The True, the Bad, and the Ugly: Where we are in the Pandemic and what it's doing to Commercial Real Estate
March 20, 2020
March 18, 2020
The word “panic” has its root in the name of the Greek God Pan. Pan was a party god, drinking, chasing nymphs and playing his eponymous pipe flute. But like all who overindulge, Pan liked his afternoon naps, and if an unlucky soul happened upon him during one of his respites and disturbed his sleep, he would utter a spine-chilling shriek which induced a reaction of panikon deima, now shortened in English to “panic.” In the last few weeks, a viral plague has inadvertently disrupted the calm in our good times rest, and we are now hearing the panic cry.
We are officially in a bear market. A bear market is defined as when securities prices fall 20% or more from recent highs.
Thursday, March 12th saw the largest stock sell-off since 1987’s Black Monday. Prices recovered the next day but since then each day has brought continued volatility.
The Fed has started quantitative easing, just like in the 2008 crisis.
Interest rates are near zero. as of March 19, the lowest ever. The average 30-year fixed mortgage rates are 3.65%, according to Freddie Mac.
Job losses are starting to be reported as of mid-March. Experts are predicting these numbers to rise in coming weeks, possibly months, but they also predict the impact to look more like post-September 11, not 2008, meaning the job recovery will be more swift. Hotels and restaurants have already begun laying off staff. American Hotel & Lodging Association CEO Chip Rogers said on Tuesday in a press call that “Millions of people could get laid off in the next few days, not weeks.”
For the 3-week period following February 21, when the stock markets started retreating, the pace of commercial property sales was approximately 50% of he same period a year ago, according to Costar.
Momentum across the economy was slowing prior to the onset of the new coronavirus epidemic.
The Bad: What is Unique about this Crisis
The economy has weathered many downturns, and several in the lifetimes of most readers. However, this has been a faster start to a bear market than in 2008, 2000, 1998 or even 1987.
Prior to March 6, when OPEC failed to reach an agreement on production cuts, oil prices had already dropped 32% year-to-date as demands had dropped due to the spread of the virus. With Saudi Arabia and Russia fighting for market share, US shale will face a sharp decline. In fact, the energy sector of the S&P has underperformed the rest of the index by 11% in recent days. A price of $35 per barrel is too low for most oil companies to meet their debt and interest payments.
Corporations are more in debt than any time in history.
Recessions have never been triggered by a virus in the last century. This pandemic is hitting a world economy with record levels of debt. Today, the global debt burden is at an all-time high. America’s corporate debt is equal to 75% of the United States’ GDP, higher than in 2008.
“Zombie” companies (those that earn too little to even make interest payments on their debt and rely on more borrowing to continue) are 16% of all publicly traded companies in the US and 10% in Europe.
The Ugly: Commercial Real Estate’s Place in the Storm
Real estate markets react more slowly than equities or bond markets. The length of time needed to enact a transaction reduces liquidity. For this reason, we have yet to see the same type of volatility or impact in the CRE markets as we have witnessed in other financial sectors. But all investment worlds are connected. There is anecdotal evidence among brokerages that deal volume is down as uncertainty in the financial markets and quarantines of various degree are present—things are on hold in many cases. As travel is restricted, many due-diligence trips are causing delays and postponements. One $5.8 billion hotel portfolio deal between Anbang Insurance Group and Mirae Asset Global is reportedly in trouble due to CMBS investor worries.
Carl Icahn, the billionaire investor and activist personality, is shorting the commercial mortgage bond market and claiming it’s his “biggest position by far.” His shorts are specific to credit default swaps, assets that back corporate office and shopping mall mortgages. Icahn predicts that these bonds are in grave danger of defaulting. Shopping malls have been in trouble for some time, but in most areas office properties were stable or growing.
The office market makes for an interesting study. Longer term lease structures may shore up some properties (and sectors) for the time being, and if there is not widespread corporate collapse, these will weather the contagion. But the combination of the drop in oil prices and the impact of the virus will make some markets, like Houston, more vulnerable. According to an analysis by CoStar, the variables of a market’s industry coupled with their number of positive viral cases will determine the blow. The market industries of goods-producing and leisure space/hospitality are the most at risk, and the analysis showed that San Diego and Seattle were the markets most vulnerable to commercial real estate hits. Houston was noted as a close third, ranked only behind the west coast cities due to the relatively small number of cases reported there. If the virus spreads to Houston the way it bloomed in Seattle, at a time when oil companies are projecting laying off 10,000 people, there will be a hard hit to the office market there.
In addition to the above mentioned impacts to the office market, a more cultural shift may create pressure to change as well. While 2019 saw the rise of co-working spaces and open-space concepts in office design, the new realizations of what epidemics really look like are expected to change the space that companies want. As workers get comfortable and efficient working from home, it will be clear to many that traditional office space might not be necessary in the same way. Luxury amenities like fitness centers and coffee bars may look less attractive than options to easily plug in from safer, more controllable space.
In contrast, the shorter the lease term for a commercial property, the more quickly it can be affected by market forces. No properties lease for shorter terms than hotels, renting their space by the night. Hotels are facing a dark time as event cancellations and non-essential travel are curtailed. Marriott’s CEO, Arne Sorensen, noted in February that RevPAR in China was down 90% year over year.
The one bright spot among the sectors may be industrial. With prudent or mandated social distancing now widely being practiced, the demand for e-commerce and grocery supply has surged. This makes warehousing and cold storage well positioned for the future, especially for properties located in urban areas close to stores. Industrial is likely to be the sector least affected by the outbreak, perhaps even benefiting from it.
As for retail, anyone doing business in essentials (food, paper products, cleaning supplies, hygiene items) is seeing a sharp uptick in business. Grocery and big box retailers like Target, Walmart, Costco and Sam’s Club will probably be reporting high sales this month as anxious shoppers stock up. Luxury, experiential and other non-essential retailers will be facing tough times and tough decisions. Landlords would be wise to listen to tenants needing to restructure lease terms to get through the rough patch—vacancies will not be easy to fill once they appear.
Information on the spread of the virus, the governmental response to it at national and local levels, and the decisions of each actor in the global market’s interconnected web are changing by the hour. No one can predict exactly what will happen next, and what the impact will be, but let us hope that Pan has only briefly been awoken and will soon return to his usual merrymaking ways.