Real Estate Market Outlook: Airbnb, Commercial and Residential Properties

By: Brian Seay, CFA

Remember that Real Estate is a Diverse Market!

We begin with the observation that the real estate market is very large, and very diverse. Recommending that clients “invest in real estate” would be akin to suggesting clients should “invest in stocks.” The natural reaction is a puzzled expression and questions like: which ones, through what vehicle and how?

We think about the real estate market in three main categories land, residential, and business-oriented or commercial. Raw land includes empty lots, farmland, timber, natural resource leases and other non-developed property. Residential includes single-family homes along with condos, apartments and other properties meant for housing. Commercial properties include offices, industrial facilities, retail stores, medical buildings, and other business-oriented properties. While classic hotels are a form of commercial property, we put short-term rentals in the residential category because the original intent of the property was for housing and ownership tends to be individual families instead of large institutions. When building a real-estate portfolio, remember to diversify across different types of real estate holdings. Let’s discuss some of these different areas for investors.

Don’t forget to listen to our podcast discussion of the real estate market.

Investing in Residential Real Estate in 2023

Housing was underbuilt in the United States over the last decade by 5 million to 7 million homes depending on the study you read. Housing starts are currently running about 200,000 per year over the long-term average, so it will likely take years to build enough inventory to balance the market. This has been reflected in home prices and rents so far in 2023. Even with mortgage rates hovering above 7%, the Case-Shiller National Home Price Index is essentially flat over the past year. The significant value increases in 2021 and 2022 are behind us, but prices are stable given higher rates because there is so much demand for housing. We expect values in most markets to continue to grow modestly over the next few years, back to single-digit historical trends.

Multi-family apartments and homes for rent can increase rent rates, but closer to 1-3% per year according to Zillow and Redfin. A far cry from the double-digit increases over the last few years.  Rental units will continue to benefit in the near term while mortgage rates are high, and buyers delay home purchases. Even with incremental rent growth, values are down 10% to 15% in the multi-family space due to higher interest rates.

Are Short-Term Rentals and Airbnbs a Good Investment?

We examined short-term rental (i.e. Airbnb & VRBO) economics across five markets: Huntsville, Los Angeles, Salt Lake City, Nashville and Atlanta. We combined value data from Zillow and rental market data from Rabbu. Click to see the data and analysis.

For existing owners with mortgages at low rates, good properties continue to provide solid cash-flow and returns across all markets. However, for investors looking to add properties to their portfolio, high mortgage rates and flattening rent revenue means annual operating cash flow losses for new properties. That means investors will need to add their own cash on top of rent revenue to meet mortgage, tax and property management obligations each year. Mid-teen return percentages are still possible, but the return comes from property value appreciation and inherent mortgage leverage, not from rental cash flow. For high-income earners, after-tax returns can be even higher after depreciation and interest deductions but remember that the depreciation benefit may get paid back (or “recaptured”) when you sell the property.

Given the interest rate environment, we view residential real estate as the most attractive opportunity in the current environment. For investors that can purchase long-term rentals, discounted multi-family properties or single-family properties with cash, we think the market will support current price levels for years to come.

Investing in Commercial Real Estate in 2023

In the commercial space, the future of office space is top of mind for investors. According to Bloomberg research, return to office rates in the U.S. are only about 50% of their pre-pandemic levels. Millions of square feet of existing office space sit unused every day.  In addition to the existing glut, new office construction deliveries remain above average.  Many projects started before the pandemic with long lead times and are just now being completed. New deliveries will put even more pressure on the existing market. New projects are not starting, but that will only begin to help in 5-7 years when those projects would have been completed.

Additionally, much has been made about the vicious cycle of office refinancing. A recent Wall Street Journal article called it the “doom loop.” We view this as over exaggerated, but more pain will come in 2024.

Consider a commercial property originally purchased at $10 million with 70% in debt and a 30% equity downpayment. That means the owner borrowed $7 million and used their own capital for $3 million of the purchase price. That property is now worth closer to $8.5 million. To refinance the loan, the owner can only borrow 70% of the current value, or about $6 million dollars. That means the owner needs to add another $1 million of their own money to the deal to refinance. Additionally, the new loan will come at a significantly higher interest rate. If the owner cannot add the extra capital and support higher interest payments, the building must be sold quickly or returned to the bank as a default. Keep in mind the bank only needs to sell the property for $7MM to be made whole. Banks are incentivized to sell quickly rather than attempt to get full price. This cycle further depresses the value of other similar properties. As more properties hit their loan maturity dates and need to be refinanced, prices will likely continue to deteriorate. The good news is that if interest rates fall in 2024 and 2025, refinancing will become easier. Our view is that the long, slow grind of the process keeps office property values low but also prevents a banking crisis or panic.

In the office space market, one category of office has been completely unaffected by these dynamics. “Class A” Office, better known as the best office space in a market or trophy properties. These spaces are modern and cause workers to desire more “in-office” time. As a result, they are more desirable to companies looking to lease space. Firms may trade down to less square footage in nicer space to drive workers back into the office. That means lower tier “Class B” and “Class C” space will suffer the most over the next few years. Afterall, no one wants to be in boring cubicles from the 90s with fluorescent lights overhead for 10 hours a day.

One proposed solution is the conversion of existing office buildings to residential apartments and condos. This seems like a good idea, but it is too expensive for developers to execute at current prices. Modern offices have centralized plumbing, large elevator banks and non-functioning windows. Each of these areas requires a massive overhaul for residential zoning, often requiring more investment than simply building a new building. In dense cities where land is scarce, or if regulations ease (you don’t need to open the window on the 40th floor) then perhaps some conversions occur. However, time, not conversions, will bring the office market back into balance.

Moving to slightly more attractive sectors, industrial sector rents are still growing modestly even as demand slows off records in 2022. The hype around the warehouse space required to support e-commerce is probably overrated because the amount of physical goods bought during the pandemic was unusually high. However, industrial space that supports advanced manufacturing is in better shape as companies move production back into the United States.

Retail, contrary to popular opinion given e-commerce, continues to perform well. Rents are increasing, but only for the right spaces and businesses. Retail designed for services is doing well while older retail for selling goods is underperforming. Think about places you enjoy going, those retail spaces are doing well. The places that you go begrudgingly to pick up things you would rather order online, are doing poorly.

Real Estate Market Assessment: Caution Warranted Moving Forward

Overall, residential real estate is more attractive than commercial space.  Within commercial, industrial and retail are more attractive than office for the foreseeable future. While we do not think there will be a crisis akin to the 2007-2008 financial crisis, we are in a prolonged slow grind for office prices to adjust to reduced occupancy. While the commercial market needs more time to balance, there may be opportunities for investors as individual properties need to be refinanced. Investors should consider lending to property owners in addition to traditional purchase transactions. Providing financing when bank financing is scarce may generate significant long-term returns on the right properties with less risk than ownership.

Sources:

https://www.bloomberg.com/news/features/2023-09-04/what-the-return-to-office-looks-like-globally

https://www.cbre.com/insights/books/midyear-global-real-estate-market-outlook-2023