Sorting properties as favored, unfavored could hide nuances

Real estate managers and investors could be missing investment risks and opportunities by sorting their portfolios into favored sectors — industrial and suburban apartments — and unfavored sectors — office and retail — as a result of the pandemic's impact on those property types, a report said.

But the devil is in the details. When the pandemic hit, asset owners and managers quickly reclassified their portfolios based on the asset types, potentially missing out on the nuances of specific situations and deals, said Jacques Gordon, Chicago-based global head of research and strategy and managing editor of LaSalle Investment Management's midyear report.

"That was the story we were finding in our own experience; the great divide between favored and unfavored sector was missing the best parts of the unfavored sectors and glossing over the flaws in the favored sectors," Mr. Gordon said.

Real estate took a hit during the pandemic with transactions volume falling 64% year over year in the second quarter alone and pricing became challenging, according to Real Capital Analytics data. In response, many investors repositioned their real estate portfolios hoping to capture returns.

At the same time, values across many property types were propped up during the pandemic by long-term leases in some sectors, which could lead to challenges in investors' real estate portfolios when the leases come up for renewal, according to the midyear report. In some property types, conditions have changed since the leases were struck, the report said.

Real estate managers and investors' mass re-sorting of their real estate portfolios was informed by the transaction activity, albeit lower than average, and valuations during the pandemic so far. Much of the transactions and price increases in 2020 and the first quarter of 2021 have been in favored sectors such as industrial and suburban apartments as well as niche sectors including single-family homes for rent, medical offices, self-storage and life sciences, LaSalle's report showed. Meanwhile, less popular property types of retail and office haven't fared as well.

For example, office transactions worldwide fell sharply in the second and third quarters of 2020 relative to average quarterly volume in 2017 to 2019. While transaction volume rose in the fourth quarter of 2020 and first quarter of 2021, it was still 80% of average transaction volume before the pandemic, the report said.

Office transaction volume in the U.S. alone fell 40% at the end of 2020 from the year before.

But these macro trends ignore some real estate gems among the least favored sectors, Mr. Gordon said.

"We all know shopping centers had a very tough pandemic and they are lagging in their ability to drive rent growth, to drive value growth," Mr. Gordon said.

Even so, there are some shopping centers that are good value, he said. There was a 28% year-over-year jump in retail sales in May in the U.S., especially at restaurants and other service-oriented retail stores as a result of the fiscal stimulus and vaccination campaign, the report said. In Europe, led by the U.K., there was a 9.2% increase in sales volume in April compared with April 2020, it said.

While fashion-dominated shopping malls have fared poorly in the pandemic around the world, they have performed slightly better in China and Canada. In China, the growth was driven by people's inability to travel overseas, resulting in strong demand for domestic fashion retail, the report said. Grocery-centered shopping centers where there is a balance between discretionary and non-discretionary goods have fared well.

In office properties, there are enormous differences between cities and regions, Mr. Gordon said.

In the first half of 2021, the percentage of employees who returned to work in an office in Tokyo and Shanghai was in the mid-90% levels, he said. However, in the U.S. that percentage ranged between 40% in cities such as Dallas to 10% in New York, Mr. Gordon said.

LaSalle expects volatility in office vacancy rates across the Asia Pacific region due to changes in office policies, including limits on percentage of workers in offices under Japan's COVID-19 state of emergency, the report said. Even so, LaSalle favors core and non-core office investments in Tokyo as well as Osaka because while vacancy rates in the two cities have increased, they have the highest office occupancy in the Asia-Pacific region, the report said.

The same trends are in Europe, with London, particularly central London, at the low end and business parks in the suburbs seeing between 50% and 60% of workers returning to the office, he said.

"Don't get too caught up in the return-to-work" because it is a multiyear, multistage process, Mr. Gordon said. "Those statistics are effervescent, here today but will change in six months," he added.

Although rent is continuing to be paid around the world, LaSalle expects tenants to make big decisions about their office needs when those leases expire, Mr. Gordon said.

One small indicator that he calls the "canary in the coal mine" is that sublet office space has increased to record levels in San Francisco and New York.

"A lot of tenants are doing anything they can to cut losses and sublet office space," Mr. Gordon said. "They are getting a good idea that their workforce is not coming back, at least not in San Francisco and New York."

People in the U.S. have more mobility than in other countries in the world, he said.

Some people are not going to return to big cities such as San Francisco and New York, but instead are opting for the cities in the U.S. that have had the strongest inflows of people such as Phoenix; Jacksonville, Fla.; Tampa, Fla.; and Austin, Texas, Mr. Gordon said.

Indeed, the report noted there is a mismatch of inventory, located in the largest gateway cities, and tenant demand, located in the secondary markets, with higher quality of life or lower housing costs.

LaSalle is not alone in its thinking that office property is a big question mark but that there are investments to be made in other unfavored property sectors. For Blackstone Group Inc., offices have not been a focus in recent years, said Jonathan Gray, president and chief operating officer, during the alternative investment manager's July 22 second-quarter earnings call. Traditional U.S. office space represents 4% of its real estate portfolio.

Especially in coastal cities such as New York, return to work has been a slower process, Mr. Gray said. "Tenants are cautious because they don't know their space needs," he said. Even so, companies are concluding that they need their employees to be together in an office, even with some flexibility, Mr. Gray said. Office will be "challenging in the near term" until the pandemic is under control, but the office market will recover, he said.

However, although Blackstone has cut down to 7% what had been "a very large" exposure to hotels and leisure properties in its real estate portfolio, firm executives now want more of it, Mr. Gray said.

"We will see recovery in existing assets," he said. What's more, Blackstone has been acquiring assets. In February, its real estate and private equity businesses jointly invested in U.K. company Bourne Leisure Holdings Ltd., which owns resorts, hotels and sells vacation homes. In March, a joint venture between Blackstone's real estate business and Starwood Capital Group acquired hotel operator Extended Stay America Inc. and its paired-share real estate investment trust, ESH Hospitality Inc., for about $6 billion.

"We do think people will return to travel" starting with individuals and leisure travel first, followed by business and group travel, Mr. Gray said.