Thomas Urano 0:04
Hi. This is Thomas Urano, CO-CIO at Sage. Thanks for joining me today. I'm here with Andrew Demand, our Senior PM for Corporate Credit. Andrew recently attended NAREIT's Annual Investor Conference in New York. He had a great opportunity to hear valuable insight direct from issuers across the entire spectrum of commercial real estate operators. Andrew, thanks again for joining me. Let's get right into it. What would you say were your top three takeaways from REIT week?
Andrew Demand 0:32
You know, my first takeaway is that the health and sentiment of the REIT space is very much being driven by property subtypes.
Thomas Urano 0:39
So you mean certain property issuers or property types are doing better than others?
Andrew Demand 0:45
Absolutely. So data centers, retail and senior housing look very strong, while life science and industrial face near term challenges, and office being very topical, is facing more persistent challenges. But in general, balance sheets, for the most part, are in good shape, and liquidity is solid. My second takeaway is cap rates have remained low despite raising rates.
Thomas Urano 1:10
I've heard about this issue where we've seen this cycle of rising interest rates, but cap rates in certain segments of the market have remained pretty stable, and in some cases, are pretty low.
Andrew Demand 1:20
That's correct. Multi family properties are trading with four handle on the cap rates. Storage is trading with a five handle. Industrials also trading in the high fours. This demonstrates the demand for commercial real estate. The sector has shown strong resiliency in the face of higher rates. My third takeaway is developed properties are trading well below replacement costs in many sub sectors.
Thomas Urano 1:43
So does that mean — just a question on this — does that mean, when we're thinking about development pipelines in commercial real estate, kind of like in the housing market, where construction costs are high and elevated, development costs and construction costs in commercial real estate space are elevated and probably uncertain?
Andrew Demand 1:59
That is correct. So I mean construction, particularly in commercial real estate, has long lead times, so there will continue to be deliveries, but the amount of starts is slowing down dramatically, particularly with the tariffs that are in fact, that there's just too many unknowns, and the real cost of producing some of these, some of this commercial real estate is just completely unknown.
Thomas Urano 2:24
Well you know, for me, the most shocking thing is seeing cap rates with a four handle. You know, seems like multifamily in that sense, is the darling of commercial real estate. The market's view on commercial real estate has certainly evolved over the last year. We've seen office real estate go from the hot potato to starting to recover. What's the outlook from operators in the office real estate space?
Andrew Demand 2:46
Yeah, so office, very topical as the COVID 19 crisis changed how and where we work from. There are issuers who are struggling with occupancy, as well as over levered balance sheets, who still have some progress, to be made before they can really start delivering. Well, different parts of the country have better dynamics than others. The average tenant is still looking for less space.
Thomas Urano 3:09
So let's talk about that for a second. Return to Office, RTO, right? It's been in place for a while in the finance space, RTO has been a thing. Tech, RTO is starting to pick back up, right? So are we seeing a difference between, say, East Coast dominated financial industry and a West Coast dominated tech industry?
Andrew Demand 3:27
Absolutely, the East Coast return to office is much further advanced than the West Coast. In fact, some are saying it's done, that there's no return to office. It's steady state there. That being said, there are green shoots on the West Coast, particularly in San Francisco, where the quality of life inside the city has risen in tandem with a new mayor and several city council members, as well as support from the AI boom. In the last nine months, you've also had several West Coast tech companies announce return to office initiatives, Apple, Amazon, Google, Meta, Lyft, TikTok — all have implemented, at least partial returns to office. Hope springs internal, but with chunky move outs in the space, I wouldn't be surprised to see slightly less occupancy in office as we make our way throughout 2025 and maybe early 2026 but I would suspect that by mid 2026 we're turning the corner, you're going to see some office occupancy rise as maybe as well as leverage come down in the space in general that so that being said, it certainly feels we're much closer to the bottom than where we were a year or two ago.
Thomas Urano 4:35
Right? You know, office real estate needs a little bit of a lift here. Fingers crossed there. I want to turn to turn to the housing market for a second, with US housing still undergoing some affordability issues. Talk to me a little bit about how people are feeling about multi family properties. We talked about cap rates being so low, but give us some insight on that space.
Andrew Demand 4:54
Yeah. So everyone thought this would be a tough year for multi family and you know, they haven't seen super robust growth or anything, but you know, it's been a lot more muted than expected. So this year, multi family properties coming online, have you know, particularly in the Sun Belt, have been robust, but absorption of those properties has been a lot more tolerable than expected, and what's really driving that is the affordability of housing. Rising rates have continued to push affordability to challenging levels. There is no multifamily armageddon that was feared. In fact, rates on multifamily rentals are improving better than most expected, as well as they continue to have strong tenant retention. Deliveries into many of the challenge areas, the countries, are beginning to slow in the middle of 2025, so it creates a pretty robust and dynamic outlook for multifamily going into the second half of the year.
Thomas Urano 5:56
So it does sound like multifamily is still operating with a nice tailwind. Let's talk retail for a second. Highlights in the commercial retail space.
Andrew Demand 6:05
Retail is strong. There's been very limited to almost no construction in the space since 2008. In fact, as a percentage of supply, deliveries and retail will be even less than office this year. There are estimates that rents will need to rise nearly 40 to 50% to make construction make sense. So you have a very limited amount of supply.
Thomas Urano 6:27
So it's too expensive to build. The pipeline is limited in new construction, but I'm sure online shopping is weighing on the minds of developers. How is that impacting retail and brick and mortar development?
Andrew Demand 6:39
Yeah, so COVID really accelerated how the last mile of retail works. And what was discovered is that brick and mortar are often the most cost effective distribution for that last mile. On top of that, when a business can get a customer become a multichannel customer, meaning they shop in store and online, they will spend multiples of two to three times what a single channel customer will. Recent bankruptcies as well, such as Bed Bath and Beyond and Joanne's have been back filled with ease. Tenants often take non ideal sizes just because they are so desperate to get their hands on space. Retail is showing a lot of resilience, and high demand has allowed many of these shopping center REITs to focus more on essential service based businesses as well as companies with strong balance sheets and possibly investment grade ratings.
Thomas Urano 7:27
So it seems like the the idea of the death of the brick and mortar, everything is going to go online, has been greatly exaggerated, right? And this term multi channel customers something that we've heard a lot more of lately, which is the combination of in store and online shopping, definitely a support there for the retail space and the fact that it hasn't been development just from a commercial real estate REIT perspective, that retail space has been pretty resilient. Let's talk about capital markets and funding for a second. How are commercial real estate operators feeling about debt? Are they looking to increase borrowing? Is cost of capital a problem?
Andrew Demand 8:02
Yeah, so the market is open, and it's open to everybody, just about. As we mentioned early on, you know, there is a bifurcation going on, and office has to defend their leverage, and they're going to pay a premium, while you have other companies such as, or other sectors, I should say, such as one senior year housing executive who told a room of fixed income analysts when asked about whether they would...when we would see them in the market again, he said, "When you learn to price credit correctly from a value relative value standpoint, we will come back to the market." You know, currently they believe their stock is more fairly valued, and will likely use that for their financing needs going forward. So there's definitely a rags and a riches story here with, you know, senior housing being in the riches and office being in the rags, but it is open.
Thomas Urano 8:55
So good to hear that. My takeaway from that is, liquidity is there. The market's open. Funding is open. Costs can vary depending on operators and industries. Andrew, thank you for joining me today to talk real estate. We really appreciate the insight from the NAREIT Conference and looking forward to speaking again.
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