Implications of the COVID-19 Crisis for Commercial Real Estate Values
June 30, 2020
By James M. Molloy, MAI, FRICS, CRE
The coronavirus pandemic has delivered an unprecedented shock to the U.S. economy, ushering in an era of volatility and uncertainty in the capital markets, the employment landscape and the ways people work and live. These effects are cascading across commercial real estate, impacting asset values and triggering material responses from banks, pension funds, life companies, real estate investment trusts and equity funds. Here is a brief examination of the ways COVID-19 has affected real estate asset classes so far.
The Office Sector
Although the office sector enjoys an abundance of long-term leases, it is hardly immune from the crisis. Owners in many parts of the country are reporting declines in rent growth of 1.5 to 2.5 percent, according to the latest survey of institutional investors by RERC, a SitusAMC Company.1 Leasing volume fell 80 percent in March from the prior month, and the slowdown is likely to continue in the second quarter. The vacancy rate in the office sector rose to 12.3 percent in the first quarter according to UBS, as leasing activity plummeted, and fresh inventory hit the market.
With an intense focus on health and safety, some occupiers are looking to augment headquarters space with satellite offices in the suburbs to provide adequate social distancing and reduce employees’ time on public transit. Some 63 percent of Americans worked from home the last week of April, according to a Gallup poll, and some companies have discovered they are just as efficient and productive. Three-quarters of U.S. businesses anticipate at least some of their staff will continue to work remotely after the pandemic subsides, according to a survey by Gartner of corporate financial leaders. A University of Chicago study found at least one-third of all U.S. jobs could be plausibly done remotely. In May, Facebook said it expects up to half of its workers to be remote in the next five to ten years.
All of these developments suggest that while companies may retain real estate in urban centers to foster team connectivity, they will likely need less space, and there are huge financial incentives to shrink footprints. As a result, a wave of sublet space could come to market, driving vacancies higher and rents lower.
The Hospitality Sector
The hospitality sector has been pummeled by the lockdown of travel, both business and leisure, though there are glimmers of hope. Occupancies hit 32.4 percent in the week ended May 16, up from a low of 21 percent for the week ended April 11, according to The Wall Street Journal. A forecast by The Urban Land Institute suggests hotel occupancies could rebound to nearly 60 percent by 2022.
The hotel sector had the lowest quarterly return vs. risk rating and the sharpest quarterly decline in the rating among all property types, according to the quarterly RERC survey of investors. Similarly, hotel had the lowest quarterly value vs. price rating and largest quarterly drop among the property types. Meanwhile, the number of deals is plummeting as owners and buyers wait for more price discovery. Transaction activity fell 56 percent year-over-year in March, according to RCA.2
The Retail Sector
As lockdowns froze economic activity and unemployment rose, U.S. retail spending plunged a record 16.4 percent in April, with clothing and furniture stores suffering most. Consumers are limiting purchases to essentials, boosting supermarkets, drugstores and dollar stores. Big box retailers that have successfully adopted an omnichannel sales model are benefitting as well. Walmart’s sales, for example, grew 10 percent in its latest quarter, on a 74 percent surge in online purchases.
The pandemic has pushed the fast-forward button on the ecommerce evolution, just as 5G cellular networks and devices emerge, enabling more capacity. We anticipate that over time, 35 percent of retail transactions will be done virtually. Augmented reality (AR) will allow consumers to strap on headsets, be transported into stores and virtually try on the goods. An estimated 100 million consumers are expected to shop with AR this year.
Some indoor malls had entered a slow death spiral before COVID-19 hit, stricken by the loss of department stores and other anchors. Five major retailers filed for bankruptcy since the crisis began, including J.Crew, JCPenney and Nieman Marcus. Many retailers have a glut of inventory in their distribution centers, and in May a coalition of 1,000 companies told the government they want Treasury or Fed guarantees of their routine finances or the industry risks seizing up. Indoor shopping centers will continue to face complex challenges, although luxury malls with strong demographics in wealthy trade areas should do well. Open-air lifestyle centers may outperform, as they provide direct entrances to stores from parking lots and less exposure to large crowds. Institutional investors surveyed by RERC gave regional malls the lowest “buy” recommendation among all property types, and nearly 70 percent indicated that retail was the property type to avoid for the coming four quarters.3
Main Street retail in many cities has suffered damage in recent protests, just as stores were beginning to reopen. From Colorado to New Jersey, dozens of cities are supporting local shops by closing off avenues to creating pedestrian plazas, allowing restaurant tables to spill into the streets and offering a wider margin of safety for shoppers to access stores.
The Industrial Sector
More than three-quarters of RERC survey respondents said that industrial would be the best investment opportunity over the next four quarters.4 Ecommerce sales rocketed 49 percent in April, fueling demand for warehousing and last-mile delivery. Meanwhile, the data center sector is quite strong as corporations modernize networks, enhance data management platforms and move more traffic to the cloud. Asset values are rising with exponential growth in demand.
The national vacancy rate for industrial assets is 5.4 percent, and total leasing volume broke a record with 160 million SF in the first quarter. Rent growth for industrial will decrease in the next couple of quarters, but it will outperform other property types.5 According to RCA, the industrial sector has outperformed all other property types in the first quarter of 2020, due to a handful of large, entity-level transactions.19
The Multifamily Sector
About 16 percent of RERC institutional respondents chose apartments as the best investment opportunity over the next four quarters.6 Rent collections remain fairly robust and the property type appears to be a relatively safe place for capital. More than 93 percent of apartment households made a full or partial rent payment by May 27, according to The National Multifamily Housing Council’s survey of 11.4 million units of professionally managed apartment units across the country.
The multifamily outlook varies city by city. Houston and Chicago are declining in value due to oversupply, according to the RERC quarterly investor survey. Manhattan faces considerable uncertainty amid talk of even more stringent rent control regulations, which would limit future rent increases. Millennials moving into their childbearing years may choose to abandon urban rentals to buy homes in less dense suburbs. In addition, as credit standards tighten, making it more difficult to obtain a mortgage, companies that rent single-family housing could get a boost.
In the first quarter, the multifamily vacancy rate rose – marking the first-ever spike during a first quarter, according to CoStar.7 The vacancy rate is expected to climb above 8 percent nationwide in the second quarter. Rent losses are forecast through 2020, but rents are expected to bounce back in 2021. If the COVID-19 crisis spurs above-average numbers of divorces, marriages and births, these trends could stimulate long-term housing demand, according to CoStar. Individual asset sales fell 12 percent year-over-year for the quarter.8
Every property has been impacted by the pandemic in some way and will have to be revalued. The effects will be idiosyncratic because every piece of real estate is unique. Patterns of recovery will play out differently across various asset classes: Some will benefit, others suffer permanent damage, while still others will survive through adaptive reuse. We expect technology to play a key role; 5G networks in particular are critical for nextgen applications. With faster speeds, more reliability, greater capacity, better performance and improved efficiency, 5G capabilities together with the pandemic-driven issues of densification will accelerate transformation to the digital economy. The digital economy has material implications for the entire real estate asset class. From our perspective, the industry’s most significant challenge is opacity; with a dearth of transactional activity, markets lack concrete data to back valuations. Physical inspections are also problematic in the current environment. SitusAMC is utilizing a cash-flow model that assigns probabilities around particular outcomes from a given set of tenants. Investors need to stabilize cash flow by working with their tenants, implementing workouts, and positioning their asset as best they can for future refinancing opportunities. SitusAMC is involved with the valuation or valuation review of over $300 billion each quarter of commercial properties globally. Contact us to see how we can help you prepare for the impact of COVID-19 on your commercial real estate investments.
1 Riggs, Kenneth. “Valuation Trends,” The RERC Real Estate Report, May 2020, 38. RERC, a SitusAMC Company, issues a quarterly summary of the required rates of return (ex-ante), property selection criteria and investment outlook of a representative sample of large institutional investors and regional respondents throughout the U.S. Visit store.rerc.com to order the full report.
2 The RERC Real Estate Report, p. 43.
3 The RERC Real Estate Report, 41.
4 The RERC Real Estate Report, 40.
5 The RERC Real Estate Report, 40.
6 The RERC Real Estate Report, 42.
7 The RERC Real Estate Report, 42.
8 The RERC Real Estate Report, 43