Post-pandemic real estate markets present many interesting opportunities, despite their ongoing challenges. Join Jan deRoos, Jeanne Varney and Daniel Lebret from the Cornell Nolan School of Hotel Administration as they explore the forces driving trends in the industry.
While "back-to-office" efforts remain weak in many urban cores, those same downtowns are experiencing booming retail, entertainment and cultural visitation. Associate Professor Emeritus Jan deRoos and senior lecturers Daniel Lebret and Jeanne Varney — a power trio of real estate experts from the Cornell Nolan School of Hotel Administration — explore the forces driving real estate market trends and delve into recent efforts to convert "office-to-anything-else" spaces.
What You'll Learn
The Cornell Keynotes podcast is brought to you by eCornell, which offers more than 200 online certificate programs to help professionals advance their careers and organizations. Learn more from Jan deRoos, Jeanne Varney and Daniel Lebret in these programs:
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Chris Wofford: Today on Cornell Keynotes, we're joined by a power trio of real estate experts from the Cornell Nolan School of Hotel Administration to make sense of real estate market trends and understand what's going on with conversion of office to anything else spaces. We'll learn why back to office efforts still remain weak in many urban cores.
Chris Wofford: While those same downtowns are actually experiencing booming retail, entertainment, and even cultural visitation lots of challenges, but also lots of opportunity for financiers and real estate investors. Be sure to check out the episode notes for info on eCornell's catalog of online real estate courses, all authored by today's guests.
Chris Wofford: Listeners, here's our conversation with Jan deRoos, Jeanne Varney and Daniel Lebret.
Jan DeRoos: Our title is nominally called Real Estate Right Now, and can it transition from toxic to timely. We're going to start with a lightning round on each of the five major uh, property classes. You can only answer one answer. It's a hold, buy or sell for each of, and we're going to start with multifamily. What do you think, Jeanne? Hold, buy or sell?
Jeanne Varney: Hold.
Daniel Lebret: I'm a little more optimistic. So I'd say that it's going to be time to buy.
Jan DeRoos: Okay. I'm a hold and be opportunistic. Number two for retail. I'm sorry for industrial. Let's say number two, industrial logistics properties. What do you think? I'm going to go with you, Daniel, first.
Daniel Lebret: I'll hold.
Jeanne Varney: I'll hold too.
Jan DeRoos: I'll hold. Those property types have been darlings, but maybe it's time to hold at this point with increasing vacancies in that sector. Retail, is retail ever going to be good again? Daniel, hold, buy, sell.
Daniel Lebret: Again, I'm, I'm just neutral. I think retail has gone through a lot but it also has now, you know, absorbed a lot of what was going on so I'll hold on retail.
Jeanne Varney: I'm going to say it's really specific and dependent on the location and the scale of retail. It has settled. I'll agree with that.
Jan DeRoos: Going to go with hold. I live in a different place from them, rather than upstate New York. I live in western Florida and retail is crazy here, but it is also a lot. There's a lot of it. So, this 1 is going to be easy office buildings, hold, sell, or buy.
Daniel Lebret: There's just a lot of unknowns yet, with the office space, I think there's a good 40 percent of the leases that have not renewed yet. So we, I would, I'd be cautious with office and I would not touch it too much.
Jeanne Varney: Agreed.
Jan DeRoos: People that didn't sell earlier are really feeling sorry for themselves and now they're catching a falling knife and I would say it's office, is very difficult to make the argument to uh, hold. I'd be looking to sell. How about entertainment or lodging facilities? What do you think?
Jeanne Varney: I would say, again, very, very market specific. We'll probably get into that a little bit today as well. But we've got some really stabilized numbers. So, in general, I would say hold. But it is very market specific.
Daniel Lebret: Yeah, I completely agree with Jeanne in saying that depending on the type of properties you're looking at the market, the segment, the location, but overall, I think it's still healthy and I would hold right now, hotels.
Jan DeRoos: I would hold and look to buy uh, selectively. I think it's a great asset class and I think hotels have sort of regained their footing after being some body blows with both the reservation systems and with Airbnb. They're really viable short term alternative now, when people need transient lodging or transient accommodation.
Jan DeRoos: There's a whole series of I call specialized asset classes out there. Now, one of the things that's impacting the industrial logistic space is you don't put your data center. Or your cell tower or, you know, some of your other special properties inside of one of those facilities that make it work. You build a specialized facility for it. And there's a whole industry around either cell tower, data centers or storage.
Jan DeRoos: Anybody care to comment on those types of assets?
Daniel Lebret: Well what I was able to gather, for example, about data centers is that they had a hard time just making a case for themselves over the years and that with AI emergence, it's become a hotter asset class. So, it's, it's all perhaps in line with what the AI business model would turn into and could make a strong case for data centers going forward.
Daniel Lebret: Self-storage is working great as far as I understand it. So those two, you know, seem to be you know, increasingly interesting.
Jan DeRoos: One of the real niche classes that I follow is casino, which is a flip to a net lease model. And it's fascinating that I think the net lease reads will do well. And I think casinos are going to continue to well, as they expand their call, their traditional experience offerings.
Daniel Lebret: Yeah, and they're recession proof. So, I mean, in many ways, they seem to be a great way to adjust risk adjusted returns uh, ski resorts are great assets. I mean, it's not surprising that a lot of private equity has stepped into casinos.
Jan DeRoos: Well, I see them as sort of, they're not the natural long term holders. What they do is buy opportunities and sell to the REITs who then did it. Yep. So Jeanne, anything to add with that?
Jeanne Varney: Actually, just a sort of a side note. A lot of these special use buildings have really hit the ground running with sustainability and a lot of the construction that's been really amazing in the efficiencies and what they're putting in place with some of these. I just want to chime in on that.
Jan DeRoos: So I have a set of sort of macro forces that are going to impact us. All of us said, well, it depends on location and subproperty type. Let's drill into that a little bit. What do you think of the macro forces that we're going to impact? Both valuations and returns. Jeanne, why don't you pick up on what we think, what I think is a big one, which is sustainability.
Jan DeRoos: And I'm going to go with the formal ISO, or the International Standards Organization definitions of sustainability, and then more broadly, climate change.
Jeanne Varney: From a sustainability perspective, it's such a huge topic and it really, you know, covers so, so many pieces of a puzzle that affects valuation, you know, for real estate. The environmental side we've seen a significant increase in regulations, owner reporting requirements, and measurements and tracking. And so that's a piece that I think everyone is paying much more attention to.
Jeanne Varney: So when we look at the energy side. Um, we've seen, I think, kind of a stabilization in costs of energy, but energy efficiency has become, you know, more important than ever. Paramount the ISO side, actually, ISO, the International Standards Organization, actually has a lot of great resources. And tools for building owners to use to, you know, to help them set up standards and systems and programs and protocols.
Jeanne Varney: So they're a very, very good, good tool. Certifications also are driving value in real estate. There's a lot of perception of healthy environments, more efficient buildings. They are much more attractive from a leasing perspective. Their occupancies and rates are usually double digit um, over non certified buildings.
Jan DeRoos: Does it hit the capital markets in terms of either a tipping point, either you will or you won't lend, or is it underwritten into underwriting uh, either a lack of sustainability or positive sustainability? Daniel, have you seen any evidence of that, or is it still too early to tell?
Daniel Lebret: It does impact the lending ability, I think, in the sense of, like, how it impacts the cash flows. So that's certainly something debt lenders will take into account you know, whether it's uh, in from an energy efficiency standpoint, the efficiency costs insurance are related. Insurance costs are definitely related to some of the climate change provisions that Jeanne was talking about, and those have a strong impact on the cash flows.
Daniel Lebret: And then, there is also this entire story about whether capital is becoming more, you know, adept to, clean sort of like investments. And so that may also have an impact on the cost of capital whether you're investing in certain type of properties that are sustainable or not.
Jan DeRoos: Any other comments on the larger forces that are driving valuations, driving returns in terms of really either capital markets or on the, what I'll call space side, you know, population changes, employment or user preferences changing.
Daniel Lebret: The three main aspects that I have on my radar right now, and it's hard to make the claim that they are autonomous or, or independent from one another. So I'm going to list them without necessarily ranking them. Number one, the drop in interest rate. Cost of capitals have reached the level they have right now.
Daniel Lebret: I think there is a consensus that interest rates are about to decrease but no one has a clear picture about how quickly they're going to drop and how far they're going to drop. I think that's a question mark that impacts not only the real estate and commercial real estate sector, but the broader economy.
Daniel Lebret: And we'll certainly see how that plays out over the next 12 to 18 months. Second I would say, are we gonna experience a soft landing? Or are we gonna hit a recession? There is a lot of uncertainty around the labor type of data that we're seeing there is an important talk tomorrow uh, and important statistics that are going to be released.
Daniel Lebret: It's probably going to shape in some way and form the Fed policy in terms of rates. Is it going to be a quarter point? It's going to be half a point. Those are going to be important. And then the last major macro force is that we are in an election year and with the presidential election, with control of Congress, with a variety of things, you could see different policies being put in place fiscal policies, et cetera, et cetera.
Daniel Lebret: So all of these things are obviously related and they will impact for sure commercial real estate markets going forward.
Jeanne Varney: I want to chime in in a little bit more on the labor side. Labor has become an enormous issue in pretty much every industry. The shifts in worker preference, the shifts since COVID of where people thought they were sort of slated for certain traditional employment opportunities have found all kinds of different opportunities.
Jeanne Varney: The availability of work online, certainly the shift in worker preference for being in the office versus not in the office has had a tremendous impact on commercial office space, which we'll talk a little bit more about as well. But it really the, the labor force is impacting actually real estate itself and, you know, user or worker preferences, you know, for that.
Jeanne Varney: And certainly pressures from organized labor and inflation rates, labor rates going up discussions of minimum wage increases and different markets having different minimum wage standards. Also, you know, putting pressure on the labor models as well as the financial statement from labor cost perspective.
Jan DeRoos: So let's link this all to what's going on in capital markets. Daniel started with, okay, we don't know how far it's going to drop. And it's, I think it's, and I agree, it's good. It's clear that interest rates will drop over the next quarter. Is that a sustainable thing? Is it something that's needed to stimulate, or is it really it's time for the Fed to take its foot off, slowing things down in the capital markets and speeding up because clearly if interest rates drop transaction volumes and overall financing will increase.
Daniel Lebret: Yeah. So, you know, I don't have a crystal ball and we just look at, you know, the situation right now and try to think through step by step. I think that uh, the obviously cost of capital now is reached the point where uh, it's fully priced in the market property values have captured what the impact of this high interest rate environment is.
Daniel Lebret: I think it's turning a corner. From the commercial real estate markets overall. And now we are facing a decrease in interest rate environment. In certain time periods, certainly over the last decade, rates have been near zero for a long period of time. That helped boom the entire commercial real estate sector, it's very unlikely that it will go back to zero.
Daniel Lebret: I think most economists opinions that I read and I see is that most probably rates will go higher than zero and then how quickly they'll drop may have something to do with whether the economy is stronger, resilient, we have a soft landing or something like that. What it does. That is certainly open capital and makes funds available for properties that are facing maturity on their existing loans at a more affordable rate.
Daniel Lebret: So that's something that is certainly going to be welcome and alleviate a lot of current borrowers as they are facing the impending sort of decision of what they're going to have to do next over the next two or three years with these loans that are coming due. And that is obviously a challenge for both the borrowers and the lenders. But there is certainly other aspects that are also going to play a role, like what sources of capital are going to be coming into the market? Are we going to see investors mostly from the private equity world uh, REITs, institutional, cross border capital coming? I think, you know, we have seen a lot of institutional and cross border capital taking place in 2021, 2022.
Daniel Lebret: And typically when we face a more challenged real estate market, we see REITs and private equity stepping in first as they find opportunities. And so that's what I would expect also a lower interest rate environment. With movements coming from the private equity world and from the REITs world 1st, as they're able to identify opportunities, strategical acquisitions and things like that before we see again institutions and cross border capital coming in.
Daniel Lebret: What else? What other aspect we should talk about?
Jan DeRoos: One of the things that I've seen is this sort of maturity to uh, tsunami that so called with trillions of dollars of debt coming due, or at least hundreds of billions of dollars of debt coming due depending on the sector that has turned out to be not that big of a problem, but that's actually, to me, where the rubber hits the road on hold versus sell.
Jan DeRoos: I've seen a lot of recent refinancing transactions uh, individual transactions where the borrower has to write a check to pay off the old debt because the new debt size is smaller. And that's clearly, I'm going to hold this asset strategy rather than defaulting and saying goodbye to it. As the markets come down, that will make that a lot easier, but I'm wondering if there's enough capital there to meet the need.
Daniel Lebret: Well, and that's again a very interesting question. A lot of the capital that was needed at times came from abroad for things like that, or came from the private equity world, and it will depend on the appetite of these sectors and taking on that role in recapitalizations, as you're saying on injecting new equity in order to lessen the burden from the debt side.
Daniel Lebret: So, you know, there is appetite. I'm seeing lenders willing to work on refinancing, but the underwriting criteria is tightened up. LTVs went down a little bit. Coverage ratios also went down. So, it's harder to get access to this capital, to the debt capital, which requires therefore an increase in the equity check.
Daniel Lebret: How much control are you losing for that equity? How much, you know, you're willing to, part away from in order to bring in some of this new equity and keep the deal floating? These are deal by deal negotiations that are taking place and certainly not easy conversations for the existing owners.
Jan DeRoos: It's easy to track when interest rates go up, cap rates go up, and when interest rates go down, cap rates go down. So, is there a cap rate compression story as well to the, what I'll call debt financing story? As interest rates go down, valuations will go up because cap rates are dropping, and that will drive some either sales or other harvesting, or is that, is it really too early to tell?
Daniel Lebret: Well, what I'm, what I'm seeing right now is overall cap rates and mortgage rates are almost equal by now on different property types. And so that doesn't leave a lot of positive leverage for equity holders. If you have a situation where interest rates go down and you alleviate a little bit of the cost of borrowing, then you're going to start seeing again, some positive leverage on a lot of these deals, which is going to entice equity to come in and possibly then compress cap rates in some way.
Daniel Lebret: So, I would say that, yes the drop in interest rates, mortgage rates going to create some positive leverage situations, which will bring in obviously a large amount of supply and capital and, and make things more efficient.
Jan DeRoos: Chris, you had a question that had come in. Why don't you pass that along to us?
Chris Wofford: I do. Viewer drew meal asks, what are the panelists thoughts on medical office spaces? That is office buildings that are set up for doctor's office medical use. Jan, I'll have you direct that to the panel if you don't mind.
Jan DeRoos: Okay, I'll take it first. I mean within that medical office, or, you know, there's a sort of, I'll call a medical property are a wide range of property types. There's not only the medical office building, there's also skilled nursing facilities, and then there's a other sort of, I'll call housing within that.
Jan DeRoos: Some of a lot of reporting I've seen recently have said there's been a large increase in supply of medical office building style and that rents are dropping quickly and landlords are looking for alternative uses to the traditional doctor uses or medical office for some of those properties. I don't know if any of either of you have a comment on that.
Jan DeRoos: Daniel or Jeanne, either of you can take that.
Daniel Lebret: I've seen the same thing and expanding beyond medical offices was also the case with life science buildings. I think for a long while the bonus and rents that were coming with medical offices and with life science building tended to just yield a lot of new building supply and development into these two property types and they've reached an oversupply situation where you have a lot of investments that have been put in capex and lab equipments and medical office equipments that cannot necessarily find tenants anymore, and so some of these buildings are now being marketed at just general office tenants.
Daniel Lebret: So it's interesting that maybe developers overdid it, seeking those bonus and rents.
Jeanne Varney: It's actually still surprisingly one of the higher building uses the life sciences and medical buildings for actually traditional office space conversions that we've seen recently. It's upward close to 20%. And so there's definitely an oversupply situation. Agreed.
Jan DeRoos: So let's switch topics from I'll call it transacting and capital markets to the our consensus was at the beginning in this lightning round that maybe holding makes a lot of sense for a lot of these asset classes. So, if selling isn't a great option, how should owners operate and position their properties in the current market environment, both on the demand for space side, as well as a financial asset.
Jan DeRoos: So both either the tenants or the owners think about this.
Jeanne Varney: So I'll take that for the first recommendation of the first focus that I always look at is and that I see current building owners look at is, take care of the building the best you can, because that's the asset. That's your collateral. That so many things really roll down the hill from there.
Jeanne Varney: You need to have a clean building. You need to have everything in working order. You need to have your spaces as modernized and attractive as possible. Now, I'm not saying invest in CapEx for, you know, a large variety of renovations or anything like that. But keep it attractive. The maniacal focus on maintenance really becomes very, very important here.
Jeanne Varney: I know it's really, really tempting to go ahead and try to cut those costs first because the maintenance area is an expense unit, right? And so when you're trying to cut expenses, it's a pretty big number. But when you end up cutting the maintenance activities, you end up again, you have depletion of the quality of the asset itself.
Jeanne Varney: When you really extend the cutting of maintenance activities, particularly things like preventative maintenance on your building system equipment, you end up with failing equipment. You end up with you're not providing the mechanical services to this space that you need to. The occupants then become, the occupants that you do have, become unsatisfied.
Jeanne Varney: You can end up with some, you know, hazardous material or health issues, things like potentially mold infiltration or other toxins that can sort of enter sort of the, the spaces if you're not doing proper maintenance there as well. And another piece to that, if you're not keeping up with proper maintenance, you really can end up with a maintenance issue becoming a capital expenditure issue.
Jeanne Varney: And that's really the last thing you want. We, if you are looking at real estate valuations, you understand the significant impact that capital expenditures have on the value of a real estate asset. And the more that adds up, the harder it, it just makes things worse and the harder it is to, you know, value the asset, transact the asset as well.
Jeanne Varney: And so, you really, really, I just cannot emphasize enough, you know, to the greatest extent you can, continue your focus on maintenance. And just and even in the courses that we have, we spent a lot of time actually in the eCornell courses talking about the maintenance activities and how to have great maintenance.
Jeanne Varney: One of the pieces to look at as well for fantastic maintenance and this is probably for your whole you know, building team, whoever you're working with, you want to have really good leadership. I mentioned earlier the issue with labor. Labor being, if not the highest cost in the financial statement, one of the highest cost in the financial statement.
Jeanne Varney: And it's an old adage that people don't work for companies. They work for other people. And I think that's really true that you really want to have the best leaders in place, the best managers in place that you can, so you can have the most stable labor force that you can.
Jan DeRoos: Jeanne, can I challenge you on that just a little bit? So I'm going to take a financial owner's view of this and I'm going to decompose my internal rate of return that I have to my equity and I'm going to buy a cap rate call it seven percent for a building or six or seven percent I'm going to finance that to a 12 or 13. Okay with my finance team and then my asset management team is going to raise rents and manage the building over a period of time, they're going to only add like 3 or 4%.
Jan DeRoos: Maybe 5 percent to the overall IRR. So the big value that I get are from my acquisitions and my finance team. I might even have a story at the end with some cap rate compression that makes some money uh, on transacting at the end. So if my asset management team, isn't adding that much value, how do I compensate them in a way and get the best managers? Cause all the best people want to be making more money. Creating value on the acquisitions or the financing team.
Jeanne Varney: Well, again, I'm going to go back to you know, treating your people right. You've got to have a great work environment. You've if you're going to talk about the asset manager and the manager relationship, you need to have a transparent collaborative partnership, and you need to set the goals, you know, right up front with your management team in the ownership group and say, you know, this is what we've got to get done.
Jeanne Varney: And put together a collaborative plan to achieve whatever the goals are. One of the things that is, that we haven't really qualified here is what is the whole period? How long is ownership going to be holding this asset? And that really is going to drive almost every decision you make. When we talk about some classic asset management strategies, the first thing you look at is ownership goals in the whole strategy.
Jeanne Varney: And so, in kind of in my, even in my maintenance discussion here, it was a little bit more aimed at a longer term hold, you know, an owner that wants to try to hang on to the asset if they can, you know, waiting out you know the whatever, our economic environment, whatever market they're in till things get a little bit better.
Jeanne Varney: If you're in one of those situations where, you're just biding time until you can get an, you know, another buyer or convert the real estate use into something else that is more viable, then you're going to be making different decisions. But fundamentally, again you've got to keep the building running as best as possible.
Jeanne Varney: You've got to keep it safe. You've got to keep it, you know, in code compliance. And if you're ignoring these things on the building management side, it's going to end up costing you more money in the long run. Anyway, if you're a very short term holder, you're just trying to you know, pop your cash flow to look as good as possible until you can actually transact.
Jan DeRoos: Well, there's actually a play that's run. Go ahead, Daniel. Sorry.
Daniel Lebret: Yeah, I know. I just I just wanted also interject for a second and in favor of the asset management team and the value they can unlock. I think you know, the acquisition team and the acquisition decisions are made very often with the you know, an existing building or an existing plan regarding the development environment changes a lot.
Daniel Lebret: The market changed during the holding period. And I think the most important thing an asset manager will do is position the asset for sale. Positioning the asset for sale means what do we need to do with this property so that it becomes attractive to the person we want to sell it to? And that conveys a lot of the returns on the back end.
Daniel Lebret: I mean, the big share of your internal rate of return is how well are you going to be able to dispose of that property? And if you're sell it to someone that has a very low cost of capital. They're going to pay a high multiple on NY. So, I think the idea and what the asset manager will do is from the beginning, they are given a property and ideally they can look around given the market environment, find the highest and best sale, as opposed to the highest and best use and think, wow, how can I position this property in the highest and best way to hit the best possible returns at the back end. Most of your returns could go away if you don't sell the property well. And so that's, that's also, I think, one of the roles of the asset manager is to strategically manage the property to position it well at the time of sale. As Jeanne was saying, it's very much a function of who the ownership is.
Daniel Lebret: What's their mandate in terms of holding period? How long can they keep the property in order to execute that strategy? But certainly bringing the right operator tenanting the property with the right tenants, having and managing lease turnovers, things like that will affect tremendously the resale value and at the end, and it will impact your internal rate of return.
Daniel Lebret: And all of these things are typically unclear at the time of acquisition. You buy it cause it looks healthy. It looks solid, but you still have to go through the entire holding and the entire positioning so that you can sell and unlock that return.
Jeanne Varney: Yeah, agreed. There's an adage that building is always for sale and the asset manager should always be positioning that building for optimal value and potential sale.
Daniel Lebret: Yeah. So that's where I see asset management potentially bringing in a lot of value to to, to the investment. Someone has to execute the strategy and someone has to be, you know, clear about where the, the most market and the most value could be at the time of resale.
Jeanne Varney: Yeah, one of the key tools actually that we work with in the courses is a strategic asset management plan. It's a plan that really dives into all the corners of the asset, the buy, the hold and the sell strategy, which again shifts over time. But it's like a, it's sort of the, it's the document or the go to plan that you have that, and again, it gets updated every year or maybe even more often.
Jeanne Varney: And it's something that you work with in conjunction with ownership and you're constantly updating it to make sure that you're meeting ownership goals.
Daniel Lebret: And from a financial modeling standpoint I think these are strategical decisions and that's where also models help make better decisions. You can compare cash flows under one type of resale strategy versus cash flows under a different type of resale strategies. What did they mean in terms of adaptive reuse?
Daniel Lebret: What should be the asset management transformation costs? What exit capital will they give you access to? All of these scenarios can be certainly evaluated through financial models. And you can then make the highest and best value decision for your asset. Once you
Jan DeRoos: So, Chris, we had a question that came in regarding the gap between green buildings and brown buildings. And if there's ever if that gap is ever going to tighten or increase over time and then the 2nd, part of that are our REITs and private equity, preferably looking for green buildings.
Daniel Lebret: I've certainly seen specialized vehicles raising capital for so called green investments. And so as a consequence it's interesting to see what is time of the kind of returns that are attached to these vehicles relative to just more generic vehicles. There seems to be kind of a story to fundraise around green vehicles and, and that makes it, I think, just appealing from, you know, the teams that are fundraising, they have created an avenue to get access to capital around certain promises for development that weren't necessarily here before.
Daniel Lebret: So just for that, I think there's something to be said about uh, this different strategy. Whether that spread uh, between the returns observed around the brown properties and the green properties will uh, necessarily go away. You know, there is operating costs that are going to be different and they could go away for sure.
Daniel Lebret: That's on the cash flow side. There is also differences in risk and in cost of capital, and that also could go away. I don't want to take a stand, but most probably one would expect that in the long run a lot of the investments will be greener. One way or the other just because it is just more efficient.
Daniel Lebret: And so in that case, I'm not sure we'll see necessarily the gap narrow between these investments. We just may see fewer brown buildings in the long run.
Jan DeRoos: my sense is that everything is underwritten. And as you said, it's underwritten both on the numerator side, which is the cash flows that come out of the building. And it's underwritten on the denominator side as well, which is the risk side. So I think long term, we, the industry has accepted regulation that does make the industry itself much more sustainable um, and less risky.
Jan DeRoos: So, there's not I think there's both there's a story that's understood on the cash flow side because these buildings have lower operating costs. I don't think the risk side is is yet understood and it will take a test of time. 1 little comment on your comment regarding some of these vehicles.
Jan DeRoos: For that were specialized for either infrastructure or real estate. That was green. I've seen the blushes off the rose on those because the promises didn't meet the expectations when they were originally sold. And I think some of those funds are being unwound as well as they're being, I'm not seeing a lot of new offerings because things just didn't work out as well.
Daniel Lebret: And I think there is an issue with what the mandate of these vehicles wise, you know, under the umbrella of ESG or green, it was never really clear what that, Objective was and that should also become clearer going forward. What is it to invest in a sustainable way? And so once that definition becomes clear in terms of property types, locations, etcetera, etcetera, I think these vehicles will make a comeback.
Jan DeRoos: We have another topic and that I'd really love to dive into that that it, I'm sorry, I was typing in um, office conversions. We hear a lot about just how toxic offices are, how awful downtowns are because people aren't going back to office. You see these reports now I'm seeing in my analyst reports on real estate that, oh my gosh office occupancy is up to 2.
Jan DeRoos: 6 days per week. Now and that's like improving from 2. 4 days per week that it was, you know, two months ago. That still really stinks. Downtowns are going to work when offices are occupied like four or five days a week, or we're going to find another use for these buildings. Daniel, I know you've done a lot of work on this.
Jan DeRoos: Gene, you've got some opinions too, but what are we seeing? What's going on with that? And, you know, we're seeing some spectacular transactions with things trading at 30 percent of replacement costs. So what's going on?
Daniel Lebret: Well, I think I think it's a very interesting question, and it's one that is terribly exciting to be in this space. And in this sector, I mean, what a chance to be working in real estate and see such a. High change of land use over the last five years. I think technology has been a major disruptor and it's reset the way we organize human activity on the planet and land.
Daniel Lebret: And so that's something that obviously has consequences in terms of like, central business districts, downtown. It's not as easy to change the land use because real estate is real and you can't move use that easily. And so we are facing a situation where we have a massive amount of office supply located in certain areas and people are not that interested in being these in this areas right now.
Daniel Lebret: How long will that Behavior stand. It certainly is clear that these are ecosystems. The CBDs everybody depends on everybody. Lower floors depend on higher floors, but higher floors also depend on lower floors. It all holds together. If the offices are vacant, then the retail down downstairs is also gonna suffer.
Daniel Lebret: And so is transportation systems and a variety of things. So in this context we do have a situation which is. What can we do with this massive amount of supply of real estate that is being underutilized? And there's talks of converting it, adaptive reuse as it's called. And in some cases it's going to work and in some other cases we're going to have to wait for prices to go further down because the conversion costs are so high.
Daniel Lebret: It has to do with the vintage of the office building. It has to do with the floor plates. It has to do with what the building looks like, and can it be easily converted? It has to do with the local regulations. Is zoning going to be amenable to a change of land use? It has to do with financing costs.
Daniel Lebret: How much does the construction will cost? And do you have tax abatements? Because the city is you know, losing sale taxes and property taxes from everywhere. And needs someone to live in this building. So there are a lot of questions that are going to have to be tackled deal by deal, location by location office conversion from office to residential with the crisis we have with respect to affordable housing seems to be the most easy and common pursuit that people are looking at, but there are certainly all kinds of other conversions that are going to be contemplated.
Daniel Lebret: Each one of them, will trigger a different entry point in terms of how low do the office property values need to go. That's where, again, a good financial model will help tremendously. You can map out what your pro formas would be after the conversion. You can map out the construction cost. You can map out the sequence of financing vehicles between the construction loan.
Daniel Lebret: And the permanent loan and so on and so forth. You can include your tax abatements and the different public financing tools are being put in place and see how low does the office price needs to go before you can actually do it. We're not seeing a lot of people doing it right now. We're seeing some sporadic cases of people converting, but we're not seeing a lot of people doing it.
Daniel Lebret: And I would make the case that that's where good decision making tools like financial models are helpful. In a stabilized market. Pretty much everybody knows the inputs and their relationship to the outputs, and the business models are clear. Everybody knows that if you have an NOI of such by square foot, you're in, you're good.
Daniel Lebret: When you have such a large amount of risk like a conversion, then you really need to get very specific with the details, look into what's going on get a good tool to sensitize the different inputs, understand what they do to your metrics on the back end and talk to it with your investors. Are they willing to do this?
Daniel Lebret: Can, can you execute such a strategy well, you see delays in the zoning process and so on and so forth. And so based on that, I would argue that now more than the last decade, probably good financial models are going to help support decision making, are going to help fundraise, are going to help with the execution.
Daniel Lebret: But it's a case by case, it's not going to be easy.
Jeanne Varney: Yeah, I'll, I'll, I'll chime in on that too. First, I completely agree with you, especially on the sensitivity models there with that. It's been interesting and it's been a fascinating asset class to follow, especially since about 2021 when we started to notice the dynamic of the resistance of traditional office workers going back full time into their spaces there.
Jeanne Varney: And I think there was a pause for a couple of years where office building owners were trying to figure out as were the really the lessees were trying to figure out. You know, what are we going to do with our employees? You know, can we get them back in the office? Do we even want to get them back into the office?
Jeanne Varney: So these are starting to flush out now. These, these answers and these decisions are starting to be made. They're actually in 2023, there really was finally starting to be some movement in conversions of commercial office buildings into alternative real estate uses. So this is about A hundred transactions or so or conversions were happening where historically maybe it was about, you know, 40 or so, but we got to about 100.
Jeanne Varney: And that was probably again, the accumulation of multiple years of planning in there. So, I think this was brought up earlier. Johnny, you might have mentioned this, that the majority of the conversions are really happening to multifamily, that they're it's probably an easier use, as you mentioned, the considerations of the floor plans and the window availability and all those other types of physical considerations in, you know, the building itself.
Jeanne Varney: The other thing, another factor that we're seeing is. Um, And as these other alternative uses like multifamily like hotel, they're starting to be a little bit more aggressive in their analyses of can we take this office building and turn it into another space so they're approaching the commercial office building users as well and we're seeing you know, multiple examples of hospitality going into commercial office buildings and converting them into A really particular piece is, you know, for example, if it is hospitality, hospitality is interested in that central business district.
Jeanne Varney: So the location of these becomes very, very important to whatever that potential conversion could be. Hospitality would be very sensitive to the retail options to the restaurant, to the nightlife, to the tourism attractions, that type of thing, where multifamily is would have a sensitivity to it, but maybe a little bit less depending on neighborhood attraction, that type of thing.
Jeanne Varney: So, I think that we we, we have to do a little bit of wait and see to, to see how these projects are converting and the success rate of those as well, depending on the use.
Daniel Lebret: And I have to uh, you know, just try to bring back what's the pros and cons of living in a city. I mean, why just accept that you're going to be living in a higher density environment. The pros are just amenities. I mean, amenities are available. Cultural amenities are available. Education. Health care. And and the cons can be at times related to crime.
Daniel Lebret: The time spent commuting and transportation. If you're not willing to pay the premium for being close to work. I mean, those are going to be the trade offs that people are constantly contemplating. So cities are still incredibly attractive. They're incredibly attractive, and they haven't. Completely disappeared for sure, because they're still the preferred way of organizing human populations.
Daniel Lebret: And that's something that we should not forget when we're sort of like, telling that the office sector is going through impending doom. Not at all. I think there's just a need to re equilib re balance. The amount of supplied was allocated to office in certain neighborhoods perhaps, and we are seeing this moving it to suburban suburban office sector is doing a lot better than CBD.
Daniel Lebret: Why? Because you have access to more space and there is obviously in terms of the residential units. And so, I think there's just a need to bifurcate the office sector into sub sectors, understand what's going on. And yes. Markets like Manhattan and markets like San Francisco are being challenged right now.
Daniel Lebret: But overall, if you look across the globe and the planet, Asia is not seeing nearly the same amount of remote work. Europe is not seeing as much remote work as the U. S. right now. So if you were to rank also different continents the U. S. has hit the hardest right now with this office sort of transformation.
Daniel Lebret: It doesn't necessarily mean that the entire office sector Is going to be penalized in the same way, whether it's in Asia or it's in Europe.
Jan DeRoos: I'm going to pick up on that a little bit. Daniel is, as I have traveled the world, what I've noticed is that the North America is becoming more like the rest of the world in that people will are now much more willing to live where they are close to where they work. And I think the reason that Asia and Europe have a bad impact is because people do live close to where they work on the Commuting costs are lower where in the States you're ought you would have to keep, you know, in New York You'd come in from, you know, Westchester or you know, San Francisco you come in from the South Bay I think that will need to change but as you said the balance is really the key I agree all these cities need more housing.
Jan DeRoos: And then the question is, do I build something new or it's very proforma. I sort of know what I can do versus this conversion where I can probably maybe do it for a little bit less cost, but there's all these other uncertainty. So, and then the, the, the. The question and the balance always becomes, okay, so the building needs to be discounted to this value in order for it to work.
Jan DeRoos: And I don't think we're at a tipping point yet where it works on a wholesale way. And it's also impacted by regulations as well in terms of zoning. So I think we have a ways to go on it. Um, Let's take a question at this point. And move the conversation on which I think is a fabulous question. If you don't mind, Chris, I'm going to reword it.
Jan DeRoos: But so Mike asked, do you think that we don't real estate is priced well compared to other asset classes, creating a good vintage in that there's. Some room to roam. I'm going to reframe that a little bit and saying that, you know, real estate now is one of the large, what I'll call asset classes in the world, according to the GICS classifications.
Jan DeRoos: And so where does real estate compete with say consumer durables or industrials or banking or other industries? And is it fairly priced and can it compete effectively? Or are there places where we can look for maybe little advantages?
Daniel Lebret: have to be very honest. It's an excellent question and I would need to think more carefully through it without saying anything stupid. I, I think it's just an excellent question. Is real estate, you know, well priced as it is right now? Um, I don't know. I'm sorry to be dishonest.
Jan DeRoos: I, I feel that sort of everything is priced to perfection right now. We are in a place where things are really, really priced very fairly, if not you know, maybe aggressively and, but they're the world is a wash in capital. It's looking for returns and I really think that real estate is very fairly priced and the.
Jan DeRoos: The opportunities are like in any industry. It's along, it's along the edges and the niches where people find value that others didn't see. The beautiful thing about real estate is it is Um, and and it, but it's also it's, it's, it's, it's the same time. It's, it's, it's, it's, it's Achilles heel. So, it's a, you know, it's a good thing and a bad thing, but I think the fact that real estate is fixed and rents are can move very quickly is a good thing for real estate.
Jan DeRoos: I'm going to take that question and also ask it a slightly different way. There used to be a bumper stick that was out, was a Dear Lord please give me another bout of inflation. I promise I won't mess it up this time because I get to raise Um, if, as interest rates come down, everybody's saying, Hey, it's going to be great.
Jan DeRoos: We'll have the party again, transactions, but that means rents won't go up as fast. Is that a good or a, you know, overall is interest rates coming down or a good or a bad thing for the
Daniel Lebret: Well, the, the, the nonlinear relationship between the numerator and the denominator indicates that a drop in cost of capital is always to your favor. And so, certainly seeing capital coming cheaper. Even if rents are going down we typically favor value at least because rents would need to drop by a whole lot before that becomes a problem from the income side.
Daniel Lebret: So, sure. I think, you know, alleviating the cost of capital will always work in favor. And, and just to come back to the previous question where I acknowledged that I was Clueless. I, I just would like to say that I agree with you, Dan. under the hypothesis that markets are efficient you do have typically good pricing in place at any point in time.
Daniel Lebret: And it certainly is true that in real estate and commercial real estate, we have more information and more transparent information that we've ever had. So I would tend to agree with you that overall prices are fairly efficient right now, but I think That bubbles exist. I think it was just a deep and profound question.
Daniel Lebret: How do you relate, you know, the real estate to other asset classes? And that's where I was sort of stopped for a second.
Jan DeRoos: I will say that real estate is less efficient in corporate governance than many We, I had a former colleague that said real estate's the dirty little backwater of corporate governance and there's there's a, you really have to dig in, especially when things are privately held. Um, There's just many of well, maybe it's because I follow the industry, but many of the scams and frauds that I see involve some sort of a real estate
Daniel Lebret: There's a lot. That's
Jan DeRoos: So I do think we worry, we have to worry about that. But I think in the end as Daniel says uh, data is getting in my career. Now that I'm retired, but my career was really dominated by an incredible increase in in transparency and information that made the industry better, mostly by lowering its cost of capital. We have another question, Chris.
Chris Wofford: Yeah, we do. We have one from Natasha who switches gears a little bit. And Natasha asks the extended stay hotel sector has experienced a remarkable educate uh, evolution rather over the past years. And it has become an interesting asset, not only for traditional hotel investors, right? What are your thoughts about this asset class buy or hold?
Jeanne Varney: I can take that one if you want. I think yes, it is experienced significant growth. It really shot through the roof there right after COVID or right as we were you know, the country opened up again after COVID you know, it's an attractive sector in lodging for its space and travel, it is received enhanced use for the.
Jeanne Varney: Remote worker who can work anywhere and needs extra space needs the you know, the extra desk wants the couch, wants sort of the studio apartment type of look for family travel. Very, very attractive as well. The. P& L model for it or the cost model for it is highly lucrative. The net cash flows are typically very high.
Jeanne Varney: They don't have the heavy overheads of food and beverage spaces or some of the other amenities that can drag down profitability in a traditional full service hotel. So, the brands have become more aggressive with their distribution of them as well as demand has increased even bringing in new brands.
Jeanne Varney: For extended stay as well. It's also a little bit more encouraging now that some of the larger city centers have put in those regulations for Airbnb that we're not having this huge supply of these apartments for rent for business travelers as well. So that's opening up more room for these extended stay products.
Jeanne Varney: So I I'm bullish on them. Yes. Mhm.
Jan DeRoos: you can and buy more.
Daniel Lebret: And I think, I think there's another way of looking at extended stays, which is that an extended stay property is kind of a call option for a residential owner. They can easily convert to extended stay take advantage of higher short term rent. And then when that market sort of slows down, then you can go back and sell that option and come back to your residential long term play of having annual leases.
Daniel Lebret: So the cost of conversion from residential to extended stay typically is minimal and you can ride the short term to long term to short term if the regulation locally permits it. So it's it's a free option. If you were to think about it someone that has a residential unit can. Unlock additional value by adopting the mindset of extended stay and then coming back, which is not
Jan DeRoos: agree. It's really up to me. It's a lease like question. What's your average lease length? And you can even section off different pieces of your building and have shorter leases and longer leases. There are some regulations around that. I'm going to bring up 1 case study example of something that we got.
Jan DeRoos: Three minutes at the end. I was reading recently there's some hotel strikes, and this is a analyst note about some of the companies that might be hit by this hotel strike, and they were talking specifically about California and San Francisco, where there's some owners there that have walked away from their mortgages because it's less costly than trying to sell the property to get rid of it because the combined cost of a labor strike and seeing increased operating costs.
Jan DeRoos: Plus, there's a 10 percent exit tax on very high value buildings made it unviable for you to actually try to sell the building. So they just defaulted and walked away. And that was a lower cost option. It's interesting that the commentator mentioned the exit tax. And I'm wondering if you're seeing this as something, not just the exit tax, but these sorts of scenarios where people default because it's less costly than trying to
Jeanne Varney: I know, I know that there are multiple ownership groups that have taken on that strategy when you're establishing, you know, when, when you're buying these assets, you're putting them in their own corporate entity. And so you're sheltering yourself or you're protecting yourself from, you know, the default to the rest of your assets.
Jeanne Varney: So I feel like It's something that owners are still looking at. Absolutely. And as the labor issues have uh, obviously they're in the news today as they're bubbling up and depending on what the labor contracts look like on the back end, we don't know what they're going to look like, but they, we could see more of it.
Jeanne Varney: Absolutely.
Chris Wofford: Thanks for listening to Cornell Keynotes, and be sure to check out the episode notes for more information on eCornell's online real estate certificate programs. Thanks again for listening, and subscribe to stay in touch.