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The Impact of Coronavirus and Market Tumult on Commercial Real Estate - LI

The Impact of Coronavirus Covid-19 on Commercial Real Estate

 

Over the past few weeks, I've fielded questions from investors, real estate professionals, and others in the CRE world regarding the potential effects of Covid-19, aka the "Coronavirus." People want to know if this pandemic is really the end of the world, or if it is just another flash in the pan, irrational selloff that should right itself in a few months.

 

The truth lies somewhere in the middle.

Walls Don't Stop Pandemics.

 

Pandemics don't respect international borders. Our interconnected world is replete with cheap flights and the mass movement of people and goods over borders on an unprecedented scale. Outside of hermit states like North Korea or Eritrea, most nations cannot truly close their borders to infected visitors or returning travelers – just take a look at the controversy over allowing cruise ship passengers suffering from Covid-19 back into the US.

 

While indications coming from China suggest that Covid-19 has a limited lifespan in society when appropriate measures are taken early on, proposals for containment in the US are far from those that were taken in China. Additionally, the nature of the American healthcare system – costly for users, inadequate for crises such as the current one – leaves many in the United States at a disadvantage, particularly when we're talking about an infectious disease on this scale.

 

With the lack of voluminous testing needed to identify and contain the virus, it is likely spreading across the nation very quickly, and the impact on the healthcare system will be the most severe. How we get through this crisis will depend on how the US handles the outbreak and how quickly the government moves from containment to delay.

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Of course, this is all very scary, but what you're probably wondering is: How the heck is going to affect my CRE assets? Should I get out before another '08 crash? Is the world coming to an end?

 

Consider these facts.

 

As real estate is a long-term investment with lower liquidity, it provides investors greater stability than ‘traditional’ investments like stocks or bonds that can be traded instantly and exposes them to market sentiment and the emotional swings that come with that. Keep in mind that this is not the first time we’ve seen coronaviruses spread. When others like SARS and MERS, both of which exhibited far higher mortality rates than Covid-19, their impacts were short-term market volatility that stabilized within three to six months.

 

A Putin Panic? What Does Shale Have to do With it?

 

The first thing you have to realize about our current predicament is that we are looking at a triple whammy of elements contributing to recent market volatility. These events include Covid-19 itself, our reaction to the spread of the disease and its mortality rate, and a third variable – a raging economic war between major oil producers, including the Kingdom of Saudi Arabia, Russia, OPEC members, and the United States. This past Monday, the 9th of March, saw an oil shock that is unprecedented in the modern age, with prices dropping up to 30% for a barrel of crude in a single day. On the face of it you would think that lower oil prices are always a good thing leading to cheaper transportation costs result in cheaper goods, increased spending, and a higher overall level of economic activity.

 

Unfortunately, the United States is not just an oil consumer, we are a producer. From oil wells that sit within the city limits of Los Angeles, to shale production on the Permian Basin, to our extensive crude refining capacity, we remain dependent on oil and oil products.

 

This means that we as a society are vulnerable to the deleterious effects of too-cheap oil, problems which have more traditionally been the concern of oil-states like Russia, Saudi Arabia, Venezuela, etc.

 

Mr. Putin’s decision to walk away from supply-cut talks has potentially sparked a price war that could dramatically lower the cost of oil in the short term, which will have negative ramifications for shale oil producers here in the United States, their employees and investors, as well as any banks or lenders that they owe money. Fear of this new oil war and the deleterious impact it will have on those states dependent on oil production like those in Texas, New Mexico, North Dakota, Montana and Alaska, is a major contributor to our current economic woes and contributes to any serious discussion of Covid-19 ramifications.

Specific Repercussions and Trends

 

Single Family Residential/SFR

Foreign investors are piling into the US home market as a safe haven and are buying homes on sites like Roofstock where an end to end transaction can be completed entirely online.  Investors are coming in from countries across the world, Germany, Australia, and the UK. Asia in particular is driving foreign investor numbers, with web activity from them on home buying/selling platform Roofstock rising 500% over the past few weeks. Boston and LA are popular destinations for these investors. This is likely in part due to their reputations for excellent healthcare systems with Covid-19 dominating headlines worldwide, as much as they are seen as being financial safe havens.

 

Office

With interest rates down to historically low levels, companies are cutting their cost of borrowing. However, there is the potential for corporate debt to spiral as companies take on more debt, tapping into existing credit lines to compensate for lost revenues. If this happens, banks may start tightening further lending requirements creating credit crises leading to bankruptcies that could create problems for office lease holders and their landlords.

If and as companies stall, tenant stability could falter for office owners, causing vacancy rates to increase pushing rents down. This might be offset somewhat as investors, troubled by the volatility of the stock market, will seek stability in hard assets like CRE and may migrate from stocks into real estate driving pricing up, especially as cost of capital is so low.  There will likely be few buy opportunities however, and few distressed deals out there. This is because by the time the CRE industry starts to feel the pain, the Coronavirus crisis will be over, and as the underlying economy still remains strong they will bounce back.

 

Entertainment

The out-of-home entertainment industry is going to feel the pinch as people stop congregating in public places. This will affect cinemas, restaurants, bowling alleys, sports events, nightlife, bars etc.  As these are drivers also to the already teetering retail industry, we may see a snowball effect of negative consequences, particularly if some sort of government assistance for workers and business owners/investors is not forthcoming in a timely fashion and even then it will have to be substantial to make an impact.

 

Hospitality

This sector is always the first to be hit during downturns and the most severely affected, primarily due to the super short lease terms (one day) and highly discretionary nature of most travel.  When people are not travelling, and they are staying away from other people not just to cut personal expenditures, but also for health reasons, hospitality is likely again to be the most negatively impacted. In the US there was over $300 billion of mortgage debt across the hospitality sector in 2019 – a jump of 7.8% from 2018 and 14.2% in 2017.  Hotel operators with high debt, especially in New York, LA, and Las Vegas are going to be particularly vulnerable because of the drop off, not only in domestic travel, but also of foreign visitors.

 

Cap Rates

Cap rates won’t fluctuate because even with predictions of vacancies, those vacancies will be short lived and as cap rates tend to be driven by predictions of future revenues, there shouldn’t be much impact. What impact there will be, will be that while you might expect cap rates to drop as interest rates drop, they may not follow suit quite as quickly as they might otherwise if there were no pandemic to be dealing with at the same time.

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Keep Calm and Carry On

 

I’m sure you’ve seen posters, memes, or images of the phrase “Keep Calm and Carry On.” This phrase originated in British government messaging to citizens during the dark days of World War 2 and the Blitz, and it was an exhortation to those reading it to remember their “stiff upper lip” and sense of resolve even during the worst of times. I would advise you to take a similar attitude to this crisis.

 

Imagine if that train station poster, instead of encouraging strength, encouraged fear and panic. Yes, our lives are going to be disrupted for a while and there will be tragedy as people perish from this illness, but take a moment to catch your breath, digest the facts, and know that almost as soon as it emerged, it will be gone, and life will be back to normal.

 

Until the next time.

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