Investors

The Impact of COVID-19 and Commercial Real Estate

The human and business impact of the COVID-19 pandemic continues to unfold globally. The rapid pace at which the pandemic is spreading and global actions to curtail it are having an unprecedented impact on the way we live and do business. While it is too early to fully understand the impact of these events, history can serve as a valuable source of information as we look forward.  According to many real estate advisors, CRE and the overall economy will rebound. However, the speed with which the country and the industry emerge from the crisis depends on the ability to ramp up virus testing, development of a vaccine, patience with social distancing, the magnitude of monetary stimulus, and the relative health of the CRE property types, markets and individual projects.

Many property owners who’ve fallen behind on debt are going to have to put more money into their buildings, sell at distressed prices or hand the keys back to the bank. Roughly $430 billion in commercial and multifamily real estate debt matures in 2021, forcing lenders and borrowers to come to terms about what buildings are worth in a world the pandemic reshaped.  

We will focus on the hardest hit sectors in the commercial real estate sector…

Offices

Based on data in the third quarter of 2020, while rents in the country’s top downtown office markets have softened, companies are renewing leases at a higher rate than in 2019, said Dennis Perkins, founder and president of Civitas and Carmen’s husband. That “tells us that during a downturn, companies have opted to stay put and maintain a consistent urban presence.” However, while businesses are staying downtown, he says their workers are moving toward the suburbs.  

Even when states began to reopen from the coronavirus pandemic in May, nearly 70 percent of U.S. employees were still working remotely. In addition, Gallup reports that only one in four want to return to shared offices once restrictions are lifted. When the majority imagine the office of the future, they now picture a flexible workspace that can be physically located anywhere. And with the right technology, a remote workforce can share a great work experience and being just as productive as before.

But the physical office will not become irrelevant. There is too much history and investment there, and the role of the office in the war for talent cannot be ignored. The office of the future will succeed or fail based on whether it provides the flexibility and in-person collaboration that future office workers demand. By examining the historical importance of physical office space in employee engagement, we can better imagine the future of office space in a remote work world.

Retails

Retail property was once a simple business — how times have changed. The COVID-19 pandemic has overturned much of what retail landlords and their tenants have long taken for granted.  Lockdowns earlier in the year to delay the spread of the virus left many retailers unable to trade, while continuing restrictions have badly damaged revenues in particular locations. Many have been unable to pay some or all of their rent. Retail landlords are faced with a market in which many of their customers are struggling to survive. Even if landlords wanted to evict them, some governments have placed temporary bans on them doing so.

But the dilemma posed to retail landlords by COVID-19 already loomed over many of them. If a large part of the retail sector is to avoid collapse, landlords must agree to rents that reflect what retailers can afford to pay. Struggling retailers argue some link must exist between the revenue a retailer brings in from the space it leases and the rent a landlord should expect from leasing that space.  Turnover-based leases appear to be the answer. “What the lockdown has done is put so much more pressure on the retail model that the move towards turnover leases has accelerated really fast”.

Many retailers have been unable or refused to pay rent as a result. As of 60 days after the third-quarter rent collection day in June, retail landlords had collected 60% of due rent, according to commercial property data firm Re-leased. This compared to 59% collected 60 days after the second-quarter rent day in March.

Hotels

The hotel industry is among the hardest hit. Our research suggests that recovery to pre-COVID-19 levels could take until 2023—or later. Investors are providing similar views of hotel companies’ prospects, as seen in the underperformance of US lodging real estate investment trusts (REITs). Like so many industries, hospitality will also see both subtle and substantial shifts in the post-pandemic era. Some are already apparent today.  

Many US hotels are closed, especially luxury hotels. Occupancy rates show what’s happening. In early May, occupancy was less than 15 percent for luxury hotels and around 40 percent for economy.  Looking ahead, we expect economy hotels to have the fastest return to pre-pandemic levels, and luxury and upper upscale hotels to have the slowest. That’s in part because economy hotels are better able to tap segments of demand that remain relatively healthy despite travel restrictions, including truck drivers and extended-stay guests.  

Investors are pessimistic. While publicly traded hotel companies have done much worse than the broader market—bottoming out at a 60 percent share price decrease, 25 percentage points below the S&P 500—lodging REITs, which make up a large portion of publicly traded hotel groups, have fared even worse. Mid-cap REIT share prices have fallen as much as 70 percent since January 1, and some small-cap funds have fared even worse. That’s driven by the structure of the REIT, a pass-through vehicle required to pay out 80 to 90 percent of its net income as shareholder dividends. Shareholders’ confidence in REITs has fallen, as many assume that with component properties hit hard, REITS will not be able to pay dividends, their primary value proposition. 

To summarize, as during the period following the global financial crisis of 2008, while some real estate players go beyond just adapting and flourishing, others fade. Individual firms’ abilities to weather the storm will depend on how they respond to immediate challenges to the industry—particularly the current declines in short-term cash flow and demand for space, as well as the uncertainty surrounding commercial tenants’ ability to pay their bills. In the medium to long term, the changed behaviors forced upon the industry will have likely altered the way consumers and businesses use and interact with real estate. The critical question is which of these changes will stick. Throughout, acting quickly and smartly will help determine the fate of players not only in these challenging times but also as the industry emerges from the current crisis and inevitably reinvents itself.

 

 

 

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