Finding value in U.S. commercial real estate

When it comes to real estate opportunities over the next two to three years, portfolio manager Chip McKinley sees the U.S. apartment market as “exceptionally well-positioned.”

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McKinley, senior vice-president and portfolio manager with Cohen & Steers in New York, said in a mid-September interview that the U.S. apartment market is strong in terms of valuation and fundamentals in the near- and medium-term.

His positive outlook might be a surprise, he added, because that market has done “quite well” over the last decade, so it’s harder to find undervalued gems.

“But what’s really changed over the last year is [U.S. apartments] have underperformed for a little bit from a stock point of view,” said McKinley, whose firm manages the Renaissance Global Real Estate Fund.

Valuations have fallen back in line with expectations as a result, leading to opportunities. Even after years of rental apartment construction in key cities and secondary markets, demand growth has exceeded supply, McKinley said.

The construction cycle for apartments began picking up as the U.S. economy started recovering several years ago, McKinley said. He also pointed to the “slow-moving boom in job growth in the U.S.” The unemployment rate fell to 3.7% in September, its lowest level since December 1969.

Job growth “is the number one driver of demand of all forms of residential real estate,” McKinley said. “So demand’s been very healthy and supply has been trying to keep up, but it’s usually been trailing […].”

This is likely to continue, he forecasts, as more millennials look to get their own places and start families. This will affect the apartment and single-family housing markets.

Investment sales volume of multi-family buildings (i.e. apartment buildings) totalled US$48 billion as of June 30, says Avison Young’s Fall 2018 Commercial Real Estate Investment Review. That accounted for 35% of total investment sales volume in the U.S. commercial real estate space and was a 12% increase from the same period a year earlier.

Hurdles for brick-and-mortar retail spaces

Another area McKinley monitors is the commercial retail space, which means finding out how e-commerce is impacting traditional retailers and their landlords: U.S. shopping centres.

“It’s a zero-sum game when it comes to e-commerce,” McKinley said. “What Amazon and other e-commerce retailers win is a direct loss for traditional brick-and-mortar retailers. This has been very painful [and] very destructive” for retailers and their landlords.

Underperforming stores—both department stores and boutique retail chains—have contracted sharply, McKinley said, and many have gone bankrupt.

“Of course, we’ve seen this train wreck coming [for] many miles away, so it hasn’t been a surprise,” he said. “But the rate of destruction and contraction […] really accelerated in 2016 and 2017. It caused a lot of damage to the retailer, share prices and landlord share prices.”

Sears, which filed for bankruptcy earlier this month, is the latest high-profile victim, planning to close 142 more stores.

“How much destruction in share price and value is appropriate or realistic?” McKinleys asks. “Our assessment is most of the destruction in share prices of all these mall and shopping centre REITs is appropriate.”

The space became “oversold” as some investors “extrapolated a little bit too much,” he said, and prices started to become more attractive almost a year ago.

Retailers are also getting better at competing with e-commerce, McKinley said, re-evaluating their business models and improving the in-person shopping experience.

“We have seen a real bounce back this year. Some of the retailers and some of the malls are starting to show better progress in their rate of sales and profitability,” he said.

A word of caution, however: “You have to really separate the high-quality from the low-quality [names],” he says. There will be “a lot of real losers.”

McKinley’s looking for “high-quality shopping centres and malls” that are close to their customers and that can stay relevant. They may not return to the heyday pre-dating e-commerce, he said,  but these players will “actually see positive cash flow growth over time.” Based on where they’re trading today, there are some attractive values worth taking advantage of, he added.

He’ll also apply this approach globally.

“Everything I’ve said is focused on the U.S. market, but this same kind of trend is happening everywhere around the world,” he said. “But you have to take care to distinguish between different markets just because of market structures, shopper habits and the supply of retail space per capita. There are massive differences.”

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