Navigating the Commercial Real Estate Market in the Post-Pandemic Period
Is the COVID-19 pandemic beginning to have an impact on commercial real estate?
First quarter sales data from First American DataTree suggests we might already be seeing a glimpse into what’s likely to be a difficult year for commercial real estate (CRE) sales in 2020.
At first glance, sales volume appears relatively stable, if uninspiring. Three sectors—apartments, industrial and hotels—actually showed modest year-over-year increases in the total dollar volume of sales, while the office and retail sectors showed fairly
significant declines.
But a closer look at the number of units sold probably offers more insights into what’s likely to be a trend for the rest of the year. Only the apartment sector was able to eke out a small increase in unit sales. The industrial, hotel and senior living sectors showed modest declines. Both the Office and Retail sectors showed a significant drop-off in the number of properties sold.
How the CRE Market Has Already Changed
The COVID-19 pandemic has had devastating consequences for the U.S. economy. Entire industries, mostly in the service sector, were shuttered. The implications for the CRE market were ominous, particularly for commercial properties that hosted sports and entertainment events, housed restaurants and retail stores, and supported travel and lodging. These were the types of businesses that most often closed in an attempt to “flatten the curve” and minimize the spread of the virus.
For an economy where consumer spending accounts for 70% of its gross domestic product, shutting down these businesses effectively put an end to the longest period of sustained economic growth in U.S. history and sent the country into a recession. GDP dropped by 5% in the first quarter. Analysts are forecasting a drop of 25% to 42% drop in the second quarter GDP. Unemployment jumped from 50-year lows to over 15%, and
new jobless claims continue to exceed 1 million a week in July.
It’s no surprise that an economic shock of this size has had an effect on every sector of the CRE market—some more than others—and each with a different outlook for the post-pandemic future.
The good news is that transactions and development haven’t completely stopped, although they have slowed dramatically. The unanswered questions the industry faces are making financing new deals more difficult: When will consumers feel confident enough to spend again? How many businesses won’t survive the downturn and how many jobs will be permanently lost? And what sort of behavioral and structural changes will have an impact on the utility of commercial space in the years ahead?
Until we have answers to those questions, it’s hard to predict whether the CRE market will experience the kind of crash it did in 2008. It’s not hard, however, to see some of the short-term implications from the pandemic.
For example, the office sector may see the most long-term changes due to COVID-19. The segment is likely to see two countervailing forces at work.
On one hand, there will be a need for more space-per-employee and modifications to entrances and points of egress to facilitate social distancing. Apparently jamming employees into crowded cubicle farms or setting up coworking facilities where workers sit shoulder-to-shoulder aren’t great ideas during a pandemic. On the other hand, it’s likely that many companies will need less office space in general, since work-from-home productivity was better than expected.
Will companies move toward a more distributed workforce, with employees working from home some or all of the time, and/or offices set up in less expensive markets across the country rather than in the more expensive major metro areas? Anecdotally, these conversations are already happening in Silicon Valley. Twitter has announced a permanent work-from-home policy, and Facebook executives have discussed the benefits of having employees in other, less expensive states. The pandemic may well have already changed the size, location and the very structure of tomorrow’s offices.
In the short term, the hotel sector will probably suffer most. The outlook for travel is bleak. Consumers seem unlikely to travel in large numbers until the pandemic is under control or there’s an effective vaccine available. The major brands like Marriott and Hyatt will certainly weather the storm (albeit not without some pain). But many of the limited service hotels are owned by smaller investors, and they may not have the financial wherewithal to survive the downturn.
In the long run, the retail sector is likely to be the biggest casualty as we exit the pandemic. This sector was already struggling before COVID-19, with vacant suburban shopping malls and big box retailers like Macy’s, Sears and J.C. Penney Co. shuttering stores across the country.
Since the pandemic hit, many other well-known brands (e.g., Brooks Brothers, Neiman Marcus, GNC, Pier 1 Imports and JCrew) have all filed for bankruptcy. The weakness of the retailers themselves, the accelerated growth of e-commerce and questions about how quickly shoppers will head back to the stores all weigh against a strong recovery. It’s very likely that the most successful resolution for the retail sector might be the repurposing of existing shopping centers into multiuse facilities.
On a more positive note, the industrial sector seems poised for post-pandemic growth. As mentioned, the pandemic has fast-tracked the country’s already growing shop online habits. To accommodate this growth, we may see Amazon and other major online retailers invest heavily in warehouse and distribution hubs across the country. A distributed workforce will likely create the need for more cloud computing facilities. And it seems likely that we’ll see investment in more flex manufacturing facilities, since the inability to produce the kind of personal protective equipment needed by health care providers and first responders shined a light on that weakness in our manufacturing ecosystem. All three of these trends should drive industrial growth.
The apartment sector may experience some short-term pain. Most unemployment claims were likely filed by renters, and there appears to be an accelerating trend among millennials to abandon urban apartments for suburban homes, in search of a healthier environment to raise their families.
But the sector is well-positioned to rebound strongly. The primary reason for optimism is demographics: U.S. household formation is likely to surpass 1 million new units again in 2020, and there simply aren’t enough homes for sale to accommodate those households. Demand for rental units should be poised for growth over the next few years.
Opportunities for Investors
There will undoubtedly be opportunities for investors who understand how to navigate the likely changes in the CRE market.
The two sectors most likely to feel short-term pain—retail and hotels—will probably be areas offering purchase bargains. On the retail front it’s unlikely we’ll see much new construction. Developers should be able to find creative ways to repurpose existing facilities, however, combining shopping with food services, offices, entertainment, health and fitness centers, and even residences.
The pandemic has also brought to light other needs that could present opportunities. Senior living facilities are desperately in need of being upgraded and overhauled. The most severe COVID-19 problems happened in nursing homes. Hospitals, especially those in large cities, were stretched to and beyond their limits trying to treat a huge influx of seriously ill patients. Are there better ways—and better facilities—to handle pandemics or other spikes in patient volume in the future?
What will a distributed workforce mean for real estate investors? From a housing perspective, will employees look to move farther away from major urban areas since commuting isn’t an issue? Will they want larger homes to accommodate offices? Will second- and third-tier markets see a surge in the development, sales and leasing of offices as major corporations allow workers to locate to areas with lower costs of living? The COVID-19 pandemic, as devastating as it’s been, may have fundamentally changed the future of the commercial real estate market. Today’s investors can participate in those changes—and help bring the country and our economy back to health.
