Board Minutes from the Chairman: January 2021

We celebrated Buchanan Street’s 20th anniversary in 2019 and with it the excitement of achieving a mark in time that would assuredly bring with it structural certainty and predictability to our next chapters. And then 2020 struck…

That black swan event that we’ve all read about in business school…an event characterized by its extreme rarity yet severe impact. Were we prepared…how would our investments respond…what emotional toil would we experience as workers and team members? The reflections and responses ran the gamut but overall, the collective resolve to work together, to survive and to moreover strive to improve has been revitalizing.

While many might prefer to return to our pre-Covid times, we observe that many of the paradigm shifts we are experiencing were in-process pre-pandemic due to a multitude of conditions including such things as certain business functional obsolescence, housing unaffordability and the speed of innovation to name a few. The pandemic has certainly magnified and accelerated many of these pre-existing conditions while simultaneously causing unparalleled financial destruction to our society. As we initiate and assess our own company’s investment strategies and pursuit of new opportunities, we will never lose sight of the many effected by this pandemic and will continue to contribute through our Buchanan Children’s Charities and our community leadership positions to bettering those less fortunate in our community.

Within the real estate business specifically, there has been much written and projected about the looming distress of the U.S. commercial real estate market and the impacts to all forms of real estate in regard to both functionalism and investment outlook. As is often the case the pendulum of prognostication will react with a great range of volatility until certain predictabilities are brought to bear…let’s take a look at a few notable trendlines:

On the capital side of the equation…the real estate debt markets continue to spark concerns by the Federal Reserve as to a potential collapse to the U.S. commercial real estate market as many lenders provide certain forbearance or postponement to borrowers to prevent distress as they await the heralded vaccines that will offer a slow return to normal life. Real estate mortgage-backed securities have reached defaults of 10-12% (predominately driven by the hotel and retail sector) of their approximate outstanding $600B only slightly below the peak of the 2008 Global Financial Crisis (GFC). Small and mid-sized regional banks vs larger banks have been most impacted with their non-performing real estate loans causing a broader credit impact to their banks balance sheets and ability to lend to small businesses and retail borrowers spilling over into the larger economy. Shadowing this short-term pressure is an overriding $2 trillion of maturing real estate debt through 2025.

The offset…historically low interest rates and manageable associated debt service payments will extend a lifeline for some and alternative capital providers will pick up the slack and provide certain recapitalization where needed. Bottom line…regulators will continue to allow banks time and accommodations to work with their borrowers…yet an increase in foreclosures will be realized…though doubtful to the levels that were seen during GFC times. Our own mortgage business as a provider of bridge loans is seeing just this myriad of opportunities unfold with its continued high volume of loan requests.

On the equity ledger…much has been discussed about the abundance of dry powder capital that has been previously raised ($200B end of 2020) in addition to new offerings in anticipation of increasing distress. Many experts feel, however, that very few assets will reach the distressed status worthy of the yield expectations of this opportunistic capital and that the degree of the distress might be overstated in anticipation of the next cycle and the wrath of the pandemic. Real Capital Analytics cites distressed sales accounted for only about 1% of all commercial property sales in past two quarters.

Let’s look at certain product lines…as Mark Twain’s famous quote about the reports of his death being greatly exaggerated, so are the many reports of the demise of office buildings and office use. The renaissance or transformation of office space was well underway pre-pandemic as employers fought over recruiting talent as up to 40% of employees felt their workplace limited their productivity with the over-densification of space. Interestingly and exacerbated by COVID-19, per employee square footage requirements might now increase offsetting certain space reduction considerations going forward. The pandemic has prioritized the discussion and ante for optionality for certain work-from-home or work-from-anywhere ongoing flexibility. We will undoubtedly see the opening of small satellite offices, alternative shift scheduling moving away from a centralized headquarter model to a more holistic hub-and-spoke arrangement. However, these accommodations will need to be mindful of the essential need for human collaboration, interaction, competitive exchange and separating work from family and play. Certainly, the pandemic has given us the need for office redesign with less density and more sensitivity to Health, Wellness, Safety and Security (HWSS) now at the forefront of all office usage/considerations. Interestingly, through our own office portfolio experience and data review it is still unclear as to whether tenants are reconsidering traditional office space or simply reacting to a new business cycle. By the way, we just extended our own lease…the same space for another 5 years.

As retail bricks and mortar continue to give way to eCommerce, industrial space with an increased emphasis on supply chains including bulk and last mile distribution will continue to be the shining light of the real estate asset class with two-thirds of North American manufacturers saying they are likely to bring production and sourcing back to the continent…known as reshoring. When combined with just-in-time deliveries, industry experts project a potential need of an additional 750 million to 1 billion sq. ft of industrial space…so no bargains to be had here…to the contrary as industrial has been fully priced and continues to see cap rate compression.

Multi-family continues to serve as a bedrock real estate asset class with continued performance subject to class stratification and urban versus suburban living as people embrace remote working and less dense living…as Covid’s effects are more pronounced in cities than suburbs. Markets remain bullish broadly on multi-family over the long-term, but there is a noted growing appetite for rental housing as a potential disruptor for apartment owners. Look to adaptive re-use opportunities to reconcile demographic shifts and supplement housing supply and affordability demand…empty hotels and certain offices might now get a second life as tiny apartments.

Retail’s reckoning…Retail’s previous decline or devolution has moved to its next level with the pandemic. Yes, piece by piece eCommerce is pulling more stores out of ground floor retail and messaging the death of the department store and hundreds of malls as more and more of us are relying upon Amazon, Costco and Home Depot to serve our needs. Retail capacity is being reduced, relocated and repurposed as an all-delivery economy that is no longer a notion, but a necessity.

A new sector of explosive growth and interest is the life science and medical office sector which by example has been catalyzed by the pandemic and is being further transformed by the viability to its existential importance. An increased demand for life sciences and bio tech facilities will create opportunities to adaptively reuse certain office and industrial facilities. We continue to explore and invest in this space as healthcare and the aging of America require property customizations and continued decentralization away from hospital campus environments.

Self-storage…Expanded economic drivers including the continued rise in housing costs, household consolidation and relocation continues to accelerate customer demand. This is a hyper local business with people wanting to be close to their stuff. Today’s largest generation is the Millennials who have now fully embraced storage and offer the highest percentage of new customer demand. Our own company while an active lender of self-storage has now expanded into the self-storage ownership space.

Urban vs Suburban…much discussion about Covid’s reshaping where people want to live and shop, but great consensus through the decade-long trend of densification is coming to an end. The suburbs will cater to society’s social distancing prioritization with fewer constraints brought on in the urban core. We will see it everywhere, including housing, restaurants and our leisure. Note San Francisco’s recent 35% plunge in rents showing the effects of tech fleeing urban settings as public transportation, housing affordability and lifestyle preferences headline workforce location prioritizations.

Until next quarter’s minutes and more market observations, I would remind each of you that most of us can probably recall surviving the savings and loan crisis of the 80’s and 90’s, the dotcom/tech bubble of 2000, the GFC of 2008 and so too will we survive today’s pandemic with a solutions-oriented resolve to not only correct but improve upon this past chapter. The difference this time will be the immediacy of our response expedited with a more financially liquid and diverse capital base that not only protects the real estate asset class but allows for its creative evolution. I thank my fellow employees for their grit, determination and industrious spirit in serving our industry and clients during this unimaginable moment in time.

Best to all,

View and download a full PDF copy of this quarter’s Board Minutes here.