I have been discussing the commercial real estate market with many players, including developers, owners, bankers, mortgage brokers, investment sales brokers and leasing brokers. Also, business organizations, including NAIOP and Minnesota Real Estate Journal, have produced webinars that provide excellent insight. There is no shortage of information and opinions as to where we are and where we are going.
Having been through several dislocations and disruptions in my career, here is my opinion based upon the information available.
General economy
This will not be a V-shaped recovery unless you’re in the haircut business. It will take at least a year for any sector, and we’re vulnerable to a second wave (“COVID-20”) if and when a new virus appears this winter. I think it will be a U-shaped or possibly hockey stick-shaped recovery.
Now, many experts disagree and think the economy will be V-shaped. Then there are other experts, like the chief economist at JP Morgan, who think it will be a W-shaped recovery, and the recurrence of the virus next winter will force us to shut down again. One thing we know: It will recover. Nothing has ever happened to the United States that has stopped our economy from recovering. Still, I’m firmly in the camp of a slower recovery
Many small business owners may suffer but they have always shown great resilience. Many big businesses will suffer, too, especially in the retail sector. Some experts think retail anchors will fail en masse, like Neiman Marcus, Sears, JC Penney and others. Many are planning bankruptcy filings at this time. This can be blamed on Amazon, but really this crisis has simply accelerated forces already in place before the virus. If these big boxes fail, that will have a domino effect on retailers who rely on traffic generation.
Government response
The PPP program is nice, but it’s not well thought-out. Why give money to companies with good balance sheets? Fortunately, Harvard University and Shake Shack have sent back their PPP money after significant protest. There is an infinite demand for this money, and it will run out quickly with every $300 million chunk that is approved. Then what happens three months from now or next winter if this re-occurs?
The government ignores upstream casualties when businesses don’t pay rent. Landlords can’t pay mortgages, banks have non-performing loans, defaults, foreclosures, etc. Surprisingly, most tenants are paying rent, unless you’re in the retail sector.
And, so far the government has ignored the farmers, who own more real estate than all commercial real estate combined. Farmers have been hammered for years, and this is just the latest punch to the gut.
Retail
This market segment is toast. A total of 90 percent of retailers aren’t paying rent because they are closed. If they open, it will be on totally different terms. Even an optimist like Spencer Levy at CBRE says it will take three years for retail to recover. Three years is an eternity to me.
Office
This segment is doing OK, but it’s a time bomb. Employers have adapted with work-at-home strategies, so when they renew, they will look for less space. There will always be tenants who want “different” space, but there are few office tenant prospects actually looking for more space. If we do see a recovery, the office market could recover in two years.
We’re seeing some office users looking to lease the safest space available, which is in a flex building. No common areas, individual entries, bathrooms, workplaces, dedicated parking. Space that can be sanitized by each tenant as needed. A totally controlled environment.
Industrial – Logistics
This segment is doing well and will get better. The challenge is finding land to build these huge buildings anywhere near metropolitan areas. Requirements for 500,000 square feet are chewing up farmland in 50- to 100-acre chunks.
Industrial – manufacturing and distribution
This segment will do just fine, as its products and customers are unique. There will be a movement to bring manufacturing back to the United States from Asia. The government stimuli will help small manufacturers and their customers.
Industrial – light
The backbone of the multi-tenant industrial market, these are usually small businesses with niche products. They may suffer in the short term because they have weak balance sheets, but they will survive. New business formation has been sparse for a long time due to government regulations, a shortage of employees and lack of capital. Expect more start-ups if the November election retains the present administration because employees will be abundant and capital should loosen up.
Industrial – flex
This segment looks a lot like office, but with a twist. Tenants may need less space if they are office-oriented, but they will also need manufacturing, production, lab and hybrid space. They can’t manufacture widgets from home. There won’t be any more of this flex product built, so existing product will continue to be upgraded and re-purposed. When this occurs, these buildings are essentially “new” on the inside, with higher rents, longer lease terms and higher values.
New demand is now occurring from office tenants – even downtown high-rise tenants – who want COVID-safe, controlled-environment office spaces. Flex buildings are uniquely positioned to offer separate entries and safe office environments, free of common-area public contamination. Expect some movement from pure office tenants to flex product.
Multi family
This industry is essentially supported by the government with Fannie Mae and Freddie Mae debt. We have become accustomed to 1 percent vacancies. That will change; get ready for 10 percent vacancies as apartment renters (especially young people) double up or move home. Empty nesters hoping to sell homes and move to luxury apartments will be thwarted by an inability to sell their homes. The same goes for senior housing – seniors wanting to move will stay at home because their houses can’t sell.
If the economy rebounds, these vacancies will recover. Expect a period when developers will pause on new construction, so rents could actually go up before a new wave of construction commences.
Interestingly, apartment renters are paying their rent despite massive layoffs. They seem to simply move out when they lose their job or double up with a friend.
Hotels
This entire industry is in work-out with their lenders. This sector will only recover when business and leisure travel resumes. That could take a while.
I call hotels “real estate” because most people do. But, really, they are operating entities. They rent their space out a day at a time. They are marketing and operating machines with high structural overhead that need 70 percent occupancy to break even. There is no alternative use for a hotel, other than a homeless shelter.
I think there is a lot of capacity in this sector, so no need for new construction, and a longer recovery period.
Brokerage
Even though brokerage fee structures have increased dramatically, less deals equals less commissions. Tenant representation will continue to thrive because all tenants have leases expiring, and they will need someone to help them sort out their needs given the current disruption. Buyers and sellers will start doing deals when the banks resume lending.
Post Pandemic
Economic policy makers will struggle with how to address our new levels of debt. Higher taxes will obviously be required, but that would stifle a recovery. Punishing China sounds good, but they hold a huge percentage of our Treasury bonds and other Federal debt. The Fed has few tools left in the box. They can’t lower interest rates below 0 percent. They shouldn’t print more money, but they will. The result will be inflation, which isn’t bad if you’re in the real estate business. In fact, it’s good for the economy in general because it encourages people to spend, and our country can pay back the debt with inflated dollars.
Our recovery depends 100 percent on consumers resuming their spending. Hopefully, they still have jobs and money to spend. If they don’t, this could be a longer recovery.
Loans
Lenders are quoting loans at 50 percent LTV down from 75-80 percent a few months ago, which might re-introduce mezzanine and bridge debt to fund the gap between equity and conventional debt.
Life companies are active but selective. Banks are scared to death, but they’re herd animals and if things loosen up later this year, they’ll resume lending.
Equity
Equity is always seeking a home. Return expectations may increase, so investors will be more selective. Seasoned sponsors will be more valuable than ever.
Pricing of Assets
Modest reductions in values will occur simply because of lack of capital for buyers. Buyers with cash can drive pricing. Buyers will scrutinize rent rolls to figure what they’re buying. Lenders will worry about COVID effects on the tenants and will ask a lot of questions. Deals will get delayed and many will blow up. Stabilized, quality assets will be more valuable than ever. Sellers, faced with no investment sales market, will elect to hold and possibly refinance. There’s nothing wrong with cash flow!
Cap rates are really irrelevant this year, as smart sellers will hold off and not bring properties to market. If we have inflation and continued low interest rates, we will actually see values go up from cap rate compression.
Some investors foresee huge distress opportunities; I do not. Lenders will be reluctant to throw assets on the market because they don’t have to; their balance sheets are strong. There aren’t really that many distressed owners. If anything, their equity may take a haircut the next year or so, but it also rose quite a bit over the last two to three years.
Development
Current developments will be completed – you can’t stop a train. New developments will need to make sense to get financing: build-to-suits, strong credit, pre-leasing, etc. Even then, construction lending will be difficult. Developers will need more equity to get deals done.
Summary
Everyone needs to chill, buckle up, hunker down and ride this out. Chances are good we will get through this and the market will “normalize,” but there will be a re-set. Everyone knew this bull market in real estate would end, but nobody thought a plague would be the cause.
The year 2020 will be a time to focus on your properties, micro-manage, work on relationships, accumulate knowledge and try to be a better real estate professional. Protect and preserve the value of your assets and look for opportunities. Don’t force deals to get done. Be patient. Work on your golf game.
“When there’s no wind, you can always mend the sails”
P. S. This all could change in a second.
Steven Hoyt is chief executive officer of Minneapolis-based Hoyt Properties. He is a Minneapolis commercial real estate developer, owner and investor, and can be reached at steveh@hoytproperties.com.
