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The COVID-19 pandemic has upended the way of life for many people, especially those who work in commercial real estate (CRE) – on the buyer or seller side – and is rewriting the typical rules for the commercial real estate market. Examining the trends in the United States, primarily in New York and California, we can begin to see how leasing space in commercial properties before the pandemic has drastically changed the real estate industry in the intervening months.
Looking at Trends
History is typically a very good guide in figuring out what could happen during an economic downturn, like the one we are experiencing during the coronavirus pandemic and resulting shutdown. Deloitte Insights assembled a chart examining the trending impact of “past epidemics, pandemics, and economic downturns on commercial real estate,” focusing on
- the H2N2 flu recession in 1957-1958,
- the recession following the 9/11 attack in 2001,
- the SARS epidemic in 2002-2003,
- the global financial crisis in 2008-2010.
Most of these trends lasted for four quarters, which already is different from the current COVID-19 pandemic that is projected last into fall 2021. They also did not have to deal with empty office buildings (due to quarantines and state-wide shutdowns) leading to skyrocketing vacancy rates as more employees work from home.
What we can gather from Deloitte’s information is that, hopefully, this too shall pass. Although not necessarily a short-term issue, the impact on CRE was the worst “during the event” and post-pandemic we can hope to see rising or positive GPD and CRE prices. Helping this point is that the CRE industry was in a strong position before the pandemic (contrary to the last major economic downturn: the 2008 global financial crisis) with CRE prices up 36 percent versus 2007 and companies maintaining a healthy advantage in their “balance sheets, capital availability, and liquidity.”
This data puts recovery for commercial real estate in a fairly strong place. But the biggest difference in the trend was that in the second week of March, when COVID-19 was declared a pandemic, the CRE industry was affected immediately along with financial markets. All of the trends for the current coronavirus pandemic are declining and negatively impacting CRE. As Jim Barry from Deloitte notes, “Unlike past economic challenges, COVID-19 is having an immediate, widespread impact on the CRE industry across the globe.” So, where does that leave us?
Commercial Real Estate Spaces: The Good, the Bad, and the Ugly
Commercial real estate, generally speaking, is any property used to generate profit as a business, workspace, or leased property. There are four kinds of commercial real estate:
- Office space
- Industrial sites, like warehouses, manufacturing, self-storage, and distribution sites
- Multi-family properties, like apartments or multi-family homes
It is important to understand these definitions because the coronavirus pandemic has decimated CRE in two of the four sectors – office space and retail. Let’s break down the good, the bad, and the ugly in CRE right now.
Housing and multifamily properties are at the top of the market right now, but also up there are industrial sites – which include warehouses and distribution sites for e-commerce giants like Amazon. “The housing market is red hot thanks to record-low mortgage rates and consumers looking to flee cities for the suburbs,” CNN Business reported in September. “But offices, shopping malls, and other commercial real estate properties have been hit hard by the coronavirus pandemic.”
The volatility of the multifamily properties is a lot lower than other CRE properties because people need a place to live, and some landlords have been negotiating lower rent with tenants – or even waiving rent during the economic slowdown. “Ultimately people still need a place to live,” Truist’s Head of National Real Estate Adam Oates notes, “so multifamily traditionally has been the more resilient property type.”
An interesting demographic change has also come to the housing market, which baby boomers typically lead. The pandemic is helping millennials become homeowners at a faster rate than previously anticipated due to low-interest rates on mortgages. A survey from Morning Consult found that 28 percent of millennial respondents who did not own a home “are more interested in purchasing one because of the pandemic.”
Looking at industrial properties, Adam Oates from Truist says, “Even as things start to open, it appears there may have been a sea change in how much we buy online and how much we go out. The repercussions of less demand for physical retail space and higher demand for industrial logistics-oriented real estate are substantial.”
Many of the larger e-commerce companies look at industrial properties as a real estate investment to provide for the community and allow for greater delivery outreach in the larger area. With developers providing a large amount of square feet, the valuations for these properties cannot be underestimated, which is why they are on the rise with investors.
Most companies shifted to work from home in March, when the pandemic hit the United States the hardest and left their office properties almost completely empty. In the months since some companies have returned to the office, but a lot have found they can still work effectively from home, which is calling into question the need for large office properties in major cities.
Empty CRE presents a crisis still looming for cities and their tax bases, according to economist Dr. Victor Calanog, head of Commercial Real Estate Economics at Moody’s Analytics. “The pandemic hit the ground floor first, knocking out smaller shops and restaurants. Trouble may not creep upstairs to the office floors until six to nine months later,” NPR reported.
On those floors, another problem awaits business and property owners: how to increase space and ensure everyone can be safe in the office. Coworking spaces will be a thing of the past, as will the open-office plan that provides no safety or distance for employees from their coworkers. Maria Sicola, founding partner of CityStream Solutions, a consulting firm, and Integrity Data Solutions says, “The move toward efficiency and lowering costs — while still important to the corporate bottom line — will now give way to flexibility, resilience, employee satisfaction, and productivity.”
Although CRE demand could return to pre-pandemic levels in the next few years, it’s the intervening time which is nerve-wracking for commercial real estate investors who have their own bills, mortgages, and taxes to pay. During the 2008-2010 financial crisis, which is the most recent economic crisis we can relate to the pandemic to, rent for new commercial listings in New York City fell 19 percent during the worst stretch. Moody’s, however, is forecasting a 21 percent drop this year. That’s going to affect other businesses in the area: small businesses will have to give up property due to a decrease in revenue while larger corporations can snap up more commercial space and take over large cities.
Retailers have been the hardest hit of all the CRE sectors because it includes stores, restaurants, and other retail space that has been closed due to social distancing guidelines. The cash flow is at a low since PPP loans stopped, and although some have pivoted to e-commerce and window shopping, the business models for retailers do not look good during this pandemic. We have already seen a lot of major retailers – like Lord & Taylor, the Paper Store, Century 21 – file for bankruptcy.
How does this hurt commercial real estate investors? With many retailers not able to pay rent, it is impacting investors and property owners. Spencer Levy, the Senior Economic Advisor and Chairman of Americas Research at CBRE, noted: “Retail is under-performing at around 20 percent to 40 percent. Tomorrow, which is likely to last for six to nine months, the assets will be reopened and will likely be reopened in phases, but further outbreaks could prompt local shutdowns.” The risk of looming shutdowns has a devastating impact on renters and the real estate sector, so much so that struggling retailers who have filed for bankruptcy protection may look for rescue from their landlords.
Forbes reported that Simon Property and Brookfield Property Partners, two U.S. mall operators, are looking at buying bankrupt brands to keep their shopping centers alive. Simon’s CEO, David Simon, believes in the brands and looks at it as outside investments to make money. But Simon is also eyeing empty properties in the mall, from retailers who close, as ripe for development. “There are too many department stores in malls,” Simon said. “It’s good real estate. It can be redeveloped…. We got to continue to evolve the product.” Forbes noted that “at the end of last year, Simon had 15 former department store space being redeveloped for projects including specialty retail, restaurants, fitness resorts, office, and hotel.”
Looking Ahead to New Opportunities
Although the coronavirus pandemic is heavily impacting the retail sector of commercial real estate, it may provide developers and investors with unique opportunities moving forward to create new spaces for consumers. New opportunities could bring back high demand, with a now thriving property, leading to better occupancy and higher pricing for renters.
With industrial, office, and multi-family spaces still working for commercial real estate developers, the next step will be outfitting these spaces for near-term usage with COVID-19 restrictions in place. Upgrades like air filters and more spacing are going to be necessary for workers to comfortable returning to office spaces. The big question will be how CRE developers adapt and move forward.
The biggest worry is one that NPR explored in a September article: if bigger companies buy more commercial real estate, and if other companies are forced to break leases and move their workers to remote work, it could impact retail, restaurants, shops, and other small businesses – leading to an entirely reshaped city after the pandemic.
Keep an eye on our Biz2Credit blog for more information as this develops.