Coronavirus Infects Commercial Real Estate

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Jonathan Lansner of The Mercury News reports that commercial real estate values nationwide fell 9% in April as pandemic containment throttled the US economy:
Green Street Advisors in Newport Beach tracks commercial real estate values in two ways. Analysts watch both publicly owned real estate investment trusts traded on Wall Street and property dealings among privately held funds. Once a month Green Street combines that research into indexes tracking real estate performance in key categories.

The coronavirus outbreak halted what had been commercial real estate’s long rebound from the depths of the Great Recession, where values plummeted by one-third. Business limitations due to various stay-at-home mandates have hurt property owners’ ability to collect rents as tenants lost jobs or cash flow. The industry also found that renting empty spaces — whether it be overnight (think, hotels) or a longer term — was very challenging.

Green Street’s overall commercial real estate index, measuring “unlevered” valuations, for April was down 9% in a month and down an overall 8% in the past 12 months. In April, all 11 subindexes fell for the month and only two had gains in the past year. April’s bigger loser was malls; smallest losses were seen in industrial, self-storage and healthcare properties.

Here’s how Green Street broke down values by commercial real estate niches. Start with the basics …

Office: down 9% in a month and lost 6% in the year.

Industrial: down 5% in a month but gained 7% in the year.

Then there are the businesses putting roofs over people’s heads or goods …

Apartments: down 10% in a month and lost 3% in the year.

Self-storage: down 5% in a month and lost 2% in the year.

Hotels: down 7% in a month and lost 16% in the year.

Student housing: down 12% in a month and lost 9% in the year.

Mobile home parks: down 6% in a month but gained 11% in the year.

Next are the retail categories …

Malls: down 20% in a month and lost 33% in the year.

Strip malls: down 15% in a month and lost 13% in the year.

And some specialty groupings …

Healthcare: down 5% in a month and lost 5% in the year.

Net-lease properties: down 8% in a month and lost 9% in the year.
Not surprisingly, some sectors of commercial real estate are getting slammed a lot harder than others as governments locked down economies and forced people to shelter at home.

Greg Dalgetty of Investment Executive recently reported on what COVID-19 will mean for commercial real estate:
Since late March, almost 40% of Canadians have been working from home as a result of Covid-19 — and it remains to be seen how many will return to the office when the pandemic is over.

In recent weeks, the CEOs of Morgan Stanley and Goldman Sachs have indicated that working from home could be the new normal for many employees going forward. Companies around the world have now transitioned to remote work, which poses the question: Will they do away with their office space entirely when their leases expire?

“This definitely has longer-term implications,” said Jeff Olin, president and CEO and portfolio manager with Toronto-based Vision Capital Corporation, an alternative investment manager focusing on publicly traded real estate securities.

Olin, who worked in corporate real estate for a decade, said there were already “secular trends in place suggesting a decrease in demand for office space” before Covid-19. For example, Deloitte offices in Toronto and Montreal have already moved from about 300 square feet per employee to 160 square feet per employee, Olin noted.

While Olin doesn’t expect all offices to be vacant after the pandemic — some employees, he suggested, will be happy to no longer work with kids underfoot — companies like WeWork, which provides shared office space, may be in trouble post-Covid.

 “The WeWorks of the world are really going to have problems coming out of this,” Olin said. “A lot of the absorption of office space in the United States and Canada has been driven by WeWork-type companies.”

Olin added that there will be “some mitigation” of the reduced demand for office space, suggesting that the trend toward smaller office footprints may slow after the pandemic.

 “People are going to want more social distancing within their work environment. That is going to offset some of the pressure on the downside [for office space],” Olin said. “We’ll want to create more distancing, and that will help put a floor on that reduction in square feet per employee.”

Another area that Olin expects will struggle is retail space. Vision Capital has taken a short position with retail “for a number of years” as e-commerce has risen in popularity. Olin expects Covid-19 to accelerate the movement away from bricks-and-mortar stores. Even businesses that were once thought of as “coveted tenants” in the retail space, such as grocery stores, will face challenges.

 “Over the last six weeks, grandma has figured out that she can go online, order her groceries and have them delivered to her door,” Olin said. “Grandma now doesn’t need to get into her car and drive to the Loblaws or the Safeway, park and have all of that stress.”

Shopping malls continue to face “long-term pressures,” Olin noted, although he thinks the best malls will recover after the pandemic, when people suffering from cabin fever are allowed to venture out in search of retail therapy.

“The best [mall] locations, where you can provide alternative uses with apartments and office space and other creative uses, will continue to do relatively better,” Olin said.

As e-commerce continues to gain ground, warehouse space will become an increasingly attractive investment, Olin predicted, noting that e-retailers need more warehousing capacity than traditional retailers.

“You need three square feet of industrial space for an e-retailer compared to every one square foot you need for a store,” Olin said. “If you buy something in a store, there’s an 8% likelihood you’ll return that item to the store. If you buy something online, there’s a 30% chance you’re going to return that item to the warehouse.”

 Olin said he expects higher levels of inventory to be held in warehouses going forward to mitigate future supply chain shocks. He also predicted there will be a “likelihood of some element of de-globalization” coming out of Covid-19, which would shore up manufacturing in North America and further increase the need for warehouse space.
Very interesting insights and there's no question the pandemic is raising a host of commercial real estate questions in Canada and the United States:
It's "too early to tell" whether the coronavirus pandemic and social distancing measures will make suburban properties more attractive after a trend toward urbanization, one industry expert said during a webinar exploring the state of commercial real estate.

JLL Boston senior director Ben Sayles said during a webinar hosted by The Warren Group that new attention on physical distancing may lead some companies to "go with an urban and suburban location" for their offices.

Boston is the second most transit-dependent metro area after New York, he said, and businesses — once they are able to reopen — will need to consider both what transportation modes workers feel comfortable using and what is an easy way for them to get into the office.

Some commercial real estate tenants might also need more space, he said.

 "I think what you're going to see is, upon re-entry, somewhere between 10 and 50 percent of the seats being utilized to allow for more appropriate physical distancing," Sayles said.

One element that makes a case for a suburban office is that people may feel more comfortable walking up "an open three-story staircase" to their desk rather than taking an enclosed elevator, potentially with others, in a high-rise building.

Stephen Davis of The Davis Companies said building managers might look into policies like regulating the number of people allowed in an elevator at one time. In common areas, he said, "enhanced sanitation" will be "first and foremost."

Individual tenants will likely develop their own protocols for their own spaces.

 "Different constituencies and different companies are going to view this issue in different ways, and there's different levels of comfort," he said.
Canada's large pensions which own a huge chunk of commercial real estate in Canada, the US, Europe and all over the world, need to start grappling with all these issues because they represent long-term risks to their funds.

A couple of days ago, I noted Climateer Investing had a great blog comment  on how commercial real estate in Europe is getting hit hard. I also read research from Moody's Analytics which states Canadian real estate is in big trouble:





No doubt, COVID-19 is roiling segments of commercial real estate which is why distressed debt funds are amassing billions to pick up opportunities over the next year:



But while distress signals are flashing in US commercial real estate, some wonder if it will need a TALF rescue:



And remember, real estate (commercial and residential) is ultimately a function of employment growth and Friday's jobs report will be a portrait of devastation:



Still, I found it interesting today that Brookfield Asset Management Inc., which made a large bet on malls back in 2018, plans to invest $5 billion to help struggling retailers:



This on a day when Neiman Marcus filed for bankruptcy protection and mass bankruptcies are set to soar in the US:





Why is Brookfield taking a minority stake in struggling retailers? Because these retailers aren't paying their rent so Brookfield sees an opportunity to buy a stake in them at distressed levels, help them ride out this storm, and make a nice profit once things (hopefully) get back to normal in a couple of years (read Brookfield's letter to unitholders here, its excellent).

I wouldn't be surprised if CPPIB and Ares are doing the same thing with Neiman Marcus, buying debt from creditors and helping that company ride out this storm (see my recent analysis here).

In any case, there are clearly big problems in some areas of commercial real estate and this is where deep pockets and patient capital will come out a winner over time.

The damage we are witnessing in commercial real estate is part of a bigger problem in private markets. The Fed's liquidity won't help these players as much as those investing in public markets.

But even in public markets, commercial real estate stocks (XLRE) bounced but remain very weak and this tells me investors are in no hurry to snap them up as they see more pain ahead in this sector:


Anyway, keep your eye on commercial real estate, this is one sector that large global investors are watching to see how the pandemic will reshape it.

Lastly, on a related matter, I was disappointed to learn after two years, countless public consultation sessions and millions of dollars spent on planning, a subsidiary of tech giant Alphabet Inc. abruptly revealed Thursday that it was walking away from a controversial smart city development on Toronto’s lakeshore.

Sidewalk Labs chief executive Dan Doctoroff announced the decision in a post published on the website Medium, suggesting that uncertainty stemming from the COVID-19 pandemic, which he did not specifically name, had contributed to the move:



Below, Sam Zell, Equity Group Investments Inc. chairman and founder, says the retail and hospitality sectors will take the biggest hits from the coronavirus pandemic. The billionaire known for buying up troubled real estate speaks during an exclusive 40-minute interview with Bloomberg's Erik Schatzker (second clip is full interview).

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