Commercial Real Estate: Uncertainty Abounds. Do Bargains?
The ongoing coronavirus pandemic is severely impacting investing in the U.S. commercial real estate market, as property developers struggle to figure out which new projects are worth building and property owners struggle to figure out which existing assets are worth holding.
Retail stores and hospitality properties have suffered crippling revenue losses that have prompted them to seek financial assistance, and banks have tightened lending standards for commercial real estate construction. A steep drop in market liquidity might only be delaying a widespread decline in property prices.
BY THE NUMBERS
- Between the start of March and the start of August, more than 20 retailers have filed for bankruptcy, including JCPenney, Brooks Brothers, and Lord & Taylor. Hotel revenues on an available per-room basis were 56% lower in July 2020 than they were in July 2019.
- From Jan. 2 through July 31, the share price of the iShares CMBS exchange-traded fund rose 4.96%. Loan delinquencies in the CMBS market hit a record of 3.59% in June, representing a total $17.2 billion pool of troubled assets.
- Billionaire investor Carl Icahn announced in March that he was establishing a short position in the commercial mortgage bond market through credit default swaps, betting on a bubble burst in properties like shopping malls.
- During the January to July stretch, the share price of the Prologis (PLD) REIT (real estate investment trust) that owns logistics facilities rose 19.25%, while the share price of the Empire State Realty Trust (ESRT) REIT that invests in New York metro area office and retail buildings fell by 51.68%.
- A July 2020 survey by the Federal Reserve reported that over 80% of banks had tightened credit standards during the previous three months for new applications of construction and land development commercial real estate loans.
- NAIOP’s July Coronavirus Impacts Survey Results found that over 92% of respondents reported industrial property acquisitions, compared to about 70% in June and under 60% in April. Regarding retail property, over 79% of respondents reported no deal activity, which is still an improvement from the April high of over 86% reporting no activity.
- According to a report from the National Association of Realtors, commercial real estate sales volume for middle and large market properties or portfolios of at least $2.5 million fell by 68% in the second quarter of 2020 compared with the year before.
Market conditions reflect the uncertainty about whether coronavirus cases will subside quickly enough for businesses to remain solvent, as well as which kinds of activities workers and shoppers will be willing to do in-person again at some point.
“Office and industrial property owners usually receive loans directly from banks, life insurance companies, and to some extent private equity, which are [all] being more selective now,” says Shawn Moura, Ph.D., Research Director at NAIOP, a national commercial real estate development association.
Yet on the investing front, there may be more opportunities than the economic environment suggests at first glance. Commercial mortgage-backed securities (CMBS) have fared relatively well thus far, thanks in large part to their collateralized and tranched structure, and perhaps also due to Federal Reserve support for multifamily residential-based CMBS. While the shares of many prominent commercial-focused REITs have fallen, other REITs are still producing gains.
“CMBS lenders, which have a big presence in the hospitality sector, seem to be following through on what they have already initiated, but are less keen to start lots of new deals,” Moura adds. “And REITs holding retail or hospitality properties will have more headwinds than those invested in better-performing sectors like industrial spaces or data centers.”
SUPPLY & DEMAND
Dorinth van Dijk, PhD, with the MIT Center for Real Estate’s Price Dynamics Platform, recently conducted research on commercial property prices and the ease of sales at fair market values in major U.S. metro areas.
He found that, at the start of the year, when buyers’ reservation prices were relatively close to sellers’ reservation prices, market liquidity was strong. But since the onset of the pandemic, seller resistance has triggered a severe drop in market liquidity.
As of June 2020, property sellers in New York City would have had to drop their prices by 28% on average in order to match the demand of buyers. In Seattle, they would have had to drop prices by over 40%. In terms of sectors, this supply-demand discrepancy was approximately 25% nationwide for industrial space and over 32% for retail space.
Furthermore, van Dijk found that although overall commercial real estate prices were stable or increasing in the first quarter of 2020 for those sales that did occur, price drops of 20% to 35% may occur sometime this year if sellers capitulate in order to conduct transactions.
However, “It very well may be the case that sellers will not move their reservation prices,” he says. “If that happens, prices will not go down but liquidity will stay down, and very low turnover will prevail in real estate markets for some time.”
If the U.S. commercial real estate market experiences a decline as steep as the one that transpired during the 2008 to 2009 financial crisis, property-based assets could plummet by almost 40%. That would allow investors to purchase quality properties at significant discounts.
These assets may be CMBS, shares of REITs, or direct possession of buildings. Buyers of buildings could enhance and adapt these properties with technology and materials suitable for a post-pandemic world, such as electronic sensors for doors, virus and bacteria-resistant surfaces, and socially distanced workspaces.
To be sure, in either case, investors might have to hold onto these assets for several years before they produce sufficient returns. That may be too long a time horizon for some investors, but it could yield a huge payday for those with the ability to endure the downturn.