David Kelly (00:24):

Welcome back to Insights Now. I'm David Kelly, Chief Global Strategist here at J.P. Morgan Asset Management. While the broader economy's remained resilient this year, the real estate sector has faced its fair share of headwinds. Higher mortgage rates and home prices have weighed on the residential sector. Tighter lending conditions following the regional banking crisis have created a challenging backdrop for commercial real estate. Additionally, it remains unclear whether pandemic induced disruptions are merely road bumps in the longer term landscape or the beginnings of a new regime within real estate. For today's episode, I'm joined by Dave Esrig, a Portfolio Manager in our Real Estate Americas Group, who will share his thoughts on the trajectory of real estate and discuss what opportunities he finds interesting.

(01:07):

So Dave, welcome to Insights Now.

Dave Esrig (01:09):

Thank you.

David Kelly (01:10):

So let's sort start with a broad question. What is the state of commercial real estate right now?

Dave Esrig (01:16):

Right, so we're in an interesting time right now. So after extremely strong growth during 2021 and early 2022, we've seen pricing in the market come off rather sharply. So we're down about 15%. And that's really due to the rise in interest rates, but also a deceleration we're seeing in operating performance on the property side. So for example, in multifamily, we've seen rent growth go from about 15% down to about 0%. So that's something we've seen kind of across the board. Now, office has been very differentiated from the rest of the commercial property market. We've seen office weak really since 2020 due to the work from home phenomenon, but we do see a call back into the office continuing, and as a consequence we see going forward a bit of an increase in-office activities, but we don't think we're going to get back to the 2019 level anytime soon.

David Kelly (02:25):

And of course that's opened up the question a lot of people have asked about converting office space into residential real estate space. What do you think about that?

Dave Esrig (02:34):

So that's something people are talking about a lot and it's actually gotten a little pushback from people in the industry who think it is very expensive. And so just to step back and talk about the opportunity and the problem here. We have across the country only 2.5% vacancy across all housing in the US. So that's housing for rent and housing for sale. And so if you can convert a fair amount of office into residential, you're really killing two birds with one stone. Obviously you're helping the housing issue and you're ameliorating the problem of too much office stock, especially in America's downtowns.

(03:21):

The challenge has been the expense of the conversions, but I would argue that of substantial share of the cost of converting from office to residential is actually due to regulatory issues and not due to actual kind of physical changes. And an example of that is there is a legal requirement that the windows and residences be operable. And that's really based on sort of old sensibilities around fresh air that really don't apply today. You really don't need to open a window up on the 30th floor of a building.

David Kelly (04:01):

I'd be scared if I did.

Dave Esrig (04:01):

Yes, right. So that's something that from a regulatory perspective is looking to change and we think that'll improve the office market.

David Kelly (04:14):

Is there a push to change those regulations then?

Dave Esrig (04:17):

Yeah, so that's under discussion, for example in New York. And that we're hearing in several other markets.

David Kelly (04:23):

So talking about very much the here and now, we've seen a sudden recent surge in long-term interest rates and mortgage rates. In fact, we've got now the highest 30 year fixed rate mortgage that we've seen in over 20 years. How's that affecting your perspective of real estate at this point?

Dave Esrig (04:39):

So we actually see the rise in interest rates as creating a bit of a benefit in the market in as much it took the froth out of commercial property pricing that we were seeing in 2021 and as I mentioned early 2022. So right now, if you have dry powder to put to work, you're able to buy properties that have been reset to this lower price. You can't lever in a cheap way. But we do like the idea of putting money to work with cheap properties as opposed to expensive properties and cheap debt. So interestingly, single family homes have fallen generally in price by less than commercial properties. So commercial properties have been more affected by the rise in mortgage interest rates than single family homes from what we observe.

David Kelly (05:31):

Interesting. Of course there are supply issues. In fact, if you look at the whole residential side, I've noticed some very different trends in terms of multifamily and single family units. Can you talk a little bit to that?

Dave Esrig (05:43):

Sure. So on the multifamily side, we saw this deceleration that I mentioned. And if you look at the way residents are behaving in this environment, they're doubling up roommate situations and sort of conserving money by renting fewer spaces. The market is still tight and we think as the economy re-accelerates later, rent growth will re-accelerate. But the apartment market, as I said, has seen rent growth fall to zero.

(06:17):

We've seen on the single family side this terrific challenge with relatively sticky home prices and these incredibly high interest rates making single family home purchases extremely expensive. So it's forced families, who are not typically doubling up as roommate situations, forced families to rent more single family homes. So we've seen extraordinary growth in that. And in fact, rent growth in that space is running eight to 10%. So that's a business we've been in a lot at J.P. Morgan Investment Management and one way, or really the only way we've approached it, is to build new stuff. So we're never bidding against families who are looking to buy single family homes. We're always building new product. It's both easier to operate, we're not competing against families looking to buy houses.

David Kelly (07:12):

And of course I appreciate that, that we're building new stuff and adding to the stock. But there is also a really interesting dynamic by which people really can't sell their home because mortgages are not assumable, so they can't really take their mortgage to new property. But I suppose you could rent out the home and I think everybody needs to be a little bit more flexible in finding housing solutions here.

(07:37):

Looking forward and thinking big picture, we've been talking a lot about artificial intelligence this year and it's sort of the buzzword I know in the stock market, but it really does have significant implications for all sectors of the economy. How do you see it affecting real estate?

Dave Esrig (07:54):

Well, so there's been a lot of news about how data centers are going to benefit from this in the real estate space. And just to step back a little bit, for several years data centers actually were seeing falling rents. And that was really due to significant additions to supply and actually very rapid technological changes that made it much cheaper to have high data throughput in these centers. About two years ago, electric utilities started to say, "Wait a minute, we can't deliver as much electricity to these centers as we could before." And that really stopped a lot of the development we were seeing at that point. And so owners of existing data centers were enjoying very strong rent growth because there was almost no new supply.

(08:51):

What we've seen recently is that the supply has picked up again, the electric utilities have started to deliver the electricity, and the enormous gain in sales that Nvidia just reported we see as evidence actually of supply really picking up quickly. Those chips are all being used in new data centers. So ironically it feels like a very hot market. But actually if you're an owner of existing data centers, you're seeing more supply, which is where all those Nvidia chips are going. So whether or not all the new AI use fills and utilizes those data centers is to be seen. But for now, there's a rapid increase in data center supply.

David Kelly (09:38):

I mean, it's the sort of area of real estate where a generation ago people wouldn't even know what you were talking about, talk about this kind of real estate. What other opportunities are you seeing in some of the evolution of commercial real estate?

Dave Esrig (09:53):

Right, so practically speaking, right now we have a capital markets environment that is challenging for many existing property owners and folks who want to buy commercial properties. And so as a consequence, we are actually able to lend mezzanine debt very profitably. So that business really involves taking, call it the 50 to 60% LTV slice for a capital stack where the zero to 50% slice is lent by say a regional bank, if it can still lend, or some other lender. Those lenders don't want to take the risk of that last 50 to 60 slice. We're able to lend on properties that we would actually love to have as equity in our portfolios. So it's kind of a win-win for us. If we do believe they'll pay off and that'll earn us a good return. But if they don't pay off, we get to take the property and have it in our portfolio.

David Kelly (10:57):

So we believe in it, but we can't really take an equity stake, so we'd like to take a high yielding lending stake in this basically.

Dave Esrig (11:04):

Right. Right. We also like building single family rentals. So as I mentioned that before. And another space we like are last mile retail, last mile services oriented retail. And we're seeing terrific growth in tenant demand in that space. And that's coming from Americans shifting their spending patterns and they're doing this kind of structurally and cyclically from buying a lot of goods to buying more services. So restaurants, we're actually seeing more medical services showing up in these, various types of health club kind of concepts, big increases in veterinary bills, for example, veterinary spending. So that's been a big driver to absorption in these centers. We like those in relatively dense prosperous communities

David Kelly (11:50):

Just following changing consumer behavior or trying to predict changing consumer behavior. You mentioned regional banks briefly there, but I'm afraid it's kind of the elephant of the room here because obviously you look at the balance sheets, regional banks have got a lot more exposure to commercial real estate than the biggest banks in this country. How do you feel about that right now after what we saw this winter?

Dave Esrig (12:14):

Sure. So, yeah, with their deposits leaving, they have certain capital challenges. And they have these large books of commercial real estate and they have been important lenders in this space. Certainly not an expert in banking, but one thing we are observing from where we sit is that they are extending loans backed by office buildings. So their inflows from mortgage payments are likely slowing broadly. So that does slow their lending and I think it hurts their capital position. From us in commercial real estate as we think about capital being supplied to the space, I would characterize the environment, for example, is much different from what we saw in 2009 in the global financial crisis, in that was kind of a systematic wide credit crunch. This is more narrowly defined to one type of credit supplier. We also have CMBS, we have insurance companies who are able to supply capital, and they're actually able to step up and supply more capital to the real estate space as the market starts to improve. So the regional bank issue may linger, but there'll be other capital sources for us in commercial real estate.

David Kelly (13:36):

So, it's still a macro issue, but not necessarily as much of an issue for commercial real estate.

Dave Esrig (13:41):

I think so.

David Kelly (13:43):

Thinking about portfolios, investors often allocate to real estate because it's an inflation hedge and provides income. Now yields on high quality fixed income are extremely high because of what the Fed's been doing and inflation's been coming down, although the Fed doesn't seem to quite notice that as much as I do. But in that kind of environment, do you think real estate still has a place in a portfolio?

Dave Esrig (14:03):

Yes, I think so. And if we may pat ourselves on the back, part of that, the inflation hedge bit. During 2021 and early 2022, as inflation was accelerating, commercial property prices were rising very sharply too as were rents. In fact, rents and multifamily assets were a big driver to the inflation challenges. And so real estate did what it was supposed to do and that is act like an inflation hedge. And so the question is now with our yields where they are and the Fed doing what it's doing is does real estate still have a place in this environment?

(14:39):

And I do think it's important to still think of real estate as a total return investment. So we are seeing, given the repricing on the market, total returns, total underwriting returns, in commercial real estate at a fairly large spread to investment grade bonds. So we still like, or we actually really like where it is today, even on an un-levered basis. And as time goes on and interest rates start to fall, we see an opportunity opportunistically to lever these properties even if we do them on an un-levered basis today.

David Kelly (15:18):

Finally, for those who are thinking about adding real estate to a portfolio, I think you've made a good case for why it needs to be in there, particularly for larger investors. But what do you think about REITs versus more direct owned real estate?

Dave Esrig (15:32):

Right. So I think REITs get some guff from observers due to their volatility, and that can be driven a lot by the fact that a large share of REIT shares are owned by so-called yield chasers and investors who are, if you will, chasing narratives. For example, retail is good today and it's bad tomorrow and back and forth.

(16:00):

But the truth of the matter is REITs, or the REIT industry, has some of the best operators in the entire real estate industry. Publicly traded REITs, for example, in the data center space are some of the best operators. So if you're looking to play that angle with AI right now, that's something to consider. And I would say too in the tower space. So the absolute dominant players in the 5G tower space are in the publicly traded REIT market. So we do think it makes sense for most real estate investors to allocate to direct properties as well as publicly traded REITs.

David Kelly (16:39):

This has been fascinating, Dave. Thank you very much for joining us.

Dave Esrig (16:39):

My pleasure.

David Kelly (16:42):

And thank you for watching Insights Now. On our next episode of this summer series, I'll be joined by Mike Feroli, Chief US Economist at J.P. Morgan for a conversation on the US economy. Thank you all for listening and speak with you soon.

Disclaimer:

This content is intended for information only based on assumptions and current market conditions and are subject to change. No warranty of accuracy is given. This content does not contain sufficient information to support investment decisions. It is not to be construed as research, legal, regulatory, tax, accounting, or investment advice. Investments involve risks. Investors should seek professional advice or make an independent evaluation before investing. The value of investments and the income from them may fluctuate, including loss of capital. Past performance and yield are not indicative of current or future results. Forecasts and estimates may or may not come to pass. JPMorgan Asset Management is the asset management business of JPMorgan Chase & Co. and its affiliates worldwide.