Thursday, August 6, 2020

Real Estate as an Asset Class Post-Coronavirus

The coronavirus pandemic has led to changes in America that we probably never thought possible. One of the most glaring examples of this are lockdowns. If back in 2019 someone told you, "at some point in 2020 the government will force Americans to stay in their homes and only let them leave to go to the grocery store, will mandate Americans to wear masks under the threat of fines and will not let parents send their kids to school for a good portion of the year..." you probably would have thought that person was crazy--that type of stuff happens in China, not America. Putting aside whether the lockdowns were necessary / effective / an overreach of governmental authority, I think an enduring question will be do we now live in a new paradigm where Americans are more comfortable with and will experience more governmental control.

In terms of how this applies to real estate, similar to lockdowns, real estate saw its own government intervention. For several months now in places like SF, NY, the government has made it so landlords can't evict tenants. This is important because this is the landlord's primary form of leverage in the constant tenant vs landlord negotiation / battle. The tenant's primary form of leverage is it can just stop paying rent at some point in time and create a huge headache for the landlord, both financially and in terms of time and effort. Removing the ability to evict tenants (this happened for both commercial and residential tenants, by the way) has given tenants massive leverage over landlords. Put another way, the government has tried to shift the pain that this pandemic has caused within the real estate market onto landlords and ease the burden that tenants feel.

I think in a typical economic downturn, the pain would first be felt by tenants. As their balance sheets eroded, they would then stop paying rent and the pain would start transferring to landlords, but first tenants would have to get to max pain. This is sort of how the free market has decided things should happen. In this pandemic, the government has tried its best to flip the standard order of operations. Again, putting aside whether this is morally correct / okay to disrupt the free market and pick winners and losers, it's just where we are right now. To me, the big question is, will the government make this a common practice going forward?

Let's be honest, landlords aren't exactly a popular group. No one likes their landlord, every article written in the media about landlords casts them in a rent seeking / unethical / Scrooge type light, etc... Probably more to the point, there are a lot more tenants than there are landlords, i.e. tenants as a voting block are more valuable than landlords as a voting block. It's easy to see why politicians would try to transfer economic pain from tenants to landlords. The question as a prudent real estate investor is, if we are in a new paradigm in terms of governments being exceptionally bold and willing to manipulate free markets and assign real estate owners as the primary takers of pain in an economic downturn, how will this change the asset class going forward?

Here are my high level thoughts and, no, I don't really have evidence or stats to support any of these assumptions, these are just my gut feelings on how things will shake out:
  • Less business friendly areas / populations more supportive of government intervention are likely to keep this trend going forward--I think, generally, once you start these government interventions, you tend to not stop. Places like NY, SF, LA, Chicago, Portland, etc... are likely to see different forms of lockdowns in the future, even after the coronavirus pandemic, and are very likely to do eviction moratoriums / shift pain onto landlords during economic downturns.
  • This will lead to less consistent / less durable cash flows for real estate investors in those areas, or, stated another way, real estate as an asset class will have more risk associated with it in those areas.
  • This will lead to less investor appetite, which leads to higher return requirements, which leads to higher cost of capital.
  • Assuming the total dollars chasing real estate deals remains relatively fixed (a big assumption, but one that seems somewhat supports by fund raising data), areas that were less prone to government intervention during this pandemic (FL, TX, sunbelt in general, WI, etc...) will become more attractive.
To put in a more relatable way, if I had $5 million that I wanted to invest in an apartment deal and I'm relatively agnostic to location (I don't only want to invest in CA because I live in CA and want to manage it myself--I'm willing to put my money with an operator anywhere in the country), then I would would be much more inclined to put my money into a deal in TX vs NY or CA than I would have been pre-coronavirus.

It'll be interesting to see if this really does play out in a more macro sense. Will LPs start allocating less to areas with more aggressive local and state governments? 

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