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Sponsored: FS Investments’ Commercial Real Estate Predictions for 2021

Despite massive dislocations across parts of the markets in 2020, we enter 2021 backed by significant vaccine and economic enthusiasm. The commercial real estate market is no exception.

Despite massive dislocations across parts of the markets in 2020, we enter 2021 backed by significant vaccine and economic enthusiasm. The commercial real estate market is no exception. Matt Malone, Managing Director of Real Estate at FS Investments, sat down with Lara Rhame, Chief U.S. economist at FS Investments, to outline several of his 2021 predictions for the CRE market.

Rhame: Headlines are generally down on the commercial real estate market. Yet you sound optimistic in your predictions. Can you please outline why?

Malone: We believe the major downside drivers that impacted the CRE market in 2020 – COVID-19 and social distancing measures and election uncertainty, among them – will either be significantly reduced or no longer present in 2021. Perhaps most importantly, we think the fundamentals backing the CRE market will improve as investors’ ongoing search for yield combined with available capital will push CRE transaction activity toward recovery.

Transactions are the lifeblood of the commercial real estate market, facilitating price discovery and ultimately greasing the rails for further capital deployment. 2020 has seen a break in that cycle. The crisis has created uncertainty around short-term property cash flows and longer-term attractiveness of certain sectors and strained the availability of financing. This has caused a chasm between buyer and seller price expectations, resulting in volumes sinking 40 percent versus the same period in 2019.

That said, we see reasons for optimism that this downturn will not mirror the last recession, when monthly volumes ran mostly below $10 billion for a 20-month period. First, investors’ hunt for yield has become much more pronounced over the past year. With the Barclays Agg yielding barely over 1 percent, CRE equity cap rates of 6.5 percent and senior CRE debt interest rates around 3-4 percent or higher, the space provides opportunity for income-starved investors. Second, private real estate funds currently hold more than $330 billion in dry powder that must be deployed. Together, we believe these factors, combined with a successful COVID-19 vaccine rollout, should lead to a speedy recovery in CRE activity.

Rhame: Hotels have been one of the hardest hit segments of the CRE market. Please take us through your view there.

Malone: Absolutely. Hotels have been the sector most acutely impacted by the COVID-19 pandemic, accounting for roughly half of newly distressed CRE properties in 2020 despite making up only about 10 percent of the market. Hotel occupancy plummeted in the spring as the first wave of the pandemic hit and lockdown measures were put in place across the country. Business recovered somewhat since, though occupancy is still languishing well below normal levels. Hotels have had to deal with rising pandemic-related costs, as well.

The short-term nature of hotel room rentals made them especially susceptible to this crisis. While an office tenant may be locked into a lease for ten years, hotel turnover is daily. With 2021 expected to bring widespread vaccination, people may again feel comfortable traveling, and there appears to be pent-up demand for leisure travel – nearly 80 percent of Americans have made vacation plans for 2021. Not all hotels are likely to benefit equally – the return of business travel is still highly uncertain, and consumers may be more comfortable taking road trips than flights at first. That said, we expect even a partial recovery in travel to underpin a much stronger environment for hotels in 2021.

Rhame: What about other property types? Do you see any standouts?

Malone: We view 2021 as the year in which alternative real estate sectors go mainstream. The COVID-19 pandemic has acted as a trend accelerant in many different industries, including real estate. One such trend has been the growth in “alternative” commercial real estate sectors, which now comprise more than 50 percent of the publicly-traded REIT universe. These newer sectors include data centers, life sciences, infrastructure, and self storage, and their growth reflects the way technology, demographics, and other secular trends have impacted the way society operates. In our view, these sectors will not replace traditional CRE sectors, but will play an important role in constructing a holistic CRE allocation as investors come to better understand their return drivers and risk factors.

Many of these alternative sectors outperformed in 2020 due to their exposure to trends enhanced by the COVID-19 pandemic. Infrastructure REITs, a $209 billion sector, is comprised mostly of companies that own IT and wireless communications infrastructure such as cell towers. These stocks have returned more than 10 percent YTD as the pandemic forced activity onto online and virtual mediums. Self storage has also shown strong defensive characteristics, returning approximately 8 percent as pandemic-related dislocation has resulted in strong demand for personal storage.

Rhame: The election was another huge source of uncertainty. Now that it has been decided, where does that leave CRE investors?

Malone: The 2020 election was historic, in terms of voter turnout and the environment in which it was held. Ultimately, though, we believe that the election will end up being more bark than bite for CRE investors. Though Democrat Joe Biden won the presidency, party control of the Senate – in characteristic 2020 fashion – remains uncertain. While the economic recovery will ultimately have the greatest impact on the CRE market, there are areas of policy that could have major effects, as well.

On taxes, President-elect Biden generally takes a heavier-handed approach than President Trump. While Biden generally supports opportunity zones, he advocates for eliminating the 1031 exchange, which allow sellers of property to reinvest proceeds into a new property without paying capital gains taxes. This and other issues could have material impact on property markets, though we see certain policies as unlikely to pass through Congress, especially if Republicans can hold their Senate majority. Biden supports a robust fiscal stimulus package to aid a still-ailing economy, though the timing, size, and scope of any additional bills remain uncertain at this juncture.

Matt Malone

Matt is Managing Director of Real Estate at FS Investments, where he focuses on the growth and management of our real estate platform. Click here for more of Matt’s insights on the CRE market.

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The interview was published as part of FS Investments’ directory sponsorship package with The DI Wire. The DI Wire did not conduct or participate in the interview.