COVID-19 Industry Outlook: Commercial Real Estate
by Mark Hefner, CEO of MGO Realty Advisors
As the COVID-19 pandemic moves into 2020’s second quarter, the commercial real estate (CRE) industry is experiencing severe pressure across multiple consumer-related fronts, ranging from hospitality to shopping centers. And, while these direct impacts are having significant effect on the CRE and affiliated industries, the more profound – and enduring – changes likely are still to come.
“Markets that are more likely to be adversely impacted have a relatively high share of leasing activity from the following industries: energy, airlines, transportation, distribution, wholesale trade, hospitality, travel and fitness,” CBRE writes in a recent update report, adding that energy-dependent markets like Houston and Denver will be most affected.
Adds Martin R. Smura, Chief Executive Officer of the Kempinski Group: “This is a very fast-evolving situation with a little outlook on how the situation will evolve in the coming weeks. Flexibility and agility are critical. Crisis, be it economic, social, environmental or health, are to become the ‘new norm’, and we shall adapt our business model and practices to this new paradigm.”
Publicly traded real estate investment trusts (REITs) took a slightly more severe hit than the broad equities market during the sharp stock market selloff. But their balance sheets remain strong and their debt seemingly manageable. Data centers weathered the storm better than other sub-sectors, while lodging owners and lodging managers were battered with market declines of 40 percent to 60 percent. Mall valuations fell 50 percent and shopping centers declined 45 percent. (More on shopping centers below.)
The impact on shopping centers, meanwhile, is significant as countless retailers (Macy’s, Gap, Neiman Marcus, Designer Shoe Warehouse and Kohl’s, among the most recent) have announced massive layoffs and furloughs.
Not surprisingly, the International Council of Shopping Centers (ICSC) is requesting states and municipalities to provide help by:
- requiring banks to offer a 90-day forbearance on all commercial loan obligations underpinning the shopping center industry;
- extending the period at the end of 90 days if public safety requirements mandate it, and enable property owners and banks to negotiate appropriate repayment options.
“An increasing number of national retailers and tenants have publicly expressed their intent to skip monthly lease payments during this crisis,” Tom McGee, ICSC president and CEO, writes in a letter to the National Governors Association and U.S. Conference of Mayors. “The non-payment of rent will jeopardize the repayment of up to $1 trillion of secured and unsecured debt held by property owners that underlays the shopping center industry.”
He says the shopping center industry generates approximately $400 billion of state and local taxes that support local communities, public safety resources and infrastructure. Additionally, McGee says most of the $6.7 trillion of consumer spending in the retail, food and beverage, entertainment and consumer service industries occurs within U.S. shopping centers, with nearly one out of four U.S. jobs retail related.
One specific proposed transaction to watch is the $3.6 billion announced acquisition of Taubman Centers Inc. (TCO) by Simon Property Group Inc. (SPG), which is expected to close this year. In late March, however, Taubman sent a letter to its mall tenants informing them they must pay rent during the COVID-19 pandemic.
Real estate deal flow
The deal market is bifurcated at this point, as commercial property specialists are slamming on the brakes when it comes to entering into new deals. New properties aren’t being listed by sellers and buyers are dragging their heels about committing to new purchases.
COVID-19, however, doesn’t seem to be negatively impacting deals that either were underway or near closing.
Regarding valuations, CBRE surveyed its capital markets team in mid-March and heard the following:
- More than half of them have seen sellers delay bringing properties to market
- Some seven in 10 forecast the delays will continue through mid-April
- Of deals that are under contract, 50 percent of the buyers, not surprisingly, are asking for price reductions, with 5 percent the most-popular request.
The company also reviewed “peak-to-trough” behavior for rents and values following the financial crisis and 9/11 and found that (in both cases) rents took some two years to go from peak to trough and then about six years to recover.
In the last week of March, the Federal Housing Finance Agency (FHFA) announced it will grant some leniency to multifamily landlords hurt by the COVID-19 spread.
Owners of multifamily properties subject to Fannie Mae- and Freddie Mac-backed mortgages (which are regulated by the FHFA) will be allowed to forego mortgage payments provided they do not evict renters unable to pay their rent due to the COVID-19 outbreak. The FHFA earlier had said the two mortgage financers – the nation’s largest – would permit owners of single-family residences to suspend mortgage payments for as long as a year without running up late fees.
Handicapping the sub-sectors
Drilling down into the sub-sectors, some of the analysis and conclusions are still preliminary and tentative – largely because of the unknowns. Moreover, the first quarter of the year is typically the weakest for commercial real estate metrics.
With some experts predicting a decline in revenue per available room of 60 percent for the second quarter and 37 percent for the full year – compared to relatively flat estimates prior to the outbreak – there is no other way to describe the lodging situation as anything other than an outright crash. Price adjustments, apparently, have had no impact either.
Industrial space: Mixed
This sector is interesting, with the long-term outlook trending toward positive and the short-term sentiments more negative. On the leasing front, near-term activity probably will slow as customers wait for greater clarity on the duration of the pandemic. Logistics-focused space generally is viewed favorably, but there are some concerns about potential supply chain disruptions. Longer-term, increased virtual/e-commerce shopping by home-bound buyers should boost demand for space. Demand for owner-occupied industrial space is also likely to accelerate against this backdrop.
Office space: Jury is still out
A common refrain during this crisis has been lamentations of the end of office life as telecommuting becomes widespread. But history tells a different story. Following the Dotcom boom of 2000-2001, many companies thought they’d save on office costs. The jury came back, with some success stories for certain groups and employees. However, overall, most companies returned to more social campuses and office centers for these reasons: social interaction, productivity and accountability, recruitment and retention.
While we must praise telecommuting capabilities for keeping many businesses open and working, the crisis has also exposed many weaknesses of telecommuting, primarily for those in smaller domiciles, and especially with family at home. There is likely to be a short-term drift to greater telecommuting potential, but the technology has been around for a while, and workers (and businesses) will likely be looking forward to returning to offices after weeks (months?) confined at home.
Occupiers of all asset classes are re-evaluating employee and customer densities in their facilities. We are very engaged in those conversations with users, architects and vendors. The outcome of those exercises will likely be lower density and more emphasis on “drop in” locations, where possible and applicable.
Retail: Balancing in the middle
The verdict: Retail is considered a mixed bag with great weakness where you would expect (enclosed malls, restaurants and gyms), but surprising strength on-line. Dollar stores, consumer electronics, toys and the apparel categories all face potential disruption in the supply chain if the crisis drags on. On the positive side: grocery and pharmaceutical stores.
Multifamily: Delays and shifts
Positive demand is likely to remain in pretty good shape, but it is expected that – at the high end of the market – there may be a transition period due stemming from some delayed moves. Interestingly, the current pressure on senior housing is causing some to forecast a possible shift to single-family rentals and a benefit to that sub-sector.
Seven changes to watch for
Supply Meets Demand: Many proactive real estate companies are taking steps now to expand their footprints as demand is at a near-term low and supply is overflowing. Companies assessing availability, and making moves now, are positioning themselves for long-term advantage when normalcy returns.
Warehouse Space: If ongoing e-commerce continue to take the place of visits to the market, there is an expectation that warehouse space will benefit as retailers’ immediate stock needs will become a different – but very welcome – change.
Stock Market Alternative: Even with the equities market staging some bounce back after the near-30 percent drop in the Dow Jones Industrial Average, some stock investors may conclude it’s time to steer clear of equities. A possible alternative: commercial real estate, which they may conclude is a lower risk in this environment of uncertainty.
Whither High-Density Living? Is COVID-19 the death-knell of collaboration? Roommates in college … roommates after college when funds are scarce ... senior living and healthcare facilities – it’s all become a common and accepted part of our culture. But what seemed to be the present and future is now threated by fears about transmitting diseases. Experts already are positing ways to convert flexible workspaces into alternative usage.
Refinancing Opportunities: With interest rates dramatically lower than a year ago, agile commercial real estate investors may choose this time – even with all the uncertainty – to refinance the higher interest rates they currently have on their properties.
Advantage: Tenants: COVID-19 quickly turned the market on its head and what was a solid landlord’s market is now a tenant’s market. Consider: demand for U.S. office space has cratered, just a year after reaching post-2008 highs. Would-be – and adventuresome – tenants may find incredible bargains on office, retail or industrial space.
Spotlight on Self-Storage: This sub-sector is a bit of outlier as it is doing better than its retail peers, even though it is heavily consumer-focused. Attraction: limited human interaction and attractive pricing.
Trusted Advisors: The CRE business, at least for now, is less of a transactional business than it usual. And brokers, as a result, have transformed themselves into advisors, providing their clients with important guidance on how to navigate through this crisis. One topic: landlords and tenants working more closely together.
If you have any questions related to real estate markets, deal flow and other opportunities, please reach out to us for a consultation.