Ramser Development Company Q2 Newsletter: The Real Estate Food Chain: Lessons from the Office Sector Debacle
The U.S. office sector has been dominating the headlines recently, but not for the right reasons. The industry is grappling with operational and financial stress due to the persistent trend of remote work, making office assets an undesirable option for lenders, resulting in almost impossible financing conditions, regardless of the price.
This has prompted some of the largest institutional investors to abandon their office holdings, leaving lenders to deal with the mess. There is a tendency in the media to blame the office fallout on COVID. However, average space per employee has been falling for years and maintenance capital expenditures in the space consume almost 40% of net operating income (NOI), per research from Green Street. In other words, the pandemic may have accelerated the trend but the conditions leading to the fallout were a long time coming.
One office market veteran recently quipped to me that the sector “isn't overbuilt but rather under-demolished." Older properties are increasingly becoming functionally obsolete due to their outdated layouts that are prohibitively expensive to upgrade or convert to another use such as apartments. With a highly improved and capex-intensive sector like office, a change in use is catastrophic and often deadly for equity investors.
At Ramser Development Company, we see the current situation in the office sector as an apt illustration of our perspective on risk and opportunity in the commercial real estate market. We view the real estate sector and its various segments as a food chain akin to those found in natural ecosystems.
In this ecosystem, more intense uses tend to consume less intense ones. If raw land (the bottom of the food chain) is the equivalent of vegetation, a high-rise tower would be a hawk or shark. We focus on vehicle storage, which is a low-intensity use and hence one of the lowest rungs of the real estate food chain.
While the notion of investing in vehicle storage facilities might lack the allure of erecting Class A office towers, it provides a degree of safety and optionality that is often misunderstood from a risk perspective. If an office tower (or mall, or hotel) undergoes a change in use, it's almost always a catastrophe, at least from an equity investor standpoint. However, when a vehicle storage facility experiences a change of use, it's generally a positive outcome, as we've observed over RDC's 30+ years in business.
Typically, well-located sites in the path of growth that are feasible for vehicle storage eventually become appealing targets for more intense use. This inherent value-add optionality forms a central tenet of our investment philosophy.
Interestingly, most lenders tend not to subscribe to the real estate food chain theory. They often regard properties with a higher degree of improvement as safer to lend against due to perceived higher barriers to entry. But as evidenced by today's office market, oversupply can be a product of increased supply, decreased demand, or a combination of both.
Ironically, in growth markets, the majority of distress is centered on high-intensity properties like offices and malls. In contrast, low-intensity uses, such as vehicle storage facilities, are rare and sought-after due to years of redevelopment. For example, a recent Green Street report projected a continued decline in the supply of industrial outdoor storage in top markets despite surging demand. I’d argue that location-sensitive uses that aren’t favored by municipalities and require extremely low-density exhibit some of the best supply and demand dynamics in the commercial real estate industry.
However, the general lender perception of these properties as specialty product or land loans inflates the cost of capital, thereby creating more opportunities. It’s our view that over time, lenders will begin to reevaluate their stance on barriers to entry based on perceived risk. While that reassessment isn’t required for our strategy to work, it certainly represents an upside scenario where vehicle storage properties could potentially benefit from both increasing rental revenue due to imbalanced supply and demand as well as decreasing cost of capital.
Currently, the market is sluggishly starting to move. Assets with any sort of transitional business plan require seller financing or all-equity transactions. Now is the time to selectively cherry-pick deals with a promising narrative rather than attempting bulk purchases.
The recent volatility and fast-paced interest rate changes, compounded by a new pricing regime in the rate cap market, will likely deter floating rate buyers for quite a while. The memory of short-term rates skyrocketing by 500 basis points in 18 months will make investors wary so long as it's fresh in their minds. However, I believe that it would still be foolish to declare aggressive floating rate debt dead at this point. Eventually, aggressive floating rate borrowing will make a comeback because it always does. Memories fade and the greed of tomorrow will eventually overcome the fear of today just as it has since the beginning of time.
Thank you for reading our second quarter newsletter. If you would like to be added to our distribution list for future investment opportunities, please visit RDC's Investor Portal.
Chief Investment Officer
Ramser Development Company