Commercial Real Estate, COVID, and the Current Economy
There are a lot of varying viewpoints and opinions on what the future holds, as well as how the broader economy, legislation, and COVID will effect real estate. Luckily, we at Realty Capital Analytics have our ears to the ground every day trying to better understand the market in this rapidly changing environment. So let’s dig into what the actual numbers and data are showing across the board.
GDP and the General Impact
As a result of the pandemic, gross domestic product (GDP), the broadest measure of the nation's economic output, took a major hit. The first quarter had a 5% decline in GDP while 2nd quarter reduction was an annualized 32.9%, the largest ever recorded in a single quarter and the largest known in the last two centuries. The economy was about 10% smaller by the end of June than it was at the beginning of the year. This is a total loss of about five years of economic growth.
While that’s a substantial hit to the US economy, the broader economic environment of each market, as well as the supply / demand situation of each asset type and class, will each tell a different story. It will provide for varying outcomes as we deal with, and ultimately come out of, this pandemic. That’s why it’s important to have a top-notch commercial real estate consultant in your corner to help you navigate through the complexities of real estate during these times.
Let’s explore some general trends in various sectors, with the caveat that some places may be different in a positive or negative way.
Residential vs Commercial Real Estate in The Post-COVID Economy
When many people think about the real estate market, they’re actually referring to the residential housing market. While this is an overall good indicator to follow, it isn’t necessarily tied to the commercial real estate market in many cases.
For example, during the last recession while housing prices were crashing, multifamily rental rates stayed steady or even increased in most markets. While residential real estate may trend in the same direction of some asset classes of CRE, it may go the opposite of others.
Commercial real estate values are primarily based on a formula including capitalization rates (or cap rates) and net operating income whereas residential real estate is usually based on comparable sales which is driven on homeowner demand. So, it stands to reason that they can diverge substantially depending on how each sector is impacted.
So, let’s dig into some of our expectations and predictions by asset class.
Industrial and Data Centers
We see continued positive trends within industrial and data center space as the “Amazon effect” continues to take hold on distribution and consumer behaviors, in addition to more companies “moving to the cloud”.
The Amazon effect as defined by Investopedia is:
“the impact created by the online, e-commerce or digital marketplace on the traditional brick and mortar business model due to the change in shopping patterns, customer expectations, and a new competitive landscape.”
Said differently, online shopping is impacting brick-and-mortar retail stores as people begin to shop more online. Obviously, this has a negative impact on physical retail locations, but it’s also a boon to industrial and data centers which are needed to support this growing industry.
As an asset class as a whole, industrial space is expected to tick up with vacancy rates, but you’ll notice it is still far below the long term averages with vacancy expected to flatten out in 2021 and never hover around 2016 averages for the next 5 years or so.
More specifically, “last-mile industrial” is expected to see huge growth in the coming years. Last mile industrial consists of the warehouses and distribution centers needed to support ecommerce retail that has exploded in recent years. Retailers have been, and continue to invest heavily in distribution centers and new warehouses to increase the speed that their products get through the “last mile” to the consumer.
Additionally, rent growth is expected to quickly move back to a very robust 6% growth rate within the next year. A lot of opportunity may exist for purchase or leasing in 2021 to take advantage of the short-term blip in rents or prices that are expected to quickly rebound within the following year or so.
Class A Multifamily
Demand for multi-family will continue but depending upon the class of property, as well as the location and economic environment entering COVID, properties will perform differently.
According to the National Multifamily Housing Council, rent collections have performed worse in Class C and best in Class A multifamily.
You can see the impact of the stimulus and increase unemployment benefits through an increase in rent collections in June, then collections dropping off substantially in July. While all classes of multifamily saw this trend, Class C is performing substantially worse than in May, Class B is slightly worse but mostly unchanged, and Class A has seen no negative impact at all comparatively speaking.
While a pullback in sales volume and price/unit is expected in 2020, by the end of 2021 or beginning of 2022 price per unit is expected to get back to pre-COVID levels. This could signal an excellent buying opportunity for value-focused investors.
As further evidence of the strength of the multifamily asset class, rents are not expected to see any pullback at all. 2020 and 2021 will have a modest rent cut of 2-4% with all reductions recovered. While this is not optimal for property owners, it may not be bad for renters and the economy considering years of heavy rent growth nationwide.
So, it’s fully expected to have some modest slack in the multifamily space during these tumultuous times, but overall, there will be stability and overall strength within this asset class.
Secondary Cities and Suburbs
Secondary cities were already starting to boom and draw an increasing number of white-collar workers prior to the pandemic, but now that has been pushed into overdrive. White-collar workers are looking for a vastly lower cost of living along with the lower tax burdens and housing costs along with great job-growth in the secondary markets.
According to Redfin, cities like Atlanta and Nashville are drawing large numbers of New York City residents while places like Phoenix, Dallas, and San Diego are drawing new residents from Los Angeles. This is because people living in the coastal markets are tired of (or cannot afford) double-digit rent and price increases, and are opting to move to commuter towns or even middle-America.
This is being furthered by the pandemic which is allowing people to work from home in unprecedented numbers. You can see this in a recent Gallup poll:
62 percent of employed Americans are working from home—double since mid-March
59 percent prefer to continue to work remotely as much as possible
Only 41 percent want to return to their workplace or office, as they did before the crisis
Office Space
As more companies move toward remote work environments, we see the office sector being challenged, however, to what degree, only time will tell. Additionally, this could be heavily impacted by the city or metro area that the property is located in.
For example, as stated earlier, secondary markets are seeing significant growth and it’s reasonable to assume that businesses will follow the trend as this trend continues. One could also deduce that office space in first tier cities such as Los Angeles or New York City would conversely be hurt as companies move to various secondary markets.
As you can see in this chart, vacancy rates have jumped considerably and are not expected to return to pre-covid levels for a few years. In turn, this means is rental rates per-square-foot are expected to drop about 6% in 2021.
If you’re looking to lease space, sometime within the next 12 months may be a great time to lock in a long-term lease.
As you can see, rents are expected to reach the bottom sometime in the middle of 2021, and you can negotiate favorable terms and rates as office owners are focused on reducing vacancy rather than pushing maximum rents.
Retail
As you can see in the chart, retail is expected to have elevated vacancy rates for the foreseeable future with only retail strip centers expected to get to pre-COVID vacancy rates within the next 5 years and general retail staying modestly flat. Other categories in retail, such as malls and power centers, could continue to face a challenging environment as broader economic pressures and trends take hold.
Short-Term Rentals
Airbnb occupancy rates dropped as low as 15% during the pandemic, down from an average between 50% and 60%. Combine the dramatic reductions in occupancy with the expectation that worldwide travel could be reduced in coming years, and it becomes more apparent that short-term rentals should be approached with caution depending upon the market.
Certain pockets of short-term rentals have performed very well during the pandemic as people “quarantined” and escaped larger cities. Many people traveled to more remote areas with outdoor amenities such as lakes, trails, or parks to be safe from the crowds and still be able to safely spend time outdoors.
Short-term sub-leasing for office space has similarly been hit hard during the pandemic. There is some potential upside though due to the huge decrease in demand nationwide for traditional office space. This may pose a good opportunity for investment in the coming months and years as companies look to downsize and gain flexibility in lease terms and increasingly move to favorable terms offered by coworking or other short-term office leasing.
The General Consensus
Opportunity will be widely available for new investors or tenants. While the opportunity may not be immediate in all asset classes, there are some that have immediate potential while others take a little more evaluation, time, or discernment.
Opportunity will likely continue to exist in multifamily and industrial in the near term. Additionally, there will be increased opportunity in other asset classes with the potential of repositioning assets from one class to another (or from one asset type to another) or in value-add situations.
Given the uncertainty and complexity of commercial real estate, it can be a difficult market to navigate. As such, it’s prudent to have a well-informed, experienced advisor in your corner. If you’re interested in real estate, or you’re a current owner or investor, let’s set up a free consultation to discuss your criteria and business objectives.