United States

Real estate and construction industry outlook

Volume 7, Spring 2021

More than a year into the pandemic, the real estate and construction industries look profoundly different. Real estate has held up better than expected, helped by a strong housing market and low interest rates. Meanwhile, construction is poised to benefit from the resurgence in infrastructure spending.

KEY TAKEAWAYS

  • Now, more than a year into the pandemic-induced recession, property values have defied expectations of a drop, moving higher.
  • The government’s policy and fiscal response has allowed for stability in the property markets, making them a safe haven for investors.
  • The construction sector is set to benefit from a $1.3 billion allocation under the Biden infrastructure plan.
  • Construction companies should be looking to invest in new technology both for the job site and in the back office to take advantage of negative inflation-adjusted interest rates.
  • The real estate and construction sectors stand to benefit from government credits and incentives meant to spur investment in energy-efficient infrastructure and buildings.
  • Social initiatives are crucial for employee and tenant retention.

The distressed real estate market that hasn’t materialize

Soon after the pandemic took hold last March and economic shutdowns ensued, real estate investors began gearing up for opportunities around distressed assets. Success stories of acquisitions following the Great Recession of 2008 were abundant, fueling expectations for a repeat. Now, more than a year into the pandemic-induced recession, property values have not only defied expectations of a drop, they have moved higher. The Commercial Property Price Index (CPPI) from Real Capital Analytics has increased almost 7% since the recession began.

 

Three reasons account for the real estate market’s unexpected resilience in the current environment: rather than a financial crisis, this recession was caused by the pandemic’s exogenous shock; the government’s policy response was stronger than in prior recessions; and demand for real estate remained strong as dry powder reached record levels.

The cause

Recessions typically percolate when weaknesses in the economic system become overexposed, creating bubbles that eventually burst. In the early 2000s, the dot-com bubble that arose from overpriced technology shares brought a shock to the system. Nearly a decade later, the subprime mortgage crisis that led to the Great Recession uncovered weaknesses in the housing market.

The current recession is different, brought on not by inherent financial weakness but a global health crisis. The fundamentals of the real estate market were on sound footing before the pandemic hit, with vacancies near record lows across all sectors, even retail, according to CoStar data. Loan-to-value ratios have maintained lower risk as asset values continue to climb. With these factors in place, lenders have not been as aggressive in foreclosing on assets. Once more people have received a COVID-19 vaccine and economic activity booms, many properties are expected to regain their success.

MIDDLE MARKET INSIGHT

Real estate cap rates have remained relatively flat. This has provided investors with confidence in the real estate asset class and a continued attractive premium.

That isn’t to say that all sectors will recover evenly. Behaviors influenced by the pandemic will have a lasting impact. The rise of e-commerce is pushing property owners to rethink the use of retail properties. The shift to remote work may change the level of demand for offices. A fall-off in business travel means a full recovery may not come until 2024 in hospitality. Some lenders may not be able to wait that long, but to the extent that properties were operating well prior to the pandemic, many have looked to cooperate with property owners. To those that do end up acquiring distressed assets, it will be important to tread the waters carefully.

The response

The government’s policy and fiscal response has allowed for stability in the property markets. Following the passage of the American Rescue Plan on March 11, the government’s total cost of pandemic relief now tallies $5.35 trillion, according to the Peter G. Peterson Foundation, which focuses on fiscal challenges in the United States.

By September, rent collections had stabilized in the industrial, office and health care sectors, according to the National Association of Real Estate Investment Trusts. Collections in apartments and freestanding retail also remained at 95%. Combined with government policy, fiscal action was also important. The Federal Reserve was proactive in purchasing commercial mortgage-backed securities loans, which provided steadiness to the market. Amid this environment, the 10-year Treasury fell below 1%, dipping to nearly .5% in August. Real estate cap rates have remained relatively flat. This has provided investors with confidence in the real estate asset class and a continued attractive premium.

 

The demand

Lastly, the fundraising market has kept demand high, and should continue supporting property values. Total dry powder for U.S.-based real estate funds currently sits at over $250 billion, according to Preqin, the highest level in the research firm’s 20 years of tracking real estate market data.

 

Funds are flush with money, waiting to take advantage of distressed assets that still have not come to the forefront. Opportunistic real estate funds, in particular, continue to lead the pack in dry powder. With steady cap rates, margins remain thinner to meet funds’ targets.

Luckily, there are other alternative investment options for investors. Some distressed asset funds looking to purchase properties at a discount have morphed into debt funds to fill in property lending gaps left by retreating banks. One European private equity firm, BentallGreekOak, has raised approximately $1 billion to issue secured loans to various sectors of real estate. The COVID-19 pandemic prompted banks to make hefty provisions for distressed loans as widespread lockdowns threatened landlord and owner rent collections and the ability to service loans. These issues led to diminishing appetite for new institutional real estate lending, particularly to hard-hit sectors such as shopping malls, retail and hospitality, which have seen their revenues flatline. Nonbank lenders have jumped at the opportunity to step in and support investors seeking to reinvent impaired properties or simply keep the doors open until consumer demand returns.

Meanwhile, average fund sizes continue to grow, resulting in greater purchasing power for larger real estate funds and fewer opportunities for middle market players. The average fund size jumped to $479 million in 2020, up from $314 in 2017, according to Preqin data. As properties start to come to market, the vast amounts of dry powder indicate there will be strong competition. With property values perched up, it will be the larger fund managers that are able to keep bidding. Middle market firms should remain grounded by their models and not overstretch into bidding wars where purchase prices can no longer justify potential returns.

The takeaway

While many real estate investors may be waiting for the shoe to drop on distressed assets, property values have not followed the trend of previous recessions brought on by pitfalls in financial systems. Aggressive fiscal and government policy has provided a safety net to the economy, and record levels of dry powder will keep property values from falling. While some sectors may take longer to recover than others, it will be important for real estate buyers to recognize that expectations around distressed assets may largely go unrealized.

Infrastructure: Rethink, reshape, redevelop

The president has unveiled a revitalization plan consisting of an ambitious $2 trillion investment in America’s infrastructure, with a focus on stimulating the economy, job growth and green development to modernize America’s old and crumbling roads, bridges, railways and other groundwork. The plan, as currently stated, should act as a catalyst to help modernize America’s network of physical and online connectivity, allowing the country to retain and build upon the economic power it has developed over the past century.

The high-level overview of the proposed plan calls for $1.3 trillion dollars to be spent on transportation, power, communities (housing, schools, childcare), water and broadband internet, with remaining amounts slated for significant nonconstruction infrastructure spending, including R&D and technology, revitalization of small and medium businesses, and workforce development. The push for investment in traditional construction infrastructure will serve as a catalyst for growth in the construction sector, resulting in increased employment and nonresidential spending, both of which have fallen below pre-pandemic levels.

Transportation infrastructure

The core of this infrastructure plan lies in funding for improved transportation. Of the $1.3 billion designated for construction-related infrastructure, $621 billion is tied to transportation infrastructure, with allocations that include:

  • $115 billion for roadways and bridges
    • An additional $174 billion for electric vehicle (EV) facilities
  • $85 billion for public transit
  • $80 billion for Amtrack/freight rail
  • $25 billion for airports
  • $17 billion for ports and waterways

The significant request for transportation infrastructure is not a surprise. The most utilized form of transportation in the United States is roadways; as the most recent and significant roadway bill (Fixing America’s Surface Transportation Act in September 2021) expires, the Biden administration will need a new plan for roadway and bridge upgrades.

 

The $115 billion requested for roadways will be spent to modernize bridges, highways and other road-related infrastructure in most critical need of repair. According to a 2021 report from American Society of Civil Engineers, 43% of public roadways are in poor or mediocre condition, and 7.5% of bridges are structurally deficient. As car transportation remains the most popular form of transportation, is it critical the necessary capital improvements are made to fix American’s roads properly and efficiently. A study by INRIX Inc., a leader in mobility analytics, calculated that in 2018, congestion alone cost Americans $87 billion in lost productivity.

Biden’s revitalization plan also outlined a grant-and-incentive program to promote the construction of 500,000 electric-vehicle charging stations across the country by 2030. While the U.S. market for EV represents only about 2.5% of the total market (based on monthly new vehicle registrations in December 2020) it is expected to quadruple over the next five years; the need for infrastructure to support this growth will be a critical component in helping to reduce carbon emissions.

Finally, the administration’s plan includes modernizing many of the old and outdated rail lines and waterways, which are in desperate need of repair.  

MIDDLE MARKET INSIGHT

Construction companies should be looking to invest in new technology both for on the job site and in the back office to take advantage of negative inflation-adjusted interest rates to pay for these long-term investments.

Water/power/communities

Beyond transportation infrastructure, the administration plans to invest in productivity-boosting projects in other infrastructure categories such as water, power, broadband and housing. In total, the plan calls for $661 billion to be spent on these infrastructure sectors, with allocation as follows:

  • $100 billion for power
  • $111 billion for water
  • $100 billion for broadband
  • $350 for community development (schools/childcare/etc.)

The vulnerabilities of these infrastructure sectors have been underscored by high-profile events ranging from the Flint, Michigan, water crisis to the more recent disruption of the Texas power grid. Meanwhile, the pandemic has highlighted the need for all Americans to have access to reliable and affordable broadband internet service. Biden’s plan addresses these shortcomings, and includes investments tax credits to incentivize improvements.

 

Housing

Included in the Biden plan is a component centered on building stronger communities. The main goal is to build and retrofit more than 2 million homes and commercial buildings to address issues of housing affordability, particularly in marginalized communities that have been significantly affected by the COVID-19 pandemic. The focus on homes will allow many Americans to build equity in property, an important path to building wealth. The plan pairs investment in housing with American school systems. In total it calls for $100 billion to be spent on school systems, with funding to make schools safer, healthier and better places for kids to grow and learn.

Takeaways

While much of Biden’s plan is just that—a plan, and there are still hurdles which need to be overcome to achieve the necessary support to turn this into a bill, it is highly likely that some of these measures will be passed before the end of 2021 to the benefit of many contractors.

In order to prepare for the anticipated rebirth and redevelopment of America’s infrastructure, construction companies should be looking to invest in new technology both for on the job site and in the back office to take advantage of negative inflation-adjusted interest rates to pay for these long-term investments.

Contractors should also be continually evaluating labor and material sourcing needs. One of the most significant industry trends during the post-Great Recession construction boom was shortages of skilled labor. While employment remains below pre-pandemic levels, it would be good for contractors to evaluate personnel across the board and ensure they have the right labor force in place for passage of this plan. With the increase in material prices, contractors also need to evaluate alternative material sources or look to hedge and/or buy out their jobs to lock in pricing.

Environmental, social and corporate governance, and a long-term strategy

As public pressure builds for industries to adhere to environmental, social and governance (ESG) standards, the real estate and construction industries are no exception. The European Union has passed many regulations that require proper ESG planning and disclosures for real estate businesses. By contrast, ESG investing in the United States and Canada is resulting more from public pressure than from regulation. Investors globally are watching ESG developments closely.

One of the largest environmental considerations for real estate investors relates to the goal of carbon neutrality. Decarbonizing new and existing buildings has been a critical focus of the Paris Agreement. The United Nations Sustainable Development Goals within the sector demonstrate that residential and commercial buildings are responsible for nearly 40% of energy and process-related emissions, according to studies conducted by the Environmental and Energy Study Institute. Because concrete used in development remains a significant source of carbon emissions, the responsibility for carbon emissions reduction will continue to be a strong focus for commercial real estate. Building stock is set to double by 2050, according to projections included in the 2018 Global Status Concrete Report on buildings and construction.

MIDDLE MARKET INSIGHT

Social initiatives, while harder to quantify, are now tied to financial metrics and considered crucial for employee and tenant retention at both commercial and residential properties.

In the United States, the Biden administration has an opportunity to enact a robust environmental agenda likely to gain bipartisan support—the question is not if, but when, policy will be enacted. A primary goal of the infrastructure plan expected to be passed later this year is reducing climate change; the private sector is already pushing for sustainability amid increasing pressure from investors. The real estate and construction sectors, along with society as a whole, stand to benefit from government credits and incentives meant to spur investment in energy-efficient infrastructure and buildings. One such example is the E-Quip Act, a bill recently introduced in the House that aims to provide assistance for expensive retrofits of aging and obsolete HVAC, lighting, windows, roofing and the like with state-of-the-art systems; it offers 10-year accelerated depreciation on new equipment in commercial and multifamily buildings. E-Quip promises to be a catalyst that will add jobs, promote energy savings and significantly reduce carbon emissions. If passed, this legislation has been estimated to save 100 million tons of CO2 emissions, or the equivalent of taking 22 million cars off the road for one year, according an analysis by the American Council for an Energy Efficient Economy (ACEEE). With over half of commercial real estate buildings constructed before 1989, the industry stands ready for a major environmental face-lift.

 

In addition to the new administration’s appetite for a federal environmental agenda, many states and cities have established energy benchmarking policies for publicly owned buildings. And it may not be long before such requirements reach private investment. Leading jurisdictions like New York City, Seattle, Washington, D.C., and Boston have already adopted transparency rules for the private sector, with some passing laws that require owners of existing buildings to make efficiency improvements. Legislative requirements aside, the ESG Dashboard of Nareit, the group that represents the interest of REITs, shows that nearly all (98%) of the 100 largest REITs were reporting sustainability efforts in 2020, up sharply from 60% in 2017. Carbon emissions aren’t the only target: REITs are reporting on carbon emissions, energy and water usage, and waste management.

Social initiatives, while harder to quantify, are now tied to financial metrics and considered crucial for employee and tenant retention at both commercial and residential properties. Internally, workforce programs are vital to attract and retain employees. Health and wellness programs contribute significantly to an employee’s overall engagement to the business. Real estate developers also have a responsibility to consider the overall community during construction. Collaborative spaces like rooftop terraces or parks connect tenants to the property and their neighbors, fostering community and wellbeing, while reducing the likelihood of turnover.

Corporate governance involves a delicate balance of the interests of a company’s shareholders, executives, customers, supply chain and overall community. Nasdaq’s recent push to potentially require listed companies to have women or members of an underrepresented group on a listed company’s board is consistent with requirements already in place in many European countries. Goldman Sachs additionally committed to only underwriting IPOs in the United States and in Europe for companies with at least one diverse board member in 2020 and two in 2021, further highlighting the focus on diversity and its importance to the public markets. It’s clear that a culture of diversity and inclusion, and the varying perspectives and backgrounds it brings, is essential for sound corporate decisions.

ESG considerations will become even more vital in the coming years for all types of real estate and construction companies as strategies with ESG focus continue to attract institutional investors such as pension funds with ESG mandates.


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