COVID-19: A Look Inside the Commercial Real Estate Capital Markets

This article written based on my conversation with Willy Walker at Walker and Dunlop, here.

The commercial real estate industry, like many others, has been dramatically shaken up by the COVID-19 crisis. Nearly all deals have ground to a halt. Interest rates, which were hovering around record lows, have marginally ticked up as lenders account for increased risk and uncertainty. That’s to say, of course, that lenders are still active – many of which are not. What the future holds remains to be seen. It will largely depend on the property type and geography. Here’s a look at what we’re seeing in the debt and liquidity markets as of today.


Where are the capital markets today?


The commercial real estate capital markets have essentially hit pause for the time being. Deals are not being done. The deals that have been funded and closed were in the works for weeks (or months) leading up to the coronavirus crisis. Deals that are looking for capital sponsors today are in much greater flux.


One of the challenges is determining property value. The dearth of M&A and sales activity due to COVID-19 has made it difficult to assess the value of a property. Absent transaction value, most capital will remain on the sidelines.


We’re seeing this take shape in both the debt and equity markets.


  • Equity capital is almost entirely on the sidelines right now. Those with dry powder are waiting to see how this crisis unfolds before making any moves. It could be three to six months or more before equity capital ramps up again.


  • Debt capital is also on the sidelines with a few exceptions. Major banks, life insurance companies and CMBS lenders are the most skittish right now. Additional risk is being baked into deals and causing spreads to increase slightly (50+ basis points). There is still debt to be had, to some degree, but depends on the product type and location.


Liquidity by Product Type


As we noted above, the amount of liquidity available right now really depends on the product type. Here’s a look at how liquidity has been affected by each of the major product types:


    • Hospitality: Hospitality is struggling worse than any other product type right now. Travel, for all purposes – domestic and international alike – has virtually stopped. Many hotels are running at about a 10% occupancy rate, assuming they haven’t closed their doors altogether right now. It could take 12-18 months or more for hospitality to pick back up again, and as a result, we’ve seen liquidity for hospitality deals completely erode. Nobody is lending or putting equity into hospitality right now (or for the foreseeable future).


    • Retail: Retail is faring nearly as bad as hospitality, but with a few exceptions. Any property anchored by a grocery store, pharmacy or hardware store is still doing well and as a result, may be able to access capital. Otherwise, retail has been clobbered. Movie theaters and other big-box retail anchors have gone dark. Retail was already struggling prior to the coronavirus crisis. Capital for retail deals will be particularly hard to come by moving forward.


    • Office: We are not seeing distress in the office sector just yet. Office tenants tend to sign longer-term leases (e.g., 7-10 years or more), so most are not seeking capital right now. Those who need capital are still able to find it; there’s some liquidity in the office sector, just not a lot. The big question is the long-term impact this crisis has on the office market: will tenants sign lease renewals? Will they invest in costly fit-out jobs? Or will more people start working remotely? The future of office will influence the availability of capital for these deals moving forward.


    • Industrial: There’s a strong appetite for industrial right now, driven in large part by Amazon and other distribution facilities that have had to ramp up activity to meet consumer demand as more people shop from the comforts of their own homes. Both debt and equity remain available for industrial, particularly for logistics and last-mile distribution centers.


  • Multifamily: Multifamily is unique in that Fannie Mae and Freddie Mac, the two government-sponsored entities (GSEs), are still providing tremendous liquidity for the sector. Unlike other product types, when there’s a downturn in the economy, the GSEs are typically mandated to pump more capital into the marketplace. As a result, the availability of capital (debt and equity) for multifamily remains strong. Beyond the GSEs, private equity remains drawn to multifamily given the strength of the underlying economy and the fact that people will always need somewhere to live, regardless of how long this public health emergency lasts.


Defaults by Product Type


It’s still too early to see widespread defaults in commercial real estate. The national economy has been shut down for roughly a month or so, but commercial real estate activity tends to lag. That said, we’re starting to see some early indications of how defaults might take root in each of the five following product types.


  • Hospitality: As mentioned above, hospitality has been hit the hardest of all product types. Nobody is traveling. Nobody. Families can’t even travel to send off their loved ones who have passed away. Many hotels have simply shut down—temporarily? Permanently? We don’t know. In fact, they don’t even really know. Many have gone to their lenders for forbearance, requests that each lender handles differently depending on the property’s underlying fundamentals. Assuming we’re 12-18 months before reaching some semblance of normalcy, those who can see the light on the other side are trying to hang in there. Many others are starting to hand back the keys to their creditors already.


  • Retail: We’re seeing an interesting dynamic play out in the retail sector. Typically, retail landlords prefer leasing to national, credit-worthy tenants. They are considered the “safest” tenants, and will usually help to anchor a retail center. However, what we’re seeing now is that the large corporate retailers are those defaulting at the highest rate compared to smaller, mom and pop retailers. The Cheesecake Factory was one of the first tenants to come out and blatantly say they wouldn’t be paying rent in April (or for the foreseeable future).

    There are a few reasons for this trend: first, national retailers have more leverage over their landlords; they are usually in long-term leases and have more bargaining power when trying to renegotiate lease terms or periods of rent forgiveness. Second, each store has less individually on the line compared to a mom and pop tenant. We’re finding that independently owned, non-credit-worthy tenants are actually more likely to keep paying, when possible. They don’t have the resources to litigate. They fear nonpayment of rent will impact their credit. Most want to be in a good position when this crisis eases so they can get back to work, and as a result, are paying rent to the extent possible.


  • Office: So far, we have seen little evidence of tenants using the crisis as a lever to renegotiate or sweeten a deal. The overwhelming majority of office tenants seem to be far more concerned with the health and wellbeing of their employees, being operational, and staying in the black. Real estate appears way down the list of priorities (for now), though we expect that to change moving forward. An estimated 85-90% of office tenants paid April rent, but this could change in May if the market softens.


  • Industrial: Industrial remains strong, again, driven by Amazon and other big shipping operations. We may start to see some kinks in industrial’s armor, however. For example, a warehouse used to store salon products coming out of China may not see the same volume of activity for some time. If the warehouse isn’t getting new product, if distributors aren’t being paid, this can carry over into industrial activity. Industrial centers with credit tenants will be the least impacted by defaults.


  • Multifamily: We initially expected to see widespread defaults in multifamily, but as of April 1st, that really hasn’t materialized. This leaves multifamily investors and creditors feeling optimistic. The federal government is starting to issue $1,200 stimulus checks and have boosted unemployment benefits by $600 per week. On average, states pay roughly $325-375 per week in unemployment insurance. Add $600 to this amount and now unemployed individuals are earning upwards of $4,000 per month – a figure that may be higher than what most earned when they were earning a full-time income in Q4 of last year when unemployment was below 3 percent. In other words, if people were able to pay April 1st rents in droves (which they did), there’s reason to believe May, June and July collections will remain strong, thereby minimizing rates of default.


Comparing this Recession to 2008-2010


Many have asked how this recession compares to the 2008-2010 “Great Recession.” There are a few points to note relative to this topic. First, the Great recession was a banking crisis, a true liquidity crisis. This recession is different. Banks are exceedingly well-capitalized. The Federal Reserve Bank has flooded the market with liquidity. Just last week, the Small Business Administration (SBA) launched a $350 billion small business loan program that is expected to be fully tapped out within two weeks’ time.


Second, there was a freezing of liquidity in 2008 unlike anything we anticipate today. Lenders pulled warehouse lines, repo lines, every line they had. Banks had absolutely no flexibility for those facing default. The situation looks much different today.


Banks are in a better position to work with their borrowers to prevent widespread defaults, restructurings, and foreclosures. This is because we’re dealing with a health crisis – not an underlying economic crisis. People are confident that this recession will ease up much faster than the last (we’re already seeing the market pick up again!), and therefore, lenders are optimistic about staying the course whenever possible to get through to the other side.

Understanding the Relationship Between Equity Market and Debt Market


There’s a relatively weak correlation between the equity market and debt market. In the equity market, stocks, bonds and other securities can be traded with the click of a button. When coronavirus first emerged as a crisis pandemic, equity investors were quick to sell. The stock market plunged but has since started to recover.


The debt markets move much more slowly, and typically lag the equity markets by a few quarters. Commercial real estate cannot be traded so quickly or easily; there’s a long lead time before we’ll start to see a real adjustment in either pricing or transaction volume. Most CRE investors seem to be optimistic about the long-term health of the CRE sector given the strength of the underlying economy. As such, we don’t anticipate seeing the panic selling that we’ve seen in the equity market. If anything, now that the equity market has started to recover (and recover faster than anyone expected), we anticipate this will give a boost of confidence to the debt market. People generally seem confident that the market will recover in 12-18 months and as such, will continue to selectively invest and/or hold onto property. We aren’t expecting to see the same flood of distressed real estate or collateralized paper that we saw during the last recession, which was a staggering 43 months in duration.

Why a 12-18 Month Recovery Seems Likely


Investors seem to be growing confident that by this summer, some business activity will be back on track. Already, the federal government is floating ideas as to how to gradually reopen the economy as early as this May. While some activity may resume in the short-term – particularly ahead of the November election – a broader recovery probably won’t happen for at least another 12 to 18 months.


Here's Why:

Reopening the economy is going to hinge on several factors, including: vaccine development, therapeutics, broad testing around the country and throughout the world, and the ability to mass produce personal protective equipment (PPE).


Until then, companies are going to be hesitant to dive back into “business as usual”. Corporations, for example, may be slow to hold company retreats, sales meetings, and conventions. People who routinely traveled for work may opt to telecommute or attend meetings virtually instead of hopping on a crowded bus, plane or train. There is likely to be a lingering psychological impact, if nothing else, that prevents the economy from getting back to “normal” this year. We put normal in quotes here because all experts seem to agree: we aren’t going back to life the way it was a few years ago. There will be adjustments. The nature of work will change. Retail and hospitality will certainly take on a new look and feel. We simply don’t know to what extent just yet. What we do know is that a return to “normal” will be a “new normal” of some sort.

Opportunities on the Horizon


Again, it’s still too early to fully understand the impacts of the COVID-19 crisis on commercial real estate. While some sectors have seen chinks in their armor, we haven’t seen widespread distress in the system just yet. That said, here are a few potential opportunities for investors to have their eyes on:


  • Hospitality: While hospitality might be doomed for the foreseeable future, well-located properties may be ripe for conversion to multifamily down the road.


  • Office: We know that some tenants won’t be resigning long-term leases—but how will they work? It’s something we’re watching closely. Will people start working remotely? We’ve heard that companies and their employees still crave human interaction, so there could be an opportunity for office space that is leased on an occasional (1-2x/week) basis for team meetings. This would take a form different than traditional coworking spaces and may be a new shared workspace model moving forward.


  • Student Housing: Some universities have already indicated that they’ll be leaving some portion of dorm rooms vacant to accommodate a potential surge of on-campus COVID cases. This could result in a dearth of on-campus student housing, creating an opportunity for private, off-campus student housing in some markets.


  • Retail: We’re watching retail closely. Some big box retailers might not be able to recover from the COVID crisis. JCPenny, Kohls, Sears and the Gap have all been suggested as businesses that do not make it to the other side. AMC movie theatres might fall into the same boat. Investors may have an opportunity to rethink these spaces in creative, more profitable ways.


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What we’ve shared here today is a glimpse at what we’re seeing in the commercial real estate markets today. It’s important for investors to understand that things are changing rapidly. The debt and equity landscape seem to be changing little by little, week by week, and could look much different come May after another round of collections takes place.


In general, investors seem to be sitting on the sidelines waiting to see how things shake out. They’re looking for more guidance from state and federal government. They want to have a clearer understanding of where we’re headed and when. Will the federal government jumpstart the economy through a public works program? Will it inject massive dollars into long-overdue infrastructure projects? When will the masses be allowed back to work? Once there’s a clear game plan in place, investors will have the direction they need to invest moving forward. Expect both equity investors and debt providers to pull back until then.

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