
We all have recognized that the business environment, the physical environment of business, is what fosters the greatest level of creativity, of collaboration, and business ultimately is successful through collaboration. It's through those conversations after the conference, after the meeting, it's through the little bit of downtime before the meeting actually starts, that we have those fringe conversations that ultimately end up being something important, and you just can't have those outside of an office environment.
Ryan Swehla:
I also think that this disease will have us be more thoughtful about our office space as well, and I think in some senses that will slow down that trend that was towards smaller, smaller, smaller, smaller office spaces, fewer square feet per employee, because now people have a greater sense of needing to have a little bit more space. So on the one hand, we will see an acceleration of the telecommuting phenomenon for the job roles where that's right. But then on the other hand, we'll also see that people who recognize the need for their office environment, they may want a little bit more room than they historically wanted.
Joe Muratore:
I think people will retreat to their separate corners, so to speak. People in more commoditized professions, where something's done in an office but it's done the same way over and over again, where there's a clear checklist on what to do, you do A, and then you do B, and then you do C, and that's how we produce our product, that may well be able to be done from home. You can have a time clock. You can monitor productivity. You can monitor how fast people are going from A, to B, to C, to D, and product gets out the door.
Joe Muratore:
But in many cases, maybe in most cases, we live in a competitive world, where, as we said earlier, what got you to here won't get you to there. That requires a creative process. That requires a coming together. That requires a high level of motivation and drive to win the account, to produce a piece of work that may have never been produced before. To do that, it's very hard to do that remotely.
Joe Muratore:
You have to have all your attention on that thing. Your team has to be in the room together for a long period of time, solving problems and working together, and the businesses that don't get that are going to lose. The businesses that are able to compel their workforce into that same space, to be the most competitive unit they can be, are going to win.
Ryan Swehla:
There's no coincidence that Apple, Google, these companies are trying to create these campus environments where food is there, if you want to take a nap there, your pet can come there. They want people there as much as possible, and the reason is because they recognize that that synergy and collaboration of people together creates the most value.
Joe Muratore:
Yeah. The smartest companies will bifurcate. They'll have the creative, competitive people in the office, as required, working together, and the more process-driven, less competitive ...
Ryan Swehla:
Less collaborative.
Joe Muratore:
Yeah, those things will be done remotely.
Ryan Swehla:
Yeah.
Joe Muratore:
But understanding those two things and getting the amount of office space in the location that serves that purpose is crucial.
Ryan Swehla:
I think, drilling down into our specific geography, you touched a little bit upon the fact that we've had no new supply added to the marketplace in a decade. I think another thing that we look at is the location of the assets that we're buying. Because on a broad brush, you could say office demand will decline to some degree, and I think that there's some validity to that, absolutely. But then you have to ask yourself, which office assets are people going to want to be locating in? Our job, in all of our geographies, is to be the office asset that people want to be locating in.
Ryan Swehla:
So it's interesting because this virus has definitely underscored trends that are already occurring, but has also taken wind out of some trends. So right now, over time, we have seen that the strongest area of retail that has been growing year over year has been service. It's been dining, it's been grooming, gyms, health, fitness, anything that you need to go to, that you can't order on the internet. Those have been the kinds of retail that have continued to flourish amidst the assault of Amazon and other online.
Ryan Swehla:
Those, ironically, were the sectors that were hit hardest by the pandemic, and so this is where, as an investor, we step back and we say, the areas that have been hit the most are also the areas that we have a fundamental conviction will thrive the best in the future. This is a buying opportunity. People are scared right now. Take a strip center or a small shopping center, where you've got a lot of mom and pop restaurants, and nail salons, and haircutting places, and people look at that and they say, "Oh my gosh, they're all going to go out of business."
Ryan Swehla:
Meanwhile, we step back and say, these are fundamentally strong retail. These are the types of retail that we need to be investing in. They're going to see some hiccups right now, and we need to underwrite those hiccups, we need to expect that there's going to be a certain level of tenancies that are going to go bankrupt, or that will need rent concessions. But if we can then go into that and buy at a price that otherwise was unheard of on an asset that we know is fundamentally going to be strong, this is the time to be doing that.
Speaker 3:
You're listening to Durable Value: An Investor's Podcast. We understand the world of commercial real estate can be daunting, but we want to make it as simple as possible for you. Get the free 56 point checklist for evaluating investment properties that Graceada Partners uses every day, at graceadapartners.com/guides.
Joe Muratore:
We have to ask ourselves, and we do, a year from now will people be going to restaurants again? Certainly, they will. They'll be in restaurants. They'll be in bars. They'll be at hair salons. Two days ago I had my wife cut my hair, and I've been going to the same barber for a decade, but I just had to have a haircut. Human beings, we're social animals, and we will congregate, and we will look for retail and community places to meet our needs, to meet other people, to relax after a hard day's work.
Joe Muratore:
So our job as contrarian longterm investors is to say, where is the market mispricing an asset irrationally? Where has too much fear crept into the pricing of that asset? Right now, that's retail, and we do have some offers in on retail. That said, we're still letting this shake out a little bit. There are tenants that will not make it through this down cycle, and yet landlords, sellers, have not recognized that yet.
Joe Muratore:
As you look at the cycle of emotions through recessions, it sort of goes fear, and then anxiety, and works its way down to depression and capitulation. There's this whole range of emotions that goes through a down cycle, and then up towards hope, and then optimism there again.
Joe Muratore:
But there's a mispriced spot right now where investors are still holding on in anxiety and fear, but their tenants may be in a different spot. So while we do have some offers in on retail, I think it's going to be a few months to sort of see where this shakes out. The main story here, though, is put in offers and see who wants to talk and that's what we're doing.
Ryan Swehla:
Well, I hear you often, and I borrow your phrase often, which is that we need sellers to go through stages of grief, and I think that that epitomizes our strategy. We are not looking to be the top bidder. We are not looking to be the one that beats out all the competition. We're looking to be that patient buyer who ultimately sticks to our guns, we know our underwriting, we know where we can be, and we can act decisively at that underwriting. Regardless of what the market is telling us, or what the seller is telling us, or the brokerage community, we can act with precision, and if that takes the seller going through various stages of grief, so be it.
Joe Muratore:
Well, and there's different pieces of pressure. There's $1.8 trillion worth of CMBS debt that's coming due in the next two or three years. It's maturing at different times, and CMBS lenders are extremely hard to work with, and there's going to be challenges there. It's our job to have, as we do, capital on the sidelines and be in the market to where we spot those opportunities and can get in front of them and can win.
Joe Muratore:
On the multi-family side, we're in an interesting point of transition, too. Over these last couple of years, multi-family has been extremely hot, selling in the four caps, in the three caps, in the five caps. But when you have 23 million people going through ... unemployed, newly unemployed, having a greater than 20% unemployment rate, worse than we even saw in the Great Recession, what does that do for multi-family pricing?
Joe Muratore:
The job of the multi-family investor is generally to get rents up as high as they can. So we've seen rents creeping up 1,500, 2,000, $2,500 for one bed, one baths. It's thought out there, and I've seen some economists predict that there might be a 20% drop in multi-family pricing. So multi-family is a great sector, it's not going away, but I think it peaked. I think that's an understood thing, and now, going through this next dip with multi-family will be interesting.
Joe Muratore:
But certainly, it will be a great time to invest in multi-family because there's a housing shortage in California, and there's a housing shortage in the Central Valley, and there's a major housing shortage in the Bay Area. The sector's not going away, but prices are becoming more favorable.
Joe Muratore:
On the office side, I'd say it's hit and miss, but now's a great time to move towards core. Normally, to get to prices that would justify or get us to a 15% internal rate of return, we've had to act more on the periphery of downtowns. In a time like this, for us, we would rather move to the core or move to better locations and still get about a 15% internal rate of return, but buy high quality, well-located assets that normally we wouldn't be able to get to buy within our price parameters. So that's generally what we're focusing on now.
Joe Muratore:
How do you see this recession and maybe this recovery playing out in our geography? There's also that question people talk about, where, is it a V shape recovery, a U shape recovery, or an L shape recovery? And we're not economists, we're just real estate investors, but how do you see it shaping up in our geography?
Ryan Swehla:
So, it's interesting. I saw a couple of graphs recently that I think really speak to our area. One showed the various sectors nationwide that are most and least impacted by this COVID pandemic, and two of the industries, well, three of the industries that were least impacted were government sector, health care, and agriculture. Government and healthcare being actually positively impacted and agriculture being neutral. Those are three of the economic sectors that are strongest in our Central Valley region.
Ryan Swehla:
The other chart that I saw showed all the major metropolitan areas in the country, ranked by most to least impacted. Of course, on the most impacted were Las Vegas, Miami, these very tourist-centric areas. On the least impacted was Washington D.C., and then Sacramento, across the entire nation. So I think that that, paired with something we talked about a little earlier, which was, in our area we have not seen the frothy development environment that also leads to deeper plummet in real estate values.
Ryan Swehla:
The reason for that is, obviously, in parts not in our region, we've had forest fires that have caused construction costs to rise. We've had regulations that have caused construction costs to rise. With that, construction costs have remained higher than rental rates justify building new construction. So I believe we're in an environment in our geography where we're not going to be as impacted as other areas that have had a more frothy development environment, and that have sectors that are more at risk to the economy.
Joe Muratore:
It's going to be interesting these next two months. So, of course, the government's put out 350 billion in PPP loans, and that's just one loan program, there's seems like three or four different loan programs going on, not to mention no evictions and other mortgage relief. So it feels like there's going to be a spate of economic activity happening in the next two months. The PPP loans have started to come out now and they have to be spent in two months on employees and on rent.
Joe Muratore:
I was talking to a restaurant owner downtown yesterday and he said, "Well, I think we're going to be in the second wave of PPP loans, and I hope so because," he says, "I don't want my check yet because they won't let me open my doors, but as soon as I get that check, the clock's ticking and I have to hire a bunch of people right away."
Joe Muratore:
So there's going to be this immediate two-month impact, where a bunch of money, 350 billion, or double that depending on what Congress approves next, that gets pushed out the door, right away, by law. So it'll be interesting to see how this recession plays out.
Joe Muratore:
Anecdotally, remembering the Great Recession, I'm just not seeing the despair that I saw last time. Maybe it's that people are home with their families and are actually seeing the silver lining in this. Most of the business owners that I talk to are getting along fine-ish. But it strikes me that this might be more of a V or more of a U recovery and not the long, drawn-out L that we experienced last time.
Joe Muratore:
I have that chart on my wall of the emotions, Howard Marks's recession emotion chart, and every week I've been ticking along where I think we are in the cycle. I started anxiety, and I got to fear, and I'm just not getting to depression. We're sort of hanging back. I think these next two months, it's going to sort of be that way, and then we're going to ease our way into the ...
Joe Muratore:
Well, certainly, in Q3 we're going to see a really dark jobs report, but I think as we head into the new year, we're going to begin to see recovery. So it'll be interesting to see how this plays out, but personally, I'm not seeing the Great Recession here, and I'm looking for it. I'm looking for it, but I'm not seeing it.
Speaker 3:
Thank you for listening to Durable Value: An Investor's Podcast, where we demystify commercial real estate with safe, sound investment strategies to help you balance your portfolio. If you enjoyed this podcast, be sure to rate it on iTunes or wherever you get your podcasts. To learn more, visit graceadapartners.com, where you'll find more information, investors' tools, case studies, and more. This podcast is hosted by Joe Muratore and Ryan Swehla. It's produced, edited and mixed by Melodic, with intro music by Ian Post. Thanks again for listening, and we'll see you next time.