Commercial Real Estate: “Parsing The Product Types – Six Months Into The Pandemic”

The Commercial Real Estate ACRE capital markets came to a shuddering halt in March of this year as the COVID-19 pandemic shutdowns shocked society and the economy. The sudden halting of businesses, schools and nearly all aspects of life were unprecedented, stock and credit markets crashed worldwide. Commercial real estate fundamentals plummeted, and capital markets froze.   

Thanks to massive fiscal and monetary stimulus from Congress and the Federal Reserve, an economic recovery is underway. The virus is still spreading as widely distributed treatments and vaccines are still months away at least. The finance markets for commercial real estate are functioning again. The reopening of society has been bumpy with many businesses operating at zero or partial capacity (restaurants, movie theaters, fitness centers, hair salons, travel).  The disruption has resulted in a wider than usual “stratification” of commercial real estate product types.

Multifamily: Multifamily’s status as the preferred asset class has grown during the pandemic. Real Capital Analytics recent “RCA CPPI” index which measures value trends indicated a +6.9% year-over-year increase in values. Factors include the shutdown of other product types and the robust lending from the federally insured agency lenders (Fannie Mae FNMA and Freddie Mac). Rock bottom treasury yields and spread compression aided by massive bond purchases by the Federal Reserve have resulted in ultra-low fixed rate loans for apartment borrowers. Banks are actively funding new construction for apartments.   Underwriting standards have tightened (example: agencies are requiring a reserve of 6 months to 1 year of debt service be held back at closing), but borrowers are navigating these issues. Potential headwinds for apartments include high unemployment levels which traditionally affect workforce housing and waning government stimulus.  New Trends: Location matters as tenants are seeking out more suburban and exurban locations, avoiding density. Urban locations are increasingly out of favor as the downtown offices, restaurants and entertainment districts are no longer a draw. Also, single family homes for rent gain popularity as an asset class as renters seek more personal space.  

Industrial: Warehouses and logistics centers are more crucial than ever as the rise of e-commerce was accelerated during the pandemic as consumers avoid brick and mortar retail.  The RCA CPPI index for this asset class is +8.6%. Massive distribution and fulfillment centers along with smaller “last mile” warehouses located within cities are all in demand. Leasing activity is dynamic with low vacancies. Industrial has always been a preferred product type for life company and bank lenders, now more than ever.  New Trend: The most likely COVID-19 virus vaccines expected to be available in 2021 need to be stored at near zero freezing temperatures.  Huge demand for “cold storage” facilities could be on the near horizon.

Retail:  Shopping centers, malls and restaurants have been hit hard by the shutdowns and ongoing consumer aversion to congregating in indoor environments.  The RCA CPPI index for this asset class is -2.8%.  A wave of major household name tenants has filed for bankruptcy including Neiman Marcus, J. Crew, JC Penney JCP , Brooks Brothers and Lord & Taylor. The pandemic has accelerated the transition from traditional brick and mortar to e-commerce sales. During the last six months, e-commerce sales jumped from 16% of total retail to well over 20%. Reopening policies mandating limited or no indoor seating in restaurants, curbside pickup only and limited hours have diminished capacity for small and large tenants. The economics of tenant leases and their landlords’ financing was based on these tenants operating at “full capacity”. Also, most movie theaters and fitness centers remain closed.

Certain tenants are thriving during the pandemic. Winners include: grocery/drug stores, home improvement centers, general merchandise mega stores (Walmart WMT , Target TGT ).  Value stores such as Ross, Dollar General DG and Dollar Tree DLTR are seeing increased activity as consumers tighten their belts during the economic slowdown.  A major victim is the apparel industry as consumers work from home and are not going out. Traditional department stores are closing in droves. Other indoor mall standbys such as stationery and jewelry stores, GameStop GME are also closing as shoppers avoid these venues. 

Some retail and large indoor mall anchor space will need to be repurposed for new uses such as office, health care and residential. New Trends:   Simon Properties is repurposing closed department store spaces as fulfillment centers for Amazon AMZN .  The definition of “retail” is blurring as online ordering, curbside pickup and delivery is turning many stores into quasi-distribution centers.  Walgreens WBA is teaming with care providers and including treatment centers within stores for increasingly health conscious consumers.

The full extent of the shakeout in retail has yet to play out. Some tenants are surviving due to PPP loans or other types of government assistance and/or reduced payment arrangements with landlords. But these stopgaps are limited as continued stimulus is being hampered by inaction from Congress. Many landlords will eventually be unable to continue carrying tenants. The path forward is not clear. Will vaccines and/or treatments become available in time? Will those developments spur a “return to normal”?  Or has changing consumer behavior permanently altered the retail landscape?

Office  Once full offices emptied out in Mid-March and many have yet to reopen.  The RCA CPPI Index for this asset class is =-0.9%. As workers quickly adapted to work from home with Zoom calls replacing in person meetings and collaboration, what is the future of office space? The path forward is the most uncertain: once the pandemic is under control, will employers and workers embrace the “new normal” as companies cut costs and workers eliminate traffic choked commutes? Or, will companies value the irreplaceable collaboration and cohesion that a physical office offers?  In the near term, office landlords are facing increased operational costs related to COVID-19 procedures (spacing protocols, sanitizing, “no touch” fixtures in bathrooms, etc.) and some softness in rents and leasing activity. The high profile midtown Manhattan office market is a nearly a ghost town.  It’s highly dependent on commuters using public transportation and many senior executives have exited the City and are living upstate or in neighboring states. Will they all return? Will suburban offices stage a comeback as workers move away from dense urban locations?   New Trends: JP Morgan, one of the largest office tenants in the country, is changing the paradigm as they welcome back workers.  Employees will cycle between working remotely and the office.  JP Morgan envisions that 25-30% of their workforce will be working remotely at any given time. Their offices will feature the “hot desk” concept: instead of regularly reporting to a permanent office or workspace, employees will be assigned a temporary space for a period, work from home for a period and then return to another temporary space. Ford Motor Company’s F Dearborn headquarters will feature a campus design by Snohetta, a Scandinavian design firm. The concept features common workspaces where workers choose where to work, including spaces that employees will set up with their laptops for the day.  

In conclusion, successful commercial real estate investors strive to “see around the next corner” and capitalize on opportunities, especially during a time of disruption. What will be the lasting effects of the pandemic on consumer, tenant, landlord, lender and investor behavior in the next cycle?

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