Over the past two weeks, we’ve moved pretty rapidly from “a virus in China” to a situation that affects all of us personally. At the same time, the rapid spread of COVID19 has translated into measures that strongly affect the global economy — most importantly, the “lockdowns” that many countries have implemented, in many different forms.
There is no shortage of articles on how the current crisis will lead to a recession, etc. I don’t have a crystal ball, I don’t want to predict where US GDP and unemployment will be in Q2 2020 (it will be bad…), and neither do I want to be either optimistic or pessimistic about the form of the recession and the subsequent recovery (V shape, U shape, recession, depression, every economist and non-economist will have their opinion). But, I do want to give you some perspective on COVID19 and the commercial real estate market in the US. Given that the situation is fluid, this is not an attempt for a 2-year market forecast, but I’d rather give you some intuition about how to think about the crisis and real estate from an economic perspective. There are many great webinars and resources around, I’ve added some to the references at the end of the article.
So….
Understanding the different parts of the real estate market
To start with, the commercial real estate market (i.e. everything but owner-occupied homes) is really three markets, that are very closely related:
- The market for space — where companies rent office space, where private individuals rent apartments, etc.
- The market for assets — where investors buy and sell office buildings, industrial assets, multifamily buildings, and where lenders provide loans to these same investors
- The construction market — where developers build buildings, financed by construction loans.
In thinking about how COVID19 will affect the commercial real estate market, you can’t just consider one part of the system, but you have to look at all three parts in combination.
The market for space (including the construction market) and COVID 19
Demand for space is determined by factors that vary for each property type. Put simply, or oversimplified:
- Demand for office is determined by the number of people employed in the service sector (on the margin, it matters how many square feet each worker requires, which has been going down over the past years, with the increasing use of flexible office space and more work from home);
- Demand for retail is determined by the number of people and their net disposable income (the big disruption here has obviously been the shift from offline retail to online retail);
- Demand for housing is determined by the number of households (quantity) and the net household income (quality);
- Demand for industrial space is determined by 1) the local need for manufacturing, and 2) the local need for distribution (read: the extent to which online retail has displaced offline retail);
- Demand for lodging/leisure/hotels is determined by 1) tourism, and 2) business travel/conventions.
COVID19 affects each property sector in different ways. While long-term effects remain unknown, here are some of the short term effects (0–6 months). Note that I’m focusing on institutional-grade real estate here, so buildings that our clients invest in, not so much the “mom and pop” buildings (i.e. smaller assets in rural markets):
- Office: The office market has been under a bit of pressure over the past years — the WeWork model provides competition to the traditional landlords, and supply of new space has been significant in most cities. For example, Chicago has a 16.7% vacancy rate, which is only slightly below where it was in 2010 (20%). Due to COVID19, most office buildings across the bigger cities are currently standing pretty much empty — employees are working from home. You’d think that’s a big problem, but commercial office space is typically leased for a longer period (on average, 5 years), which means leases won’t be canceled just now because of the crisis. Of course, if companies that lease office space are going bankrupt en masse, that would lead to increasing vacancy rates, but as of now, the current crisis is not necessarily a financial services crisis, but rather a service sector crisis (so, all businesses actually servicing our financial services economy — restaurants, retail, etc), so the likelihood of large financial firms going out of business is small, unlike during the 2007–2010 financial crisis. An important note on providers of flex space, most importantly WeWork — these spaces typically have very short lease durations and many tenants are small businesses that may suffer disproportionally from the current crisis. So, WeWork et al. are in for a ride over the next months, which again is unlikely to lead to their bankruptcy, but it may lead them to cancel leases. Summarizing: the office market won’t suffer much more than it is already doing….
- Retail: The retail sector has been outright depressed for the past decade. The adoption of online retail in the US was expected to be 12.5% in 2020 (it will be MUCH more), and the share in non-grocery is already higher. That means fewer people go to stores, and many stores/chains have gone bankrupt because of lower revenues. That has led to a lot of vacant space on the retail market, much lower rents, and very high vacancy rates. The COVID19 crisis will only increase this “death spiral,” but…not for grocery stores. Using cell phone data from Advan, consulting firm Eigen10 did an interesting analysis of increase in traffic at groceries during the past weeks, and off-the-cliff traffic at all other retail (especially shopping malls). Summarizing: the retail market will continue its freefall, including spruced-up malls (people will be more fearful of going to places with lots of people, for a long time to come). But strip retail anchored by grocery stores and providing basic needs (pharmacy, dry cleaner, flowers, food) will remain. (It’s just that there is sooo much of that type of retail…)
- Housing: Note that I’m strictly focusing on institutional grade apartment buildings, so no owner-occupied housing, no small apartment buildings, or buildings in places where our clients don’t dare to go (Oklahoma, anybody?). The multifamily housing market has done phenomenally well over the past decade — after the financial crisis, many people lost their home due to their inability to pay for their mortgage (you can fill a cabinet with books about the mortgage crisis, predatory lending, etc, so no further words on that here). All those people still needed a place to live, that’s after all a primary need (in the Maslow sense). So, as the homeownership rate dropped from 68% to 62%, the market for rental housing boomed. Beyond increasing rents in existing assets, that also led to very significant construction activity, especially in the higher segment of the market. At this point, oversupply has started to become an issue in some places in the US (NY, most notably), not because there is no demand for housing, but simply because the apartments that have been built are not affordable for the people that most need them. COVID19 will lead to temporary and structural unemployment, and will thus affect the ability of people to pay their rent, but also to pay their mortgage. Sadly, those most affected are not the mid-to-high income earners, but the ones living on lower incomes, from paycheck-to-paycheck, in housing that is non-institutional. For now, laws are being passed that prevent landlords from “evicting” tenants that can’t pay their bill, but that will eventually happen. The multifamily market will thus be affected by COVID19 — more turnover, not necessarily higher vacancy rates (people need a place to live, also those that have to give up their own home), likely lower rent increases, and more trouble for those spots with oversupply (those apartments will be rented out, but at lower levels). But…the crisis won’t solve the shortage/lack of affordable housing, and “affordability” will remain one of the key topics for the next decade. There is simply not enough space to live in places where the jobs are.
- Industrial/logistics space: The logistics space has been the flavor of the decade, perhaps even more than multifamily. As retail has shifted from online to offline, Amazon, Walmart, Zappos, UPS and the rest of the online value chain have massively expanded their real estate footprint. Vacancy rates for logistics real estate are historically low, and while supply has been increasing in some areas, it simply hasn’t been enough to satisfy demand. The COVID19 crisis has two sides for the industrial market: on the one hand, even more shopping has shifted to online, leading both Amazon and Walmart to announce hiring 100,000 additional employees (!!), which all need space to work. So, that’s good news. On the other hand, supply chains and manufacturing has been disrupted, leading to less business for logistics facilities. If China can indeed ramp up supply again, that short-term shock can likely be absorbed and the industrial sector will march on.
- Lodging/leisure/hotels: The sector that is typically most sensitive to movements in the economy is the lodging/leisure sector. Right now, there is no travel, whether it’s tourism or business travel, and hotels are empty. No revenues, but costs are continuing (although Marriott has laid off many of its staff), including real estate leases. Hotels are operated by companies different from the owners, and you can expect many operators to go bankrupt if the COVID19 crisis lasts for more than 3 months.
The market for assets and COVID19
The market for assets is different from the market for space. A big crisis in the space market does not necessarily directly translate into a big crisis on the asset market. The value of an asset is its net operating income (revenues minus expenses) divided by the capitalization rate — that rate reflects a combination of the cost of debt and the cost of equity.
- Cost of debt: Last week, central banks around the world reduced headline interest rates to near-zero. In addition, central banks are buying up bonds and mortgage securities to keep the cost of capital as low as possible. For real estate, that’s “good” news: borrowing money has just become cheaper! Of course, there needs to be a lender willing to lend, but at this point banks still seem to be willing lenders, as well as the many life insurance companies, pension funds, and debt funds that have been lending to commercial real estate over the past years. The CMBS market, the bundling of commercial real estate loans into investable securities, will be very quiet for the next 2–3 months, but it was only 14% of the commercial mortgage market to begin with, so it won’t materially affect the ability of borrowers to get a commercial real estate loan. Overall, the cost of debt will likely remain similar to what it was, where the lower interest rate will be canceled out by lower risk preference of lenders.
- Cost of equity: Equity providers, or buyers of real estate, include REITs, private equity funds, and institutional investors buying real estate directly. The latter are for example pension funds such as ADIA, GIC, PSP, etc. These pension funds differ in their risk profile and ability to allocate capital to real estate, but I expect most of them to be somewhat more careful in doing new deals. Of course, what is in the pipeline may still go through (as long-term investors, they buy through the cycle), but in a market with uncertainty, it is better to wait. In addition, public pension plans typically have a fixed allocation to real estate, and as the equity portfolio decreases in value (with the S&P500 down to 2017 levels), the allocation to real estate increases, which means a hard stop on new real estate deals. REITs won’t be net buyers either, as they need to raise equity for new acquisitions, which is expensive in the current market (their share price is down, so issuing new equity is not desirable, and many will be focused on remaining at low leverage). That leaves private equity funds. They have USD300 billion in capital to deploy, so most of them probably can’t wait for a downturn to happen — or at least, for some offloading of assets by owners that are forced to sell because of mortgage payment issues. The world is so flush with cash that once commercial real estate prices go down, many investors will want to get into real estate. That means the cost of equity won’t significantly go up in the near term.
So, is nothing happening to asset prices?
Of course not — even though cap rates may stay relatively stable, on increase just slightly, the net operating income of many properties, and the projections thereof, won’t be as rosy as it used to be. A decrease in NOI of 10% and a relative increase in the cap rate of 10% will lead to a 20% decrease in asset prices. In case a building is levered (that is, financed) at 70%, the loan to value ratio will likely break what is acceptable to the bank, potentially setting off a negative spiral of delinquencies, leading to lower asset prices, etc. But for now, that seems unlikely in a scenario where the COVID19 crisis is deep but short — banks will much rather keep the asset off their balance sheet, working with the borrower.
One last note on the construction market — currently construction projects are on hold in many cities, meaning that there will be a delay in new space coming on the market. That may provide some relief to markets with ample supply of space. Also, construction projects that were still on the drawing board will likely remain there for a while, leading to supply that will be lower than forecasted.
Stay healthy!
References
- Moody’s CRE webinar slides || recording
- RCA — Commercial Real Estate Moves Into Uncharted Territory
- Colony Capital/Barrack — Preventing CMBS market collapse
- CBRE Macro update March 2020
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