Wharton@Work, a monthly newsletter from Wharton Executive Education, recently spoke with professor Todd Sinai, chair of Wharton’s Real Estate Department, about the investment risks and opportunities in commercial real estate that have emerged as a result of the global pandemic. Sinai is the academic director of the Wharton Executive Education virtual program Assessing Commercial Real Estate Investments and Markets in the Era of COVID-19. In the interview, he shares his view of the current landscape, offering his perspective on the economic and social changes that are affecting the sector.
Wharton@Work: Right now we’re seeing large sectors of the commercial real estate market being devastated by the effects of the pandemic, while others are thriving. How do you view these changes?
Todd Sinai: My view is that COVID-19 is not an existential threat to real estate. Real estate is largely a space for people. When we’re working, we have to have a space for that. Plus, by nature we are social creatures. We need to gather somewhere. Hence, the need for real estate hasn’t changed. What has changed is where things happen. Right now people are working from home, and they’re buying more online. It’s a dislocation, but there is still a need for physical space. It requires adaptation. It doesn’t signal a long-run decline in demand.
W@W: In terms of investing, how do you view this dislocation? What are the sectors to avoid today?
Sinai: Retail and office space were not doing well before the pandemic, and they’re doing worse now. Lodging, of course, has no demand, and apartments and student housing are doing poorly. It’s not just sectors — where real estate is located makes a difference right now, too. Central business districts (CBDs) are losing out to suburbs. I would avoid areas of the country that depend on tourism or mass transit.
W@W: Who are the winners today?
Sinai: Data centers are benefiting from our heightened use of technology. Infrastructure, like cell towers, are in demand for the same reason. Logistics (warehouses), home builders, and the relatively new sector of single-family home rentals are also doing well. The latter involves companies that bought up suburban homes to rent them, and they’re doing much better than apartments.
W@W: Do you expect any of the sectors that have little or no demand now to strengthen after COVID-19?
Sinai: I expect demand for apartments to be robust and lodging and student housing to go back to normal. The jury is out, though, on office buildings and the CBD/suburban divide.
W@W: What about retail?
Sinai: Before the pandemic, e-commerce and overbuilding made about three-quarters of U.S. retail space redundant. That was exacerbated by the shutdowns, and the retail shakeout will continue. But the retail that will survive will be incredibly productive because that brick-and-mortar retail will be complementary to e-commerce and will gain operational leverage through multi-channel retailing.
Also, investors should not consider all retail space equally. Grocery sales are up, and so grocery-anchored strip centers are doing okay. Enclosed malls, which were already struggling, were already targets for redevelopment — either into densified mixed-use campuses or other uses. Basically, some (but not all) malls are in great locations, so they are ripe for redeployment into another use. That’s why you see Simon Property Group, the largest mall owner in the U.S., talking with Amazon about turning department store spaces into distribution centers. Malls typically have great highway access and are located close to population centers.
W@W: Let’s talk about office buildings. Out of necessity, numerous companies and organizations are embracing work from home or working virtually out of remote or off-site locations. Several big companies such as Facebook, Google and Twitter, just to name a few, announced earlier this summer that their employees will continue to work remotely for the foreseeable future. And in an extreme example, outdoor retailer REI announced it plans to sell its brand-new sprawling 8-acre corporate campus in Bellevue, WA, that was only just completed this year because of the dramatic shift to remote work. In a statement, the company said it would “lean into remote working as an engrained, supported and normalized model” that could also allow its employees to work outside the region. So, should investors avoid office buildings?
“My view is that COVID-19 is not an existential threat to real estate.”
Sinai: First, I’m not convinced that remote working will be “engrained” post-COVID-19. Most people don’t like working at the dining room table, need to be out of the house when the kids get back from school, and prefer an office to staring at the same four walls all the time. And once most employees return to the office, everyone will. However, until then, why would a tenant renew their lease if they don’t have employees coming into work? And landlords will be exposed to tenants that go bankrupt. So, one needs to tread lightly when investing in office buildings. Look for long leases, tenants with high relocation costs, stable tenants, and well-capitalized owners. Plus, right now, and for the foreseeable future, if your workforce needs public transportation to get to your building, that’s a problem. Some cities, like Los Angeles, are less transit dependent. New York City is the most. Suburban offices, which had been on the decline for a while, are easily accessible by car, which is a plus now. Also, think about “internal” transportation: Once people are in the building, how do they get to the upper floors? If only four people can ride an elevator at a time, that can add a long time to a commute to the upper floors, or the flexibility of when workers can arrive will be limited because they will have to be staggered.
W@W: Long leases and high moving costs mean stability in terms of tenants, but why is the owner’s capitalization important?
Sinai: If we are back to normal in six months, the number-one issue until then will be liquidity of the property owner — their ability to survive tenants not paying rent or needing forbearance. Look at landlords’ balance sheets to determine their capacity for short-term survival. I am gung-ho on finding low-leverage, long debt-maturity companies to invest in, in every sector. Beyond that, in the long run, adapting existing buildings to be robust to pandemics — in terms of air quality, elevators, and reduction of worker density — is slow and expensive. In addition, the trend of the last decade toward tenants preferring open floor plans with higher worker density may have reversed.
W@W: What do you expect to see post-COVID-19?
Sinai: I think you will see landlords investing for the long term since people now recognize that COVID-19 will not be the last pandemic. On the part of investors, there will be a flight to quality real estate, and we are seeing signs of this already. When looking to manage investment risk, don’t just think about differences between real estate sectors but look at companies, or properties, within a sector. You need tenants who have long-term leases and will stay. You need a good building in a good location, so even if a tenant leaves you can replace them. You also need to find companies that don’t need to refinance: Maturing debt can kill real estate in a downturn.