This Time It’s Different
Technology and changing demographics are the driving forces of structural changes that are underpinning the cyclical recovery. Despite the uncertain economic environment, real estate continues to benefit from accommodative monetary policies and the prolonged low-interest rate environment, providing attractive investment income and diversification benefits to a portfolio.
by Gaina Samarah, CF A, CAIA, MFin
It has been nearly a year since the lockdown measures were instituted in western countries. Most economies have experienced sharp GDP declines led by the services sectors. As vaccinations are being rolled out around the globe, the consensus view among economists postures a strong economic recovery in the second half of 2021, as economic activity and people mobility is expected to rise. While much uncertainly remains about the future economic recovery and its long-term implications on the Canadian real estate market, the important aspects to assess are the trends in place and the fundamental shifts that are shaping the course of the future.
Traditional business cycle analysis is relevant in assessing the path of economic recovery when the future is likely to be similar to the past. However, the future we are transitioning into is going to be vastly different from the past. We are currently going through the fourth industrial revolution that is characterized by digitization and the convergence of the virtual and physical space.
Second to the word unprecedented, the phrase “accelerated trends” has been used frequently to describe current events. The pandemic has accelerated secular economic, social, and cultural trends that we believe are more relevant in assessing the future path of economic activity and a way of living. In our view, technology and changing demographics are the driving forces of change and the future composition of economic activity. These forces are driving structural changes that are underpinning the cyclical recovery.
E-commerce penetration has been an existing risk in the pre-covid world, except that the risk in our minds was only to brick-and-mortal retailers. The possibility of technology enabling the digitization of almost every business in the economy was not fathomed. Similarly, the transformation of the traditional office space has begun long before the pandemic. The traditional workspace model has been challenged by the co-working models pioneered by WeWork’s alike, whose vision was to create an inspiring workplace environment as an alternative. The pandemic has not only reduced the stigma of working from home, it completely transformed the possibilities of doing nearly any business virtually. In other words, the internet and internet of things (encompasses an array of technologies that enable virtual communications networks), hasn’t only enabled e-commerce but showed that with the exception of the services sectors, the vast majority of the economy can function efficiently in the digital space.
Changing demographics of the working age population is an important factor that is helping to accelerate technological adaptation. The composition of the world’s demographics is now largely represented by the Millennials (born between 1981 and 1996) and Generation Z (born after 1997) that are forecasted to represent over half of the working age population by the end of this decade. This segment of the population has been the driving force behind the push against the traditional workspace model. More importantly, their willingness and the adaptability of behaviour and integration of life with technology enables the accelerated transition to the digital life and the economy that we are heading towards.
“Each time younger generations replace older ones in each phase of life, the composite life cycle becomes something altogether new, fundamentally changing the entire society’s mood and behaviour.”
– THE FORTH TURNING,
WILLIAM STRAUSS & NEIL HOWE
Implication for Real Estate
As we enter 2021, it is fair to say that commercial real estate has experienced its share of challenges. The immediate impact was faced by the hospitality, entertainment and retail sectors; office and multi-residential have been more resilient, while industrial has been the beneficiary of all accelerated trends (such as the rapid rise in e-commerce and logistics, and supply chains re-organizations).
It is our view that physical real estate space will remain an integral part of our lives, whether it is an office, retail, or other asset class. The technological changes are not making real estate obsolete, but rather changing the way it is integrated with the business model, with the role of technology taking precedence and assuming a greater role in its scale and scope compared with the past.
While working from home has proven to be viable and successful, office space will continue to be a viable asset class as collaborative and creative environments cannot entirely function and more importantly thrive in the digital space. Similarly, physical retail continues to be an integral part of overall sales strategy with many retailers adopting an omnichannel strategy.
The migration trend from cities to suburbs has spurred growth in commercial real estate in new markets across Ontario. This trend, which has been driven by the working from home phenomenon and enabled by technology, can also be explained by the shifts in demographics. Millennials, that are transitioning to their next life stage, flock to the suburbs to start families. Inevitably, this would have happened without the presence of the pandemic at a much slower pace. However, the rapid spread of the virus and stay-at-home technologies, have compressed the decisions of many individuals into a single cohort acting in concert, hence creating a boom in suburban real estate markets.
Despite the uncertain economic environment, real estate as an asset class is expected to continue to benefit from accommodative monetary policies that are expected to keep interest rates low for longer. During the past decade, economic growth supported real estate appreciation on the back of strong occupancy rates, rental income increases and improved capital gains.
The pressure on cash flows due to rent collection challenges suggests that investor focus will shift toward achieving safe rental yield and away from capital gains that can be diminishing in the current environment. In other words, investors will focus on the asset’s ability to generate a sustainable stream of income.
As we look into each asset class it is important not to paint all assets with the same brush. Even troubled asset classes in real estate can provide attractive opportunities. Even within struggling sectors such as retail, strong assets with quality tenants and stable cash flows can provide not only safe rental yield but rather greater yield than offered by traditional assets like fixed income.
With the backdrop of the current prolonged low-interest rate environment, real estate continues to provide attractive investment income and diversification benefits to a portfolio.