TOL - Real Estate's Transition From Commercial To Residential How To Profit

2023-04-04 03:17:04 ET

Summary

• Commercial Real Estate vacancy rates are at all-time highs as work-from-home jobs continue to increase in popularity.
• Rising interest rates coupled with decreases in housing prices have only magnified problems for CRE investors.
• To combat the possible collapse of CRE, I believe investors will start to re-purpose commercial real estate into residential real estate.
• Given the opportunity to transition from commercial to residential real estate, I think residential homebuilder stocks have significant growth potential.
• From my peer analysis below, I believe NVR, DHI, and LEN pose the best buying opportunities.

Investment Thesis

As CRE vacancy rates continue to soar and house prices continue to decline due to rising interest rates, I believe a transition will need to take place which involves transforming current CRE into Residential Real Estate. I believe this transition will lead to an increase in demand for residential home builders in the US, predominantly in high vacancy states such as Texas, Illinois, California, Georgia, and New York. Residential homebuilders with exposures to such states have potential to capitalize on large growth opportunities.

The Current State of Commercial Real Estate

The current estimated size of the Commercial Real Estate Market is approximately $20.7 trillion according to reit.com.

Not only is CRE a large sector, but the way most deals are structured can be worrisome considering current circumstances. What I'm referring to are balloon payments, where the principal is paid back in full at maturity and only interest is paid up until that point. This type of loan offers more flexibility than a traditional fully amortizing loan since you make less total monthly payments using a balloon. The below graph is according to data gathered from Trepp, displaying $2.5 trillion in CRE debt maturities due in the next 5 years.

Considering the high level of vacancy rates, combined with declining property value, could make it difficult to pay back CRE investors.

This is the highest level of office vacancy we have ever seen historically. If work from home trends continue office vacancy rates will continue to increase, making it more difficult to pay back those balloon payments coming due as described above.

Below is a list of the top 10 biggest US office markets change in vacancy rates from 2019 to 2022.

This provides good insight into what metro-areas are experiencing the largest shift towards the work from home life-style as well as where residential homebuilders should have operations located to capitalize on this transition.

Where does CRE go from here?

I believe there is a strong possibility that there could be a large transition of commercial to residential real estate in the near future considering CRE's current position outlined above. Transitions from commercial to residential real estate have already been taking place , with a large commercial building in Midtown Manhattan, New York having estimated conversion costs of $100 million. According to Moody's , " The cost to convert offices to an average apartment building is about $100-$200/SF, although that cost could be significantly inflated now. If we assume $150/SF of hard and soft costs plus a 15% profit margin of $23/SF, a developer will need to seek offices available at $262/SF. " With such high renovation costs per square foot, residential home builders could capture significant growth opportunities in the future. Additionally, California has already implemented legislation to convert commercial property into residential property more easily. If transitions from commercial to residential real estate continue, residential home builders have the potential to substantially grow their revenue.

Residential Builders; Peer Analysis

I believe residential home builders can profit the most from the high vacancy rates in commercial real estate given the potential to transition from commercial to residential real estate. On the other hand, I think that this transition could lead to a over supply of houses on the market, thus lowering prices of residential homes. This could in turn lead to hard times ahead for residential real estate investment trusts.

I gathered data below for the following residential home builders; NVR Inc ( NVR ), Skyline Champion Corp ( SKY ), D. R. Horton Inc ( DHI ), Toll Brothers Inc ( TOL ), Lennar Corp ( LEN ), and PulteGroup Inc ( PHM ). When diving into my peer analysis, I decided to look at residential builders, size, profitability, geographic operations, as well as balance sheet metrics.

I believe all of these stocks have the potential to gain revenue from the transition from commercial to residential, given their geographic footprint and nearly all of their revenue being derived from residential homebuilding. All of the above names are traditional residential home builders, with the exception of SKY, who specializes in modular homes.

Some of the residential builders that look the strongest to me are NVR, LEN, and DHI. I like these names in particular because they all generated more than $1.5 billion in cash flow from operations, have over $2 billion in cash, maintain over 19% EBITDA margins, and all have over 20% return on their equity.

Risks

There are several risks surrounding the CRE space that could change my view from a buy to a hold or even a sell.

One problem I could foresee is government intervention stepping in to support these CME loans coming due in the upcoming years. If the government were to give support, much like the discount window for banks, this could delay the collapse of CRE and thus the transition to residential real estate.

Additionally, lumber prices have been falling as of lately, but have been volatile over the last 4 years.

Volatility in lumber prices can compress companies margins ultimately making them less profitable than anticipated.

Another risk is actually completing the transition from commercial to residential. There are many different factors that could dissuade a potential investor such as zoning laws, residential vs commercial code, renovation cost to make the transition, as well as application approval time. For instance, each state has their own zoning laws and not all commercial properties can be zoned as residential properties. In addition to this, there is different levels of code a commercial property has to abide by versus a residential one. For instance, a commercial property most likely has a centralized plumbing instead of plumbing running to each room. Additionally, as outlined above from the Moody's article, the price per square foot to make these transitions can be quite substantial. Lastly, the approval process to switch from commercial to residential could take weeks to months, delaying building and your future cash flows.

Conclusion

In all, I believe that commercial real estate is at a cross roads due to increased vacancy rates, upcoming debt payments, increased interest rates, and lower home prices. I think a mass transition will take place from commercial to residential real estate resulting in a demand for residential home builders. Among the publicly traded residential home builders, I particularly like NVR, DHI, and LEN due to their high generation of cash flows from operations, historical profitability, and adequate debt to equity ratios while all maintaining over $2 billion in cash on their balance sheet.

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