Perspective on CRE Asset Classes Amid COVID
Updated 4.17.20 – Sector-specific perspective from EquityMultiple’s Asset Management Team.
As the COVID-19 pandemic continues to evolve, the impact on the global economy is manifesting in supply chain disruptions, demand shocks due to social distancing, regional shutdowns, travel restrictions, and reduced consumer spending. Certain industries, such as tourism, air travel, hospitality, and brick-and-mortar retail are experiencing the sharpest disruptions in demand. Many other industries are confronting compromised revenue and operations, and may halt hiring, expansions, or purchases. This week’s unemployment numbers resulted in an increase of new jobless claims to 22 million, wiping out a decade of hiring gains. Lastly, we are only starting to see the impact of the above mentioned factors on corporate earnings.
Responding to the crisis, the U.S. government rolled out several unprecedented monetary and fiscal stimulus packages, dwarfing the policies implemented during the Great Financial Crisis. Combined, the stimulus is estimated to be more than $6 trillion, or 29% of annual GDP. While these actions will hopefully help mitigate the long-term economic fallout, it is premature to estimate the severity of the downturn and the shape of the recovery as the macro environment is still developing and remains highly uncertain.
The US commercial real estate (“CRE”) market has begun to experience the impact of the pandemic. Hospitality, healthcare, and retail properties have seen the most pronounced impact, while other sectors reliant on longer-term leases should be better insulated. A months-long halt of economic activity to subdue the outbreak, continued employment reduction, and declining consumer demand would substantially affect demand for CRE.
It is important to remember that, prior to the pandemic, the U.S. real estate market was exhibiting manageable levels of new supply, low vacancy rates, modest leverage, and large cap rate spread to the 10-year Treasury—all factors that would support a healthy CRE market and mitigate potential value declines. While the impact from the COVID-19 crisis is severe, we remain optimistic about the long-term U.S. economic outlook and real estate fundamentals. However, we do anticipate certain CRE market dynamics and operations to be materially altered (some of which may be permanent) as we transition back to “normal life”.
While all asset classes will be affected by the current pandemic, the lodging industry is experiencing unprecedented disruption. According to a recent STR report, total U.S. Revenue Per Available Room (RevPAR) dropped 83.6% week-over-week, with occupancy declining to 21.0% for the week ending April 11. The immediate focus has been on streamlining operations, including reallocating staffing, reducing payroll and marketing, and in some cases shifting operations entirely to respond to medical needs (e.g., providing beds for healthcare workers and/or patients). In addition, the majority of hotel operators are minimizing all discretionary operational and capital expenditure. Emergency modifications have also been imposed by national hotel parent brands, including Hyatt and Marriott, to further conserve cash. Borrowers across the board are working with lenders on payment plans with a majority requesting a forbearance: a temporary deferral of mortgage payments. In addition, sponsors are actively looking to source additional capital by applying for state and federal relief programs.
At this point in time, it is impossible to forecast with confidence how the industry will perform going forward. It is probable that certain hotels will perform better than others (extended stay vs. business dependent hotels). The path to recovery will ultimately depend on how effectively the coronavirus can be contained, when states ultimately lift stay-at-home orders and, most importantly, people’s willingness to travel.
Unsurprisingly, the challenges for retailers struggling prior to the current pandemic, especially those that do not have online channels, are growing. Those demonstrating resilience, and even strength, are in-line retail anchored by “essential goods”, such as grocery, discount, and pharmaceutical stores. There are some provisions from the newly enacted CARES Act that support rent payments for small businesses, but disbursements will unlikely arrive on time for April payments. As retailers shut down operations, landlords have been actively discussing payment options such as rent relief and deferrals, modifying leases, and addressing lease provisions to prevent tenants from vacating their lease obligations.
CBRE released early estimates indicating that between 50% and 70% of April retail rents were paid on average at grocery-anchored centers, 20% to 40% in non-grocery anchored centers, and only 10% to 20% in malls and outlet centers. Projections for May rent payments are lower, as automatic payments are cancelled and April rents were paid to landlords as a sign of good faith for renegotiations for future payments. To a certain extent, retail owners will have to absorb some of the financial burdens borne by tenants, but those sponsors best positioned to navigate through this crisis will be those proactively planning with all stakeholders, including lenders and investors.
Senior housing, assisted living facilities (“ALF”), skilled nursing facilities (“SNF”), and memory care operators across the country are facing mounting operational complexities since the outbreak of the current pandemic. Older residents are more susceptible to the virus, forcing operators to strengthen infection prevention measures and implement strict control protocols. These guidelines include increased cleaning schedules, reduced or discontinued family visitation, staff schedules, reductions in payroll, and virtual property tours. While occupancy rate is steady (80% of operators saw no significant increase in move-outs according to an Activated Insights survey of 19 operators), some may experience occupancy declines due to natural attrition of older residents. In the immediate term, providers are seeking ways to maintain healthy cash flow to service operations by applying for state and federal relief programs and commencing active discussions with lenders—including the request for forbearance.
In the near-term, operators will continue to face challenges as they service a vulnerable demographic and manage the emotional component of the pandemic placed on staff, residents, and their families. Fortunately, new construction has completely halted, hoping to rebalance some of the recent oversupply added to the market created with the prospect of a wave of baby boomers requiring assisted living. Going forward, the senior housing industry will continue to face challenges in caring for their existing residents, as well as attracting future residents.
Private off-campus student housing experienced a widespread impact due to the current pandemic. Universities nationwide closed campuses and moved classes online for the remainder of the semester. Students are choosing whether to stay in off-campus housing or return home. According to a survey of 2,000 student housing residents conducted by Student Housing Business (SHB), 40-65% of properties remain occupied. Those choosing to stay expressed a desire to remain isolated rather than run the risk of returning home and potentially infecting other family members.
Operators are reminding students and guarantors that contractual lease obligations remain in place and that communities will stay open to house students for the entire term of their lease. Many off-campus communities are not offering lease terminations or refunds although almost all are waiving late fees. Residents and families with financial hardship are working with operators to create payment plans.
The main focus of uncertainty in the student housing sector is the virus’s impact on next school year’s leasing. Pre-leasing results vary by market and they typically correlate with family socioeconomic status. Remaining questions will include: (1) when students will return to campus; (2) if and when they will sign new leases; and 3) if they will require future “outs” or reimbursement provisions for similar future events.
Co-living experts believe the business is well positioned to survive a recession. Before the pandemic, co-living units priced favorably compared to studio apartment rent (a 15-30% discount according to JLL). As seen in prior recessions, households tend to consolidate to single households in order to reduce cost of living. Paired with the proposition of short-term leases, co-living provides an attractive value proposition for those seeking a flexible alternative.
Several trends that can be observed across the industry include 1) a reduction or elimination of community events and common areas; 2) increasing deliveries of cleaning supplies and other necessities; 3) implementing “no guest” policies; and 4) an increase in community support. For prospective members, operators are conducting virtual community tours (Starcity previously created a three-dimensional walkthrough of the house), which minimizes leasing friction. Starcity communities have experienced minimal payment plans or move-outs (none at the Fell Street Property to date) with the majority due to the recent implementation of travel restrictions.
The current pandemic will affect apartment communities to varying degrees depending on asset and submarket. Most operators are focused on navigating April’s rent payment cycle and accommodating tenants experiencing financial hardship to create deferred or partial payment plans. To date, no state has implemented a rent freeze and government officials continue to urge landlords to be flexible regarding payments. As a positive sign for the multifamily industry, the latest report from the National Multifamily Housing Council disclosed that 69% of renters made their rent payment by April 5. Major cities have imposed eviction moratoriums for nonpayment of rent and are discussing extensions of these policies beyond the summer. Markets that will face the biggest challenges are those with large leisure, hospitality, and oil and gas industries such as Orlando, San Diego, and Houston.
Revenue volatility may be more pronounced than vacancy in the long run, as tenants face reduced incomes or unemployment during a U-shaped recovery. Stabilized properties will be the least impacted as people remain in their homes in the short term. However, as seen in prior recessions during times of economic hardship, households tend to downsize to more affordable housing or double up in occupancy. As a result, Class B assets are better positioned to navigate the crisis than the luxury segment as renters become price sensitive and move downstream. Class C assets will also become burdened as lower-income households face greater financial instability. Prior to the viral outbreak, demand for affordable housing far outstripped supply. The effects of the pandemic will only exacerbate the fundamental challenge of housing affordability.
Construction/For-Sale Residential (Townhomes/Condos)
The pandemic is likely to impact condos and townhomes in various ways depending on the project’s stage of progress. For those currently under construction, a statewide shutdown to “non-essential” business may mandate complete or partial site closings. In addition to project delays, a site shutdown adds unexpected development costs. Typically, contingency reserves, capitalized upfront in most projects, account for unplanned circumstances. However, extended delays will certainly erode these cushions. Generally, projects under construction are in a better position than those just completed or nearing completion. For projects nearing substantial completion or that have already received a Certificate of Occupancy, we anticipate that units under contract will experience delayed closings and marketed units will see a significant decline in buyer interests and tours. Under-construction projects have the benefit of the passage of time to resolve some of the pandemic’s impact prior to entering the sales stage. Nearly all projects will be affected in varying degrees depending on project status and location. Sponsors who are actively communicating with their stakeholders will be better positioned to endure the current crisis. On the demand side, reduction of mortgage rates to historic lows will help subsidize buyers when they are able to return to market in the recovery.
Industrial is expected to outperform as the asset class becomes increasingly crucial for supply chains, e-commerce, and food and beverage suppliers. Distribution and manufacturing facilities are less prone to business interruptions than other commercial real estate classes as these operations are usually less crowded and are located in suburban areas. As a result, industrial rents are likely to remain relatively stable. Leasing activity has slowed as potential tenants exhibit a wait-and-see approach and face challenges in completing onsite inspections. Generally, leasing may see an uptick due to increased demand from high-demand industries such as last-mile distribution, cold storage, and e-commerce—but positive effects may be offset by diminished interests from non-essential retail/whole companies and third-party logistics that service them. The industrial sector will feel some short-term effects but should recover fairly quickly relative to other property types.
Compared to other commercial real estate asset classes that encountered sudden business disruption (e.g., hotel, retail, senior living), the impact to the office sector has varied largely depending on market and tenancy mix. Larger businesses typically plan for recessions and/or plan for business interruptions and are able to rely on contingency plans, cash reserves, or shifting workers remotely. On the other hand, smaller businesses who typically run lean have resorted to drawing down on all available credit and debt to maintain liquidity, including those provided by federal and state assistance programs. As a last resort, some (such as flexible space operators) have furloughed or laid off staff to preserve cash. Operators in markets concentrated in leisure, tourism, and energy industries will be hardest hit, including Orlando, Houston, and New Orleans.
Landlords are focused on determining which tenants need the most assistance and taking action accordingly—evaluating rent relief or payment deferrals, negotiating lease extensions, and addressing lease provisions in the likelihood tenants are unable to meet lease obligations. Those best positioned to navigate through this crisis will be sponsors who have been proactively planning and regularly communicating with all stakeholders, including lenders and investors.
In the short term, leasing activities will slow. But with 91% of existing leases averaging two years or longer, the sector is poised to withstand the current disruption. Historically, the office sector has gone into recessions due to overbuilding, resulting in substantial vacancy. Today, debt levels are sound and operators have built up reserves to pay lenders – a foundation for a sound recovery. It remains to be seen if this disruption will reshape how and to what extent office demand returns to its historical levels given the new “work from home” normal, along with less commute and more family time. Conversely, some contraction of demand could be offset by the requirements for more personal space and social distancing at the workplace, requiring more gross square footage per employee.
The car wash industry is principally affected by household disposable income, new vehicle sales, weather conditions, and gas prices. Household consumers represent the majority of the demand. Thus, high unemployment and weak income growth will constrain revenue growth. To insulate the business from more volatile market conditions, operators typically offer subscriptions to individual customers or contracts to transportation companies. Car wash operations have fixed costs as supplies are ordered in bulk to cover extended periods, with utility costs being the most variable. Typically, operators seek to cover these costs through subscription revenues, which provide consistent income streams.
The industry has taken preventative measures to comply with all CDC and local government orders and regulations. Operating properties will have exterior wash only options. To help prevent the spread of coronavirus, operators are temporarily closing vacuum areas and discontinuing customer use of towels and spray bottles. Customers can still wash their cars through the tunnels without leaving their vehicles. Some may see subscription rates reduced under these new guidelines. Projects currently under construction will adhere to the guidelines communicated by the local or state government as to whether or not they are permitted to continue work. Given the sector’s characteristics, we believe its resilience to recessionary conditions is poised to outperform through the current crisis.
The self storage sector may experience an inability to push rents, as certain markets are experiencing oversupply. However, the relocation of students to their parents’ homes has filled some vacancies that may not have otherwise been filled until the summer. Simultaneously, people will be less likely to move their belongings out of storage under the current shelter rules. Recent investor sentiment on the property type has increased as a safe haven with low tenant turnovers, limited customer traffic and interaction, and low cost. Historically, half of renters rent longer than two years and a quarter of all self storage renters in the US keep their possessions in storage units for a decade or more. These features make the sector less susceptible to economic disruptions.
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