What Does the Future Look Like for Commercial Real Estate?

Unlike stocks and many other investment assets, determining where U.S. Commercial Real Estate (CRE) stands any given moment is much more difficult. There is no immediate “mark-to-market” mechanism and, more significantly, CRE is comprised of many different types of property in varied locations. Changes in CRE valuations tend to react much slower than equities due to the presence of long-term debt, leases and other associated contractual obligations. With that said, let’s look at where CRE was entering before COVID-19, where it is now, and what the future might hold.

CONTINUED STRONG GROWTH FOR CRE ENTERING THE COVID-19 CRISIS

Through 2019, CRE had experienced a multi-year expansionary cycle fueled by strong general economic growth, ample liquidity, and cheap attainable debt. Driven by strong demand and growing rental rates, property values grew steadily for nearly a decade. The rate of growth in valuations had started to show signs of leveling off, however, the CRE sector was healthy before entering the COVID-19 crisis. Supply and demand were in balance with oversupply being an issue only in a few geographical markets. Within the broad CRE sector, office, industrial, and multifamily were all generating impressive returns with only certain types of retail lagging behind somewhat as ecommerce popularity continues to soar.

TODAY, CRE IS SHOWING EARLY SIGNS OF STRESS

CRE is in the early stages of dealing with stress brought on by COVID-19 pandemic and the ensuing partial shutdown of the economy. Operating performance and valuations will get worse before they get better. Tenant lease defaults and restructuring are early-stage byproducts of where the U.S. economy is, and in turn, where CRE owners are now forced to focus their resources. With the emergence of a short-term decline in rental income, highly leveraged properties are starting to have difficulty in servicing debt. Loan restructuring efforts have begun in earnest, and the success of such efforts will be largely determined by the duration of the downturn and the extent to which owners are sufficiently capitalized. The immediate state of CRE varies widely based on sector, geographical market, and leverage.

THE OUTLOOK FOR CRE WILL VARY BY SECTOR AND GEOGRAPHY

Short-term, CRE has some hurdles to jump. Revenue impairment brought on by tenant default will drive values down for some assets in some locations. The immediate impact on retail (other than grocery-anchored properties) is obvious. The office sector may have to adapt to a new work at home mantra and the unraveling of co-working concepts. Industrial and warehouse space is feeling short-term impacts from interruptions in the shipping supply chain but will likely remain a favored sector. Multifamily properties are dealing with tenants who have lost their jobs and are unable to pay rent. Resultant drops in rental income will present short-term issues, but multifamily should continue to benefit from a demographic preference for rented living space.

It’s difficult to say if there will be any real winners as the U.S. emerges from the COVID-19 crisis, however certain CRE sectors will certainly fare better than others. Industrial/warehouse, grocery-anchored retail, data centers, medical office buildings, and multifamily properties will likely perform well. Regional malls, senior housing, and co-working office operators could struggle.

Longer-term (around a year from now and beyond), there is no reason to believe CRE won’t thrive if there is underlying economic support. This point is critical: CRE performance will vary drastically based on location and property type as the U.S. works its way through the lasting impact of the COVID-19 crisis.