The Impact on Commercial Real Estate of Coronavirus – Insights from CrowdStreet
By Adam Gower Ph.D.
The COVID-19 crisis has swept America by storm. In most metro areas, retail activity has come to a grinding halt. Restaurants have been shut down. Office workers have been ordered to stay home. Layoffs and unemployment claims are simultaneously on the rise. The stock market has experienced more volatility than perhaps ever before.
The commercial real estate (CRE) industry will not go unscathed. Already, the coronavirus pandemic is leaving its toll on the industry in different ways. Several industry organizations, notably CrowdStreet’s recent webcast which had over 1,000 people tune in in real-time, have convened experts to discuss what to expect from the sector in the short- and longer-term. You can access their webcast here.
Handling as many CRE transactions as they do, the CrowdStreet platform offers a unique perspective on what is going on in the market and I have recapped the most salient points for you, below.
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• CRE remains a safe haven for investors.
One of the primary benefits to investing in commercial real estate is that it has very low correlation with the stock and bond markets. Indeed, historical data confirms that returns by sub-property type during crisis periods typically hovers between 8-10% (unlevered) and 10-15% (levered). Some property types perform better than others. Retail, industrial warehouse, downtown office and multifamily have historically outperformed hospitality and suburban office during down markets.
• Investor sentiment remains high.
Again, a look at historical data shows us that even during crisis periods, investors’ outlook toward commercial real estate remains high. It is highest among the apartment segment, industrial/warehouse, and downtown office. It tends to be lower among regional retail, hotel, industrial R&D and suburban office.
• Most investors are taking a long-term view.
There’s no doubt that it won’t be business as usual for some time, at least five or six months—perhaps longer. Yet most investors make decisions on a multi-year horizon. If we assume that an asset purchased now is not sold for another five years, that asset will most likely be traded during an up market. We are in a recession today, but there’s reason to believe CRE investment activity will continue given investors’ long-term views toward the sector (more on this below).
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CRE is an incredibly diverse sector. There are many product types, classes, geographies, investment strategies and more. We expect to see this pandemic impact assets differently throughout the sector.
With international travel grounded, travel and tourism have been pummeled. There have been widespread hotel closures this past week. Marriott International has furloughed tens of thousands of its employees for the first time in company history. In New York, the Four Seasons is offering rooms free of charge to healthcare workers in need of a place to stay. Other hotels are being asked to serve as triage centers for hospitals. Experts say hospitality occupancy rates will likely drop into the single digit range. As a result, any hospitality deal flow is expected to be put on hold. This sector is virtually unfinanceable right now. How long these circumstances last remains to be seen.
• Seniors Housing:
The COVID-19 outbreak at a Seattle-area nursing home has caused seniors housing activity to grind to a halt. Deals with occupancy in place are faring okay for the time being, but absorption will remain low moving forward. No 45-64 year old decisionmaker will be putting their parent into a facility right now, assuming they can avoid doing so. Experts predict this will create an opportunity for best-in-class seniors housing operators to buy struggling facilities at a discount, thereby weeding out some of the less established operators in the market.
Retail remains a mixed bag. Grocery-anchored centers are performing well, as grocery stores sales have skyrocketed in recent weeks. Restaurants, meanwhile, have shuttered. Even those that have shifted to take-out and delivery are struggling to stay afloat. Traditional retail has collapsed. Lifestyle shopping centers, the darling of retail in recent years, are also being clobbered. These centers, which have repositioned themselves to focus more on experiential elements, are ghost towns now that people have been asked to stay home...
It remains to be seen how lifestyle centers re-emerge coming out of this crisis: will people flood restaurants and experiential retail stores, having been cooped up at home? Or will there be lingering anxiety about the economy, causing some to curtain discretionary spending? It’s a big question mark
This segment of the market could perform in a few different ways. Well-located office buildings, such as those located downtown, may perform well – particularly if they have long-term leases with creditworthy tenants who can absorb the short-term blows presented by this crisis. Many of these office workers can continue working from home with little disruption. Yet this work from home shift may have longer-term implications on the office market. For example, if people become accustomed to working from home, employers may be less likely to renew costly leases or sign on for expansions. Instead, they might increasingly allow people to work remotely. Conversely, employees may experience remote work fatigue, creating pressure to get back into the office as quickly as possible. It’s a workstyle experiment that will play out before our very eyes.
Some types of industrial continue to perform very well – particularly last-mile distribution facilities. People don’t want to leave their homes, so many have turned to online delivery services like Instacart and Amazon Prime. This has caused a huge spike in demand for well-located logistics hubs. Meanwhile, more traditional industrial facilities, such as those needed to serve the Port of Los Angeles which has experienced a drop-off in activity, are starting to struggle. Lease-up of traditional industrial may lag for quite some time.
Multifamily has long been a darling of commercial real estate, and the coronavirus hasn’t changed that to any real degree. Fannie Mae and Freddie Mac are still lending. In fact, multifamily lenders are stumbling over each other to get well-located deals done at some of the most aggressive terms we’ve seen in the past decade. In terms of leasing, Class A might take a hit. Class A tenants tend to have more mobility than others, so those looking for a more economical living arrangement might downgrade to Class B properties in the short-term. As such, Class B properties are well positioned at this time. Class C properties are likely to struggle the most. These tenants are the least likely to have reserves, which could cause a significant disruption in cash flow if these tenants are laid off or otherwise see their income reduced.
Experts often use the “Four D’s” to describe self-storage demand: downsizing, divorce, dislocation and death. Unfortunately, the COVID-19 crisis is likely to cause an uptick in each of these four categories. As such, self-storage facilities are well positioned at this time. Self-storage REITs are performing exceptionally well right now.
• Manufactured Housing:
Manufactured housing often gets lumped into other residential categories, but it’s worth looking at on a standalone basis. Manufactured housing is among the most affordable in the U.S., with demand continuing to rise. For perspective: while hospitality and other publicly-traded REITs have come crashing down over the past week, manufactured housing REITs have ticked up by 2-3% on average.
Trends to Watch
There are other trends to watch, regardless of product type. CrowdStreet breaks down some of the most prominent trends below:
• Expect capital markets to remain active.
Contrary to popular belief, the capital markets are still highly active. Roughly 70-75% of lenders are still doing deals. Whether those deals get done or not will depend largely on the product type and its location. Regional and other balance-sheet lenders are the most active in the marketplace right now, albeit at widening spreads. Borrowers should expect to see an adjustment in leverage ratios and perhaps more stringent terms moving forward, but there is still plenty of liquidity in the market to get deals done.
• Institutional investment is likely to slow down.
Institutional investors tend to be very risk adverse. As such, we should expect some to move away from investing directly in CRE and instead, shifting toward publicly-traded REITs as a way to preserve liquidity.
If institutional investors are pressed to sell assets at a discount, this could create opportunities for other buyers.
• Sponsors may suspend investor distributions.
For the most part, we expect sponsors to stop short of making widespread capital calls. The exceptions to this may be in hospitality or retail. Otherwise, it’s more likely that sponsors will suspend investor distributions for a quarter or two until we have more certainty about how this crisis is going to play out. Many sponsors are already suspending capital projects for now, especially in value-add deals, as a strategy for preserving cash in the short-term.
• Construction delays will become the norm.
Boston was one of the first cities to announce a moratorium on all construction activity. Its neighbors, Cambridge and Somerville, quickly followed suit – even defying the governor’s orders to proceed with all construction projects. Investors should expect to see more widespread construction shutdowns. The market is already starting to price in 2- to 3-month construction delays into project underwriting.
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Finding Hope Amid Widespread Despair
Despite some of these more troubling trends, experts remain hopeful about the long-term health of the commercial real estate industry. Indeed, most are predicting the economy will experience more of a “V-shaped” bounce back than a prolonged, “U-shaped” bounce back. There are a few reasons for this.
The first is that it’s an election year. Nobody wants to be re-elected more than President Trump. The $2 trillion stimulus package announced on March 23rd is going to have a profound impact on investor confidence and will hopefully deliver on its intent to stabilize the economy and the stock market until the number of infections starts decreasing and/or the scientific community finds a vaccine and cure. The package, includes about $350 billion in forgivable loans to small businesses, $250 billion in increased unemployment insurance and $300 billion in direct payments to households.
Moreover, unlike the 2008-09 recession, in which there was a lot of finger-pointing at the financial industry that then needed a bailout, there’s no industry at fault here. We’re currently dealing with a true humanitarian crisis, a public health emergency that affects all people and industries alike. One silver lining of all this is that we are all united in the fight against the virus and hopefully that unification will last well beyond the time when the virus subsides.
Finally, it’s important to remember that the underlying economy is strong. There will be pent-up demand for things like bars, restaurants and travel. People are eager to return to normal life. The precautionary measures being taken today (e.g., the stay in evictions and bank foreclosures) will help the economy bounce back much faster than it did in 2008-09 – or at least, so we can hope.
There’s no doubt that we’re entering unchartered waters, but there are several reasons to believe now is still a good time to invest in commercial real estate. Savvy investors will use this as an opportunity to clean up their deal pipeline, to forge new relationships, and to focus on the most lucrative opportunities. Rather than sitting on the sidelines, investors who are prudent will come out on the other side of this equally as well position as when this crisis began.
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