Commercial real estate’s unusually long run of success over the past decade left many in the industry guessing when and how the cycle would end. All the guessing about the next recession is now over. The economic effects of COVID-19 have been transmitted to the entire population, and the world has not seen a global pandemic like this since 1918.
The ramifications of the current pandemic is — or will be — felt by industries far and wide, including real estate.
On the property level, rent growth will take a hit, as demand for space weakens and occupancy levels flatten or fall. Multifamily rents have been above the 2.5 percent long-term average for five years, but that run is sure to end. Workers in service industries, among them retail, hospitality, transportation and entertainment, are losing paychecks and many will have a hard time paying rent. Temporary moratoriums on evictions and foreclosure actions are being put in place to minimize disruption, but multifamily properties will be dealing with the fallout for months.
Other property types potentially could face worse problems. Many retail properties are already on the brink, and the closing of nonessential retail stores could push struggling retailers over the edge. In the office sector, mandated work-from-home policies are likely to exacerbate the long, slow reduction in demand for office space per worker. Hotels are closing or operating at a skeleton level. Lodging revenue is dropping precipitously and is not likely to spring back robustly even when social distancing is lifted.
Commercial real estate’s extremely robust capital forces are another victim of the coronavirus. Deal flow is set to take a big hit due to the uncertainty about cash flow and a drop in investor allocations. Pricing and underwriting are difficult in the face of uncertainty about when economic activity will restart. The huge drop in the equity market means that institutions’ allocations to commercial real estate have risen as a share of total allocations, which will force many to sell assets, or at least to stop new investments.
Meanwhile, the capital markets disruptions will severely curtail the amount of debt capital available. Securitized lenders, issuers of CMBS and collateralized loan obligations were hit by huge jumps in bond spreads as investor demand dried up. They will largely be on the sidelines until demand for bonds improves. The exception in the debt markets is multifamily, where Fannie Mae and Freddie Mac are still fulfilling their mission to provide liquidity in the event of a downturn.
The upshot for the property market: In the short term, owners will be focused on operational issues rather than raising rents and signing up new tenants. Property values will retreat from their all-time highs as acquisition yields will rise significantly.
At the same time, while many investors have hit the pause button, other investors, including private equity firms, private sponsors and family offices, have become very aggressive in search of investment opportunities. While most owners are well capitalized with appropriate leverage, some will no doubt be caught in a liquidity squeeze. These opportunistic investors are ready to provide that liquidity.
Paul Fiorilla is director of research for Yardi Matrix.