By now every American is aware of the unprecedented public health emergency and economic disruption caused by COVID-19. While we remain in the early stages of both the pandemic and the likely severe recession that will result, we can begin to assess the impact on commercial real estate as we position ourselves to capitalize on potential opportunities. Before doing so, I want to first express my gratitude to those on the frontlines fighting the pandemic and helping the sick. Thank you. I also wish well all those who are affected by the virus either directly or economically. My thoughts are with you. Our primary concerns should be with those who are helping and those who are affected. I work from the comfort of my home, writing about a topic that is clearly secondary. My purpose in writing this is to begin to organize my own thoughts and research in attempt to begin for formulate a plan for future acquisitions. As a real estate investor during these times, it is hard to both react to the problems within one’s existing portfolio and simultaneously begin looking for new opportunities. These two things can feel contradictory. The problems at properties we own are real and immediate, while the potential opportunity in theoretical. I try to compartmentalize the two and not let one affect the other. So what is happening out there and what should a real estate investor do?
Real estate, unlike stocks, does not reprice constantly, so we can’t yet see what is happening with pricing for buildings yet. Deals take many months to source and close; those that close today were deals consummated prior to COVID-19. For this reason, we don’t yet have data from the private real estate market on how pricing has changed. Every broker and investor is trying to figure it out.
We have begun to see the disruption in property operations, though, and this will eventually impact pricing. For example, many retailers are closed and asking for rent relief, hotel revenue has cratered, showings are down for vacancies, and office buildings are empty as workers attempt to work from home. If these impacts are short-lived, pricing may not change much, but if many stores never reopen, renters lose their jobs and can’t pay their rent, and companies that occupy office and warehouse properties begin to go bankrupt as revenues fall, we can expect significant re-pricing for the affected real estate. For now, we can continue to monitor these initial impacts and we can look to the public markets pricing of Real Estate Investment Trusts (REITS) to begin to understand how investors are pricing the underlying real estate assets.
To translate a REIT share price to the value of the underlying real estate, I calculate the market cap and add it to the long-term liabilities, which provides the current cost basis of the underlying real estate portfolio. We then take the REITs representation of Net Operating Income from its 2019 annual report and divide it by the current cost basis to arrive at the current market cap rate for the real estate. We can then compare the current implied cap rate for the REIT’s assets with its recent high to see the change in how the public markets are valuing the real estate. This can provide some insight into how real estate values may change.
Retail
With about three-fourths of Americans in some form of stay-home order, tens of thousands of retail establishments are closed. As of March 23, over 47,000 chain stores in the U.S. had temporarily closed. In addition, thousands of independent retailers have also closed by choice or state mandate. Many of these retailers are asking for rent relief or are simply not going to pay rent in April. Some may never reopen. Retail landlords can likely endure a short-term reduction in rent, but longer-term fundamentals may be impacted by retailers going bankrupt.
Based on my analysis of the change in valuation for Realty Income Corporation, a REIT focused on triple-net retail properties, the value for these properties, long perceived as safe, has fallen by 28%. Retail Opportunity Investment Corp, an owner of grocery-anchored centers on the west coast, is down 33%. Clearly the public markets are pricing in a severe disruption to retail real estate.
Hotel
Without long-term leases, hotels must re-rent their space each day, so any change in performance is realized immediately. According to a March 26 webinar from STR, a hotel data company, for the week ending March 21, revenue per available room (RevPAR) was down 69.5%, the third week in a row of double digit declines and the largest ever in 30 years of data. Corporate demand for meetings is now down to zero and U.S. occupancy is down from 65% to 30%. China’s occupancy fell to 10% during its lock down. As a result of this decline in performance hotel franchisors Marriott and Hilton are down 47% and 39% respectively as of March 27. With this level of revenue deterioration, hotels are going to face distress much faster than other types of real estate. Values for hotels seem the most uncertain.
Multifamily
Jobless claims for the week ending March 21 hit a staggering 3.28 million, more than four times the previous weekly high. Some experts project unemployment to reach 20%. With many of the laid off workers coming from shuttered businesses, such as hospitality, tourism, and restaurants, these layoffs may begin to impact renters’ ability to pay rent, particularly in Class C apartments, often termed as workforce housing, and in areas of the country where the employment base is more heavily skewed toward hospitality and tourism. With Congress set to pass a $2 trillion stimulus package that includes increased incentives to keep workers on the payroll and an additional $600 in weekly unemployment benefits from the federal government, these effects could be somewhat ameliorated, but only for a short period of time. If the retailers, hotels, and other employers don’t re-open and quickly ramp up to their former revenue level, many jobs may be permanently lost, which will in-turn impact apartments.
While this is the most sudden deterioration in labor markets in U.S. history, it will still take some time before multifamily operations are impacted to a level that causes owners to exit voluntarily or under distressed scenarios. The extent of this pain will determine the ultimate impact on pricing. Equity Residential, one of the best-known apartment REITs, has seen the value of its real estate decline by about 24% based on my analysis of its current stock price.
Office
Like multifamily, the impact on office properties will be determined by the ultimate level of economic impact resulting from COVID-19. Many office workers are now working from home, which should allow companies to limit the short-term, direct effects of the pandemic. As the impact to the economy works its way through the system, though, office demand is likely to wane as companies are forced to cut costs as business activity declines. This will eventually result in some companies failing to pay rent and impact property revenue. As this plays out some property owners may elect to sell or will be forced to sell, dragging down prices.
Franklin Street Properties, an office REIT focused on properties in the Sun Belt and Mountain West, has seen its underlying real estate decline by 20%, according to my analysis. The market appears to be more confident in future of office properties than retail and hotel. But office carries the risk of a faster shift towards work from home as more companies have been forced to adapt to this during the stay-at-home orders.
Warehouse
Warehouse appears to be best positioned to weather a recession as vacancy rates are low and demand for logistics and e-commerce has been strong. With more people forced to stay home, e-commerce companies, such as Amazon, are increasing their hiring and look poised to increase their market share. But as overall demand in the economy goes down and consumer spending declines, companies operating warehouses are going to declining sales. Some companies will be well-positioned but others will be unable to pay rent, impacting operations and eventually property pricing. Even ProLogis, a class-A warehouse REIT, has seen its implied real estate values decline by 19% as the public markets anticipate impacts on warehouse properties, according to my analysis.
Conclusion
With property operations quickly deteriorating at retail and hotel properties and future reductions in occupancy and rental revenue likely for multifamily, office, and warehouse, it is not surprising that the public markets have devalued real estate by 20-30% depending on the asset class and location. Real estate investors must be careful as they move through this uncertain environment. Sellers are likely to continue to insist on pre-COVID pricing until they are motivated by or forced by deteriorating operating income. As a result, some firms have put new acquisitions on hold as they wait for the impacts to be reflected in pricing. Every person who is interested in investing in real estate should see this as a time of caution, but one that should eventually give way to opportunity, just as was the case in the Great Recession over ten years ago. The investors that are active coming out of the recession will be those positioned to provide market leading returns.
