Navigating Risks and Opportunities in the 2021 Commercial Real Estate Markets
March 10, 2021
By Joseph Rubin
A year ago I concluded my 2020 real estate outlook by saying: “This is the time for otherwise exuberant real estate investors to use caution and resist the temptation to squeeze that last bucket of milk out of the cow.” Everyone knew something would turn the cycle, but no one anticipated the first global pandemic in more than a century, causing the death of 500,000 (and counting) Americans along with unquantifiable hardship. Many of those cash cows stopped giving milk, through no fault of their own; they just got sick. Today, the real estate industry remains a pasture full of cows, some are still robust (think industrial and multifamily), others are very ill (think retail and hospitality), while others are lying in the shade worried about oncoming storms (think office). Vaccines have created hope that all the cows will soon be grazing in the sun again, but in all likelihood the pace of recovery will vary greatly from sector to sector, market to market.
One of the most over-used phrases of 2020, besides “you’re on mute,” was “curated content.” Now that the early year conference season has ended, I thought I would highlight, if not curate, for each individual reader the major trends we are monitoring and the potential long-term impact of the pandemic on different segments of the industry through 2021.
TRENDS TO WATCH IN 2021
No Jobs, No Growth
The pandemic has wreaked havoc on the job market. Many have lost their jobs due to government-mandated closures, some parents have been forced to leave the workforce to care for children who suddenly had no daycare or in-person schooling, and others have simply stopped trying to find work in a depressed job market. We have more unemployed at the beginning of 2021 than we did at the end of the Great Recession, and back then it took about eight years to recover those jobs. A year after massive layoffs and furloughs, the monthly numbers remain grim. Without job growth there can be no growth in demand for space across property sectors. We can hope for a swifter recovery this time, but it is impossible to predict. The long-term implications on real estate fundamentals have yet to be determined.
The Blessing of Low Interest Rates
A historically low-rate environment lessened the sting of the pandemic for many real estate owners. Even with rental revenue falling, low leverage and low rates kept debt service manageable, or at least negotiable, for most property types. And low rates, even after the recent pop in Treasuries, make returns on new deals more attractive. Given the increased risk, investors have shown restraint and capitalization rates have not fallen with Treasuries, creating a wider and more appealing spread and helping to attract more relative value capital.
Capital, Capital, Capital
Who can remember when there was so much capital waiting to be invested yet so little activity? Typically, liquidity dries up when the cycle shifts. But capital is available for equity and debt, and for core and distressed investments. So far that capital is proving disciplined and patient, not rushing into deals where the risk can’t be priced. After a pause last spring, private equity, pension funds, family offices and lenders all had increasing real estate allocations—even for those with steely constitutions in retail and hospitality. The commercial mortgage-backed securities market, which took three years to recover from the Great Recession, was up and running in about three months. This capital will certainly soften the blow of the pandemic in all but the most distressed situations.
The Bubble of Bank Accommodation
Despite all that capital and low interest rates, some properties simply don’t have the cash flow to keep up with their mortgage payments. In an unprecedented move, the government and the regulators told everyone not to worry. Banks received permission to provide payment forbearance and extend maturities without having to classify the loan as non-accrual, implement troubled debt restructuring accounting, or even tell their shareholders that they had to take action on loans in their portfolios. Those accommodations were extended through 2021 in the December stimulus package. The questions now are when will banks stop kicking the can down the road and tell their borrowers to pay up; and when they do ask for all of those deferred payments, and the refunding of reserve accounts, will borrowers be able to make good? Either there will be a lot of rescue capital, or banks will have to start impairing loans. Expect loan sales this year. The artificial bubble of bank accommodation has yet to pop.
Companies and People Are on the Move
The pandemic became the perfect excuse to move businesses and families from large northern cities to smaller, more lifestyle-oriented southern and western cities. These destinations have better weather, cheaper housing and amenities, and often less or no state income tax. People are also leaving the cities for less dense communities. The results have shown up in the prices of homes in both northern suburbs and Sun Belt cities. According to the S&P CoreLogic Case-Shiller U.S. National Home Price NSA Index, home prices rose more than 10% in 2020 with some Sun Belt cities up almost 15%. What could be the beginning of a substantial migration will clearly benefit demand for commercial space in some markets at the expense of others. Investors need to ensure their capital is moving in the direction of the herd.
Cash Remains King
Despite all the liquidity in the system, it isn’t always where it needs to be. As in the corporate world, the pandemic has bifurcated real estate investors between those with cash and those without. With certain property types and markets being harder hit than others, the experiences of investors vary widely. Low leverage, cash hoarding players are always the winners when the music stops. Those without cash will have to bridge the gap with expensive rescue capital or lose their equity entirely.
Safely Taking Down the Government Safety Net
Through monetary and fiscal policy, the economy has been buttressed by an unprecedented amount of stimulus, whether through low short-term interest rates, the purchasing of hundreds of billions of securities, pumping cash into every household, or giving businesses a lifeline through forgivable loans or employee retention credits. All of this has softened the economic disaster created by the pandemic, but at some point the safety net will have to be rolled up and stored away for the next calamity. Indeed, we are living in an artificially stimulated economy, and how these temporary initiatives are unraveled will determine the long-term viability and health of the economy and demand for space. The timing, pace and tactics employed by a wide variety of government actors withdrawing from the markets will either sustain economic growth or cause a crash landing.
Valuations Are Vulnerable
Muted economic growth, greater uncertainty in real estate demand, and potentially rising interest rates may stress property values in many markets. The lack of transactions since the onset of the pandemic has made price discovery very difficult. Buyer eagerness and seller unwillingness have resulted in wide bid-ask spreads. In its February Monetary Policy Report, the Federal Reserve said, “Commercial real estate prices remain at historically high levels despite high vacancy rates and appear susceptible to sharp declines, particularly if … the pandemic leads to permanent changes in demand.” Such changes in demand make it hard to predict cash flows. In addition, a property’s value is driven by the structure and terms of its leases, and a key outcome of the pandemic is likely to be demand for more flexible leases. Flexibility translates into shorter lease terms with more rights of termination and a higher proportion of rent based on sales performance at retail properties. The math is easy. Valuations based on discounted cash flows are lower when lease terms are shorter and revenue is less predictable. And rising risk premiums will discount valuations based on capitalized net cash flow. Anticipating lower valuations and keeping leverage low will be critical for investors over the next few years.
PropTech Is Undeniable
As the traditional tech-phobic real estate industry emerges from the pandemic, it is on a trajectory to more fully embrace the many benefits of digital technology. With billions being invested in dozens of new tech startups, the menu of applications and services cover every real estate business process from transactions to operations to finance. Of course, many real estate owners have already dipped their toes into the water with tenant portals and payment transfers. But few non-institutional players have yet to invest in smart technologies that enhance controls, run buildings more efficiently, avoid business interruptions, enable predictive maintenance and reduce costs. Developers now have many options for systems that collect more real-time data and more closely monitor construction progress and costs. Owners can also use new technologies to find and sign leases with new tenants online. Some of this technology has been around for a while, but adoption has been slow. As selling space becomes increasingly competitive, these advances will help bolster customer relationships and profit margins.
PROPERTY TYPE OVERVIEW
No overview of property types can do justice to the many dynamics at play in today’s real estate markets. The significant disruption in many markets presents opportunities and risks. While a property sector may be trending one way overall, there will always be outliers depending on product and location. Investors will need to carefully study each situation and diligence opportunities and then attempt to predict what might seem unpredictable. That often means having a Plan B and access to a lot of cash—just in case.
As Cole Porter might have said, industrial is too darn hot! Purchase volumes are passing all the other property types combined, with investors clamoring to take advantage of surging individual and corporate demand for e-commerce and just-in-time delivery. Investors are rationalizing historically low capitalization rates by anticipating continued demand and rent growth. New facilities are being built near most major population areas and ports of entry. Real estate cycles stem from too many builders building the same thing at the same time in the same place, and vacancy rates are starting to increase in a few markets stressed by oversupply. Moreover, the new facilities with more bays, higher ceilings, additional power supply and better technology will eventually leave the older distribution centers in the dust. Overall, industrial may be the safest bet in real estate, but it may soon be priced to perfection. Demand-induced valuation increases may be unsustainable for all products in all locations.
Nationally, multifamily has performed exceptionally well through the pandemic. Demand for flexible living has held down home ownership rates, and there are still a lot of millennials in renter mode. Rent collection rates have held through the pandemic. According to the National Multifamily Housing Council, owners collected 93.2% of rents in January 2021, compared to 95.8% in January 2020. It should be noted that this collection rate has been trending down slightly since June, after the initial stimulus checks were mailed. These numbers are also national and, as such, they hide the locational disparities experienced by owners in different markets. Rent and occupancy in those sunny, high-tech, youth-attracting cities mentioned above are rising faster than before, while they have fallen precipitously in major urban centers such as New York and San Francisco. Let’s not forget that California and New York established tenant-friendly rent regulations in 2019 that curtailed valuation upside even before the pandemic struck.
The problem for multifamily in some markets is lower demand driven by continued unemployment, the reduction from two to one earner in a household, and people simply moving out. Estimates are from 20 million to 25 million young adults moved back in with their parents during the pandemic, sapping demand from the rental market. Work-from-home arrangements mean that they may not go back to the same apartments from which they came. Older millennials had already been leaving apartment rentals to purchase or rent single family homes. Continued unemployment will clearly impact multifamily demand in the near term, across all markets. Until the job market improves, some owners will face not only the prospect of tenants leaving but government imposed eviction moratoriums that could motivate the tenants who remain not to pay rent. As arrearages grow, the probability of collection decreases, even with long-promised stimulus checks.
For years, retail has been the problem child of the real estate industry. Coming into the pandemic hugely oversupplied and exposed to changing consumer preferences and growing competition from online shopping, the pandemic really didn’t change the retail story. Instead, it has hastened its inevitable outcome. The big lesson for mall owners was that replacing apparel with experiential tenants, such as restaurants and amusements, was unpredictably ill-timed. Even before the pandemic, restaurants were considered to have significant credit risk, but the storm of retail chain bankruptcies has proven that most mall tenants have tenuous credit. Redeveloping malls into warehouses, co-working environments, health clinics and multifamily housing brings some hope of renewal, but only for those with access to the considerable capital required for such complex transformations.
High Street retail in major urban centers was hit particularly hard by government lockdowns and outward migration, particularly in those cities reliant on business travel and tourism. Owners are now faced with the likelihood of sharply lower rents as neighborhoods emerge from the pandemic. Those lockdowns also drove initial concern that consumers were moving away from their local grocery stores in favor of online options. While many are clearly buying more online, the grocery store appears to have survived to live another day and neighborhood-anchored centers are performing well.
The jump in e-commerce is real. Based on the latest Census Bureau data, online sales rose almost 37% from Q3 of 2019 to Q3 of 2020, and now represents more than 14% of all retail sales—up from 11% in the prior year. That means the vast majority of all sales still happen in stores. The continued problem for the retail property sectors is not consumption, but oversupply. Reducing supply is a painful process for property owners and even more so for the people who work there. This transition has been going on for years and, unfortunately, will go on for many more. To make matters worse, new leases are likely to have shorter terms and a higher ratio of percentage rent to fixed rent, which is a loan underwriter’s nightmare. That translates into less predictable long-term cash flow and lower values.
The future looks bright for hotel owners that have the liquidity and perseverance to withstand the temporary collapse of room demand, particularly in business and group travel. Pent-up demand is certainly growing for tourism, and many travelers have already begun to fly to resort destinations. The bigger problem is the return of business travel after a period of higher corporate profit margins partially due to lower travel and entertainment costs. An even bigger problem is recharging large group meetings, conferences and conventions. It is hard to imagine the next time we huddle tightly with 25,000 colleagues. The pandemic decimated demand, and the 2020 decline in RevPAR was the largest in history. Hotel closures was one of the greatest contributors to job losses last year.
The good news is that hotel demand will spring back as the pandemic recedes, and reopening a hotel is faster than bringing new tenants into empty retail spaces. Indeed, lenders are currently funding the development of new hotels to be delivered in a few years. Hospitality gurus believe RevPAR will achieve pre-pandemic levels by 2024, with leisure-oriented hotels taking the lead, which is already happening. Recovery will vary widely by product and market, and it is likely that occupancy will improve before rates. Until demand is reestablished, hotel owners need cash, and many are struggling. Hotel loans that have been securitized, the only loans for which we have data, have fared poorly. According to Trepp, in January of 2021, almost 20% of hotel loans were delinquent, almost 25% were in special servicing, and just over 50% were on watch list. CBRE has written that the obstacles to hospitality’s recovery are fear and frugality: fear that travel is no longer safe and the frugality of businesses cutting costs in a tough economic environment. Until both are overcome, liquidity and perseverance are required to whether the storm. Opportunistic investors providing fresh capital to distressed owners may achieve outsized returns.
Looking out several years, office may be the most perplexing and unpredictable of all real estate property types, with some believing the pandemic has proven that workers are more productive outside the office, and others believing corporate culture, innovation and growth are impossible without the connectivity of an office environment. No one questions the need for training, coaching and team meetings. The real question is how companies will allocate employee time among either working at home, in a centralized office or in satellite offices closer to home. CBRE has predicted that overall demand for office space will decline by 15%.
That decline is not yet evident because offices leases are long. Only as leases expire will owners feel the true impact. Early indications cause concern. Depending on the source, national vacancy increased to between 15% and 17% in the fourth quarter of 2020. And those high numbers do not include tenants’ efforts to reduce their space before their leases mature. JLL indicates that there are almost 150 million square feet of office space on the sublet market. JLL also reported that the average term of new leases in 2020 fell to 6.7 years from 8.5 years pre-pandemic. Another alarming factor: According to Cushman & Wakefield, more than 100 million square feet of office space was put back on the market in the last three quarters of 2020, more than in any period in history. That is as big as the entire Seattle office inventory.
Over the past few decades, office design has shifted significantly from a hierarchical structure of offices to cubicle farms to open spaces that encourage teaming and eliminate privacy. This transition greatly increased office density from what was a typical 250 square feet per employee benchmark to just over 100 square feet. That will likely be too close for comfort in the post-pandemic period, and architects are rushing to create new floorplan concepts to bring people together safely. We may be years from knowing what happy medium corporate America adopts, but the one piece of good news for office owners is that reducing density could mean increased demand.
Co-working, a model that may have been prematurely disparaged, may play an increasing role in providing more flexible office space to corporate America as we experiment with new designs to satisfy both business and employee needs. Beyond focusing on productivity, culture, training and growth, management and workers must to consider whether conducting business from both home and an office inadvertently creates two classes of employees: one hanging out with leadership and getting opportunity, and the other sight unseen and being left behind.
THE BIG PICTURE
A year of incredible social and economic upheaval has left us with more questions than answers on the pandemic’s long-term impact on the real estate markets. A constant theme is that different products and locations will be impacted in different ways, requiring investors to do their homework and carefully pick their spots. The problem is that projecting property cash flow and investor returns is no longer just a matter of understanding the real estate. Demand for space is being impacted by what may or may not be fundamental changes in consumer and business behavior, the sustainability of work-from-home arrangements, a deceleration of urbanism, and a sudden desire for de-densification.
These dynamics and lower trading volume have made current property values difficult to estimate, and it may get worse before it gets better. The potential for lower demand for space compounded by more flexible, tenant-friendly lease structures may put further downward pressure on value. Add to those a possible rising interest rate environment once the government withdraws from monetary and fiscal accommodations, and long-term investment risks emerge for the more than $300 billion in capital estimated to be available to invest in the real estate sector. On the other hand, that wave of capital may prove to be the tonic the industry needs to heal its wounds after a tough year.
Risk brings opportunity. The real estate industry can help accelerate the recovery of space demand by continuing to invest in local businesses and communities, building back what has been lost, and providing safe places for people to work, shop and gather comfortably. Everyone is looking forward to a return to pre-pandemic conditions, but it is unlikely that when this is all over things will look exactly the same. Understanding and responding to the new reality will take time, capital and the innovation required to redesign and reconfigure space for the changing needs of businesses, consumers, travelers and residents. Hopefully, in the not-too-distant future, the disruption will pass and all those cows in the real estate pasture will thrive again.