In changing markets, one thing endures, the value of top-tier real estate. Flight to quality, sometimes called flight to safety, refers to the desire to seek the best possible asset when times are tough. It makes logical sense. Both individual and institutional investors want to avoid making a mistake. When we consider the current real estate landscape, the flight to quality tells us that tenants and investors are wrestling with great uncertainty in the market and are looking for safe havens.
Part of what is happening in real estate now pivots on the many stressors felt since the pandemic. We first had the eviction crisis, followed by a massive exodus from major cities, and then the impact of remote work on nearly every sector of real estate. We truly live in a changed world. Around 12% of workers are fully remote, and 28% are in a hybrid arrangement. This tectonic shift has led to a reconsideration of the role of cities. Large cities remain the greatest store of real estate value. However, recent market fluctuations have meant that investors and tenants are seeking out known quantities.
With sentiment around different real estate sectors changing so quickly, the flight to quality becomes even more important as a phenomenon. In the last few years, we’ve seen absorption rates for industrial real estate hit record highs. Retail which was nearly considered left for dead at the start of the pandemic has rebounded strongly. In a world where so much changes so quickly, it’s challenging to accurately forecast which sectors of real estate will see the most growth in the coming years. However, one thing is reliable, the best properties will always find buyers, investors, and tenants.
What flight to quality means
The flight-to-quality effect appears across many sorts of assets. In recent months we’ve seen a move in equities away from riskier growth stocks and toward more proven reliable blue chip stocks and dividend payers. After the recent banking crisis, both investors and depositors were drawn toward the reliability of the too-big-to-fail banking institutions. Human nature often has us reacting after an event has already occurred. Behavioral studies show that investors tend to feel the pain of losses more than they feel the pleasure of risks. When a shock hits the market, investors seek to avoid future pain.
Within real estate, this phenomenon tends to play out among the classes of real estate as investors move up toward safer properties and steer clear of ones that might be more at risk for tenant vacancies or wider economic obsolescence. Location and building quality are always important when valuing real estate, but they become even more valuable when it seems that there is a potential for more immediate loss.
Commercial space tends to be divided into three classes, A, B, and C. There is no formal classification for this, and the distinction can be a bit arbitrary. Generally, when we are speaking of Class A, we are talking about newer buildings with significant amenities. Class B refers to older buildings that may be a little out-of-date and need a refresh. Class C buildings are in less convenient locations and may need significant reformatting to appeal to tenants. A flight to quality means that companies and individuals are moving up the ladder toward Class A properties. Tenants are more interested in these properties and lenders are more likely to finance them. This phenomenon occurs across multiple CRE sectors. An example of this has played out in retail over the last decade as the Class B malls have been more likely to lose tenants and fail.
For tenants in any sector, quality has its advantages. Highly desirable properties are often in vibrant areas. There’s an amplification effect here. Areas with lower vacancies tend to appear more desirable and are better able to retain prices. Conversely, when an area or a building starts to see a lot of vacancies, it can create a situation that drags surrounding properties down. Quality acts as a bulwark in aggregate. Even in a market with lowered demand, it’s possible for a specific property to become highly attractive. However, one also has to be aware of the “best house in the worst neighborhood” effect. Properties should always be considered in relation to their surroundings.
Quality is also a backstop against value loss in uncertain times. In a high-interest rate environment with added uncertainty due to various economic forces, the financing process naturally becomes more rigorous. Lenders are looking more closely at the expectations surrounding individual buildings and ensuring they match the market realities. This tight lending environment makes it more challenging for building owners to structure attractive loans for various properties.
Does this only mean investing in Class A property?
Two things drive the current flight to quality: fear about the future of all markets and the opportunity to buy the best properties at lower prices due to market stressors. The flight to quality movement is driven by a wealth of choices and therefore tends to be a temporary phenomenon. When the market contracts again, many tenants may be forced to adjust their expectations of what they can afford. If past cycles are any guide, this will not last.
An example of this cycle was seen during the pandemic regarding hospitality. The entire hospitality sector was hard hit, but the destination and luxury hotels tended to recover faster. Those short-term tenants, known as hotel guests, returned first to higher-quality hotels that were running special deals and incentives. Once the travel sector rebounded and demand increased, those deals were gone, and the market reset.
Class A properties don’t always offer a lot of upside for the investor. In most cases, you are paying for quality, and the value is already priced in so the chance to achieve significant alpha is limited. These properties are usually cash-producing and will generate consistent returns, which only adds to their appeal for potential buyers. It is also easier to find and negotiate financing because lenders can see a track record of success and review net operating income over time.
One immediate impact of flight to quality is that a more significant price differential emerges between the top properties and the rest of the pack. Potential investors in the market to purchase an investment at a time when the economic forecast is murky are looking for safety. Safety, therefore, demands a premium. If there is commercial real estate distress, it is often less likely to hit these properties, and if it does, they will usually be easier to refinance.
Another important factor in considering the flight to quality right now is the increasing demand for properties that meet ESG requirements. With more cities enacting significant legislation on emissions and energy efficiency, Class B and C properties without improvements may end up falling even deeper behind and become more cost-effective to tear down than to update. But this could also provide a chance to extract value from properties that need less substantive renovation.
The potential of value add
One of the most common real estate investments is the “value-add.” Investing in a “value-add” project means buying a property and performing improvements that make it more attractive for tenants. This type of investment should continue to do well and provides an excellent opportunity for investors to see an attractive return on investment. Because the process of renovating can take several years, now may be the time to think strategically about purchases. A property that starts renovations now may be well-positioned when the market shifts. “Location is critical when assessing value-add opportunities,” said Realty Mogul exec. “We are looking ahead to the future so that we are prepared to take advantage of the end of the current cycle when leasing rises again.”
Quality always matters, but sometimes it matters more. When a market is constricting, quality buildings tend to retain more of their value. As a market expands, the scope widens. Smart investors will want to make sure their investments perform across a wide variety of economic scenarios.