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 COVID-19 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 COVID-19 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. 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.
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 COVID-19 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 and COVID-19
Demand for space is determined by factors that vary for each property type. Put simply:
- 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 due to the increasing use of flexible office space and 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
COVID-19 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):
The office market has been under a bit of pressure in recent 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 COVID-19, most office buildings across the bigger cities are currently standing pretty much empty because employees are working from home. You’d think that’s a massive problem, but commercial office space is typically leased for a longer period (on average, five 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.
As of now, however, the current crisis is more of a service sector crisis than a financial services crisis. Financial services firms (banks, insurance companies, law firms, etc.) are the most prevalent in office buildings. While small and midsized companies, including those in the financial services sector, may suffer disproportionately during the COVID19 crisis, larger firms (and thus larger tenants) are well-positioned to weather the storm. The likelihood of such 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. Many flex space tenants are small businesses that may suffer disproportionately from the current crisis. While these businesses are unlikely to go bankrupt, they may cancel leases. So, WeWork et al., as well as their landlords, are in for a ride over the next months.
Summarizing: the office market won’t fall off a cliff because of the COVID19 crisis, but…it may suffer more than it already was—vacancy rates will creep up and there will be downward pressure on rents.
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 in the retail market, much lower rents, and very high vacancy rates.
The COVID-19 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 in recent weeks and an off-the-cliff drop in 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, etc.) will remain. (It’s just that there is sooo much of that type of retail…)
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 most investors typically don’t invest (Oklahoma, anybody?).
The multifamily housing market has done phenomenally well over the past decade. After the financial crisis, many people lost their homes due to their inability to pay 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 as 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 demand boom also led to very significant construction activity, especially in the higher-end segment of the market. At this point, oversupply has started to become an issue in some places in the US (NY, most notably). There is still plenty of demand for housing, but the apartments that have been built are not affordable for the people that most need them.
COVID-19 will lead to temporary and structural unemployment. It will affect the ability of people to pay their rent or their mortgage. Sadly, those most affected are lower-income individuals living from paycheck-to-paycheck, in housing that is non-institutional, as opposed to multifamily assets owned by REITs and other institutional investors. It’s good news that local governments are passing laws to prevent landlords from “evicting” tenants that can’t pay their bills, but of course, for landlords, that’s bad news…
The multifamily market will thus be affected by COVID-19. More turnover will increase expenses for owners who have to clean up and remarket unoccupied units. (Those leaving a multifamily unit for cheaper housing elsewhere will be replaced by those that have to give up their own home.) There will likely be lower rent increases as demand for quality housing softens. And there will be more trouble for those spots with oversupply, especially in the high-end luxury segment (those apartments will be rented out, but at lower rents than what was expected). 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.
Summarizing: the multifamily market is fairly well-positioned to withstand the COVID19 crisis, but in the short run, landlords will have to accept missed rental payments, and owners of luxury apartments will face a continuation of softer demand, and thus lower rents.
The logistics space has been the flavor of the decade, perhaps even more than multifamily. Amazon, Walmart, Zappos, UPS, and the rest of the online value chain have massively expanded their real estate footprint as retail has shifted online. 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 COVID-19 crisis has two sides for the industrial market: on the one hand, even more, shopping has shifted 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 have 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.
Summarizing: Logistics real estate remains in high demand, potentially even more so due to an increase in online shopping, food delivery, etc. This will further reinforce a shift from offline to online, favoring the sector.
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. Hotels are empty. No revenue is coming in, but costs are continuing (although Marriott has laid off many of its staff), including real estate leases.
Summarizing: Hotels are operated by companies different from the owners, and you can expect many operators to go bankrupt if the COVID-19 crisis lasts for more than three months.
The market for assets and COVID-19
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 in 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. At this point, banks still seem to be willing lenders—as are 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. CMBS was only 14% of the commercial mortgage market to begin with, however, so it won’t materially affect the ability of borrowers to get commercial real estate loans. 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 last include pension funds such as ADIA, GIC, PSP, etc., which differ in their risk profile and ability to allocate capital to real estate. I expect most pension plans to be somewhat more careful in doing new deals. Those deals already in the pipeline may still go through. As long-term investors, pensions buy through the cycle. But in an uncertain market, they may find it better to wait. In addition, public pension plans typically have a fixed allocation to real estate. As their 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 prices are down, so issuing new equity is not desirable. Many will also 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 new opportunities to become available as asset owners are forced to sell due to 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. Cap rates may stay relatively stable or increase just slightly. The net operating income of many properties and the projections thereof, however, won’t be as rosy.
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. If a building is levered (that is, financed) at 70%, the loan to value ratio will likely break what is acceptable to the bank. Breaching that barrier could potentially set off a negative spiral of delinquencies, leading to lower asset prices, etc.
But for now, that seems unlikely in a scenario where the COVID-19 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 shift 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 lower supply than previously forecasted.
COVID-19 and the role of GeoPhy
Crisis or no crisis, our business continues! We’ve had quite a few conversations on how our existing product line can serve the current market needs and what else we could provide to the market. I’m confident and convinced that our approach to helping investors and lenders understand the real estate market will become key in the period to come. Investors and lenders need appraisals (Apprise!), and with uncertainty about where values are in the commercial real estate market, the need for data and potentially AVMs is bigger than ever.
If you’d like to learn more about GeoPhy—book an appointment here.