March 23, 2020

COVID-19 and Commercial Real Estate: What We Know, What We Don’t

Nellie Day

The coronavirus pandemic (COVID-19) has not only impacted the physical health of humans around the world, but the health of the U.S. economy as well. While the stock market rallied over 11 percent on Tuesday, its biggest jump in nearly 90 years, on news that a federal stimulus bill to rescue the economy from the coronavirus was imminent, the Dow Jones Industrial Average was still down 31 percent from its most recent high at the closing bell. Meanwhile, economists say weekly jobless claims — new filings for unemployment insurance — could hit 2 million or 3 million. The Labor Department will release the latest figures on Thursday morning. Before the coronavirus hit, weekly jobless claims hovered around 215,000.

Though no one knows the true fallout yet — because we’re still in the thick of it.

“The impact of the crisis on the commercial real estate market has been dramatic so far, and we are only in the beginning,” says Alex Zikakis, president and founder of Capstone Advisors, a real estate investment, development and asset management company in Carlsbad, Calif.

“Many small businesses, especially in retail, are facing extreme pressure as people social distance and only shop for absolute necessities. I fully expect as this crisis continues that the credit market for many property types will become illiquid, except for the highest quality assets with the strongest credits, such as top-performing grocery and drug store chains or best-in-class industrial assets under long-term leases to credit tenants.”

The Centers for Disease Control and Prevention (CDC) reported Monday that the number of U.S. cases of coronavirus, a contagious respiratory illness, had reached 33,404 and the total number of deaths nationwide had risen to 400. The CDC expects that figure to climb much higher in the days and weeks to come.

Efforts to prevent the virus from spreading have included everything from air travel bans to shelter-in-place orders and the closures of many non-essential businesses where people are likely to gather. Though the exact response to COVID-19 has been left to the states and cities, many have issued wide-sweeping orders that force offices, retailers, casinos and restaurants to shut their doors.

Telecommuting will trend for office

These closures have had varying impacts on businesses. Many companies that are able to take their workforce remote may encounter little disruption to their everyday operations, though that doesn’t mean this physical workplace shift won’t be felt in commercial real estate.

“COVID-19 has forced the nation to quickly adapt to working from home and we’ll see a multitude of small businesses continue to operate remotely and save the physical office overhead,” notes Barbara Armendariz, president and founder of SharpLine Commercial Partners in Los Angeles. “As larger businesses continue to allow employees to work from home, will they reduce their square footage needs and shrink their overhead.”

This trend, naturally, is helped along by today’s technologies.

“Regardless of whether we enter a recession or if this health crisis turns out to have only a modest effect on the commercial real estate market, our experience tells us that [many companies] are managing quite capably working mostly from home offices,” says Rick Stone, president and CEO of EverWest, an institutional real estate investment management firm based in Denver. “We believe this may have permanent effects on our work and office habits. Technology will only help this along.”

The office sector may experience further pain, just as the co-working trend had convinced start-ups, entrepreneurs and small companies to venture out of their personal dwellings and into flexible, communal spaces.

“We expect that co-working operators will be adversely impacted in the short run,” says John Pollock, CEO of Meridian, a full-service real estate developer. “Working in close proximity to others has gone from cool to dangerous in the course of weeks. The co-working leases are, by nature, short-term.

“I think you will see their vacancy spike, putting financial pressure on operators. If the co-working operators begin defaulting on their lease obligations, you will see landlords who manage large concentrations of co-working space begin to feel the squeeze. Depending on a building’s exposure to co-working tenancy, and the severity and length of this crisis, it could result in loan defaults.”

As with every down cycle, however, these instances can lead to opportunity if investors believe in the trend’s long-term viability.

“It’s not clear how the office market and, in particular, the co-working environment will fare in the months ahead,” Stone adds. “Our belief is that the co-working, collaborative office market is a secular trend and one that will expand long-term. For these reasons, we remain interested in the right buildings — whether they require an adaptive reuse or light renovation — in certain markets where this trend will flourish longer-term.”

Worries ahead for retail, restaurants, hospitality

Aside from airlines, the sectors that will arguably suffer most from coronavirus-prompted closures are hotels, casinos, retail and restaurants. States like California, Nevada, Illinois and New York have taken drastic measures to curb the virus’ spread, which includes the shuttering of all non-essential businesses.

Grocery stores, drugstores, banks and gas stations can remain open, while most other retail has either been forced to close or has closed voluntarily. Meanwhile, many restaurants throughout the country can only accommodate takeout or online orders, with dine-in orders prohibited.

“People working in restaurants, hospitality, and food and beverage had jobs at this time two weeks ago,” says Philip Voorhees, vice chairman of CBRE National Retail Partners — West in Newport Beach, Calif. “In many cases, now they do not. If the COVID-19 threat persists, many small businesses will have no other option than to close permanently. Landlord backfill tenant options will be next to none if shelter-in-place restrictions persist.”

Though Voorhees believes deal volume will slow and the market will pause as lenders and investors become accustomed to new realities, he does see this volume returning once this event is behind us. It just remains to be seen whether this “event” will be over in weeks, months or even a year.

“Transaction volumes will increase, potentially toward record levels propelled by low interest rates and motivated parties on both sides of the table,” he adds.

Ed Hanley, president of Hanley Investment Group Real Estate Advisors, has already seen the short-term impacts of COVID-19 on transaction volume, though he’s quick to point out that deals are still getting done.

“We are still closing transactions that were in escrow during the past 30 days, but we have also had a few that canceled,” he says. “Some of the past few weeks’ closings include single-tenant assets like Starbucks, 7-Eleven, Circle K, Chase Bank and Bank of America.”

“There is no doubt the restaurant sector for net-lease investments is being most affected by the COVID-19 outbreak,” continues Hanley. “Overall demand on net-lease retail assets was at an all-time high before the outbreak. At this time, we believe our net-lease activity may not meet or exceed benchmarks set in 2019, as we continue to monitor the situation.”

Many may have noticed the long lines and lack of inventory at grocery stores, discounters, drugstores and warehouses that have been allowed to remain open in every state. Though business may be robust for now, Hanley warns against putting all your eggs in these short-term baskets.

“Investors are cautious to assume drugstores and dollar stores are immune to the economic impact COVID-19 is having on the world economy,” he continues. “Right now, I don’t believe there is a retail tenant that is not impacted in the short term. It is too early to determine what the future demand will be for retail properties in general.”

E-commerce may keep industrial afloat

The same investor logic that applies to current in-demand “essential” retail may also apply to e-commerce. Though this sector has been gaining steam in recent years, it still requires consumer spending to keep it humming.

“Perhaps Amazon-, FedEx- and UPS-leased assets will fare better delivering necessities. But down their supply chains, if the population does not have income, it cannot or will not spend,” says Voorhees. “A tiny glimmer of hope for some workers is that Amazon announced it is opening 100,000 new roles to support people relying on Amazon’s service during this challenging time. Many grocery chains report that they have the product, but can’t keep the shelves stocked due to hoarding and need to hire more people.”

Zikakis believes retail’s loss will be e-commerce’s gain in the long run, with industrial investments looking more attractive as physical retail has been exposed during this pandemic.

“We’ve seen that mall operators are under extreme distress,” he explains. “The property type least impacted will probably be high-quality industrial that serves e-commerce tenants. Many consumers that had been late adopters to online shopping for items like groceries will make a permanent shift to future online shopping.”

Stone agrees with this assessment.

“It’s not unreasonable to foresee increased interest in long-duration assets like well-leased industrial properties and other commercial assets,” he notes. “Conversely, we believe this crisis will only increase the pressures now affecting retail and lodging sectors.”

Multifamily remains strong, but rental woes abound

Massive closures have done a number to business’ bottom lines, which may leave some multifamily tenants unable to pay rent in the immediate future.

Barbara Armendariz, president and founder, SharpLine Commercial Partners

“Unemployment rates are expected to be as high as 20 percent and we will soon see the virus’ domino effect attack on the multifamily sector,” says Armendariz. “The high unemployment levels will soon affect multifamily projects.”

This industry may also see an immediate decrease in demand, as open houses and apartment tours have been canceled or reduce to prevent the spread of the virus.

“Real estate is tangible and needs to be seen and experienced,” explains B.J. Turner, founder of Dunleer, a Los Angeles-based private real estate investment and development firm. “Potential tenants need to leave their existing homes to find a new apartment.  Buyers need to see the real estate and meet the tenants.”

“Property management is very challenging to run remotely, given the personal interaction that is critical to the job,” continues Turner. “There will be challenges to finding and managing labor and health risk exposure. Lenders will no doubt be exposed to borrower defaults, which will likely overwhelm legal partners, but it is unclear how that will play out on a government level.”

Industry-wide conclusions

Brett Butler, senior director in Stan Johnson Company’s Newport Beach, Calif., office says commercial real estate’s tangible attraction may play a role in a near-term drop-off of sales and projects. This is especially likely, he asserts, as there are many questions surrounding the fate of not only entire industries, but how projects and sales will be handled in this environment.

“The potential issues are with deals that require a physical presence,” he says. “Think about properties that are under construction. Are crews still on-site? And what about deals that are in the due diligence phase. Can we still get inspections completed? If local governments are furloughed, what happens to the developer who can’t get rezoning approval, or sign-off on inspections or permits?

“These are the types of issues that could cause developers to default on construction loans or miss a critical deadline turning a property over to a tenant.”

Turner says developers will face potential near-term labor disruption, difficulty in permitting, a less-liquid lending environment and significant lease-up concerns. Hanley, meanwhile, has an immediate concern about rent — or a lack thereof — and what this may mean for tenants and landlords as the end of the month looms.

“The shutdown of nearly all businesses has created a scenario where many won’t be able to pay rent come April,” he says. “This will have a significant impact nationally on all commercial property owners. How are property owners expected to make their mortgage payments if none of their tenants can or will pay rent? And what will lenders do if the property owners can’t pay their mortgages?”

“This is a very complex situation with no easy or immediate answers,” continues Turner. “Some tenants and landlords carry business interruption insurance but, currently at this time, a pandemic is not covered.”

There are many unanswered questions in a situation that seemingly changes hour by hour. The biggest ones that need to be answered are how to quell panic and thwart this virus as quickly as possible. Until then, the commercial real estate industry — like the hotels, retailers, restaurants, office tenants and multifamily residents it supports — waits for word on when businesses can reopen. Which, if any, industries will receive bailouts, what short-term remedies will be put in place, and how will lenders will react to all of the above?

“This, too, shall pass at some point,” Voorhess advises. “Remain calm. Life goes on. Seek factual information. Be pragmatic in your business dealings. We are all in this together and the pain will be shared collectively.

“It’s not just happening to you, it’s happening to everyone. It may not hurt us all equally, but it’s going to hurt us all. Concessions will be made by all parties; time passes and business marches on.”

Here’s hoping that march starts sooner rather than later.