At Long Last, the Cycle Ends. What’s Next?

Paul Fiorilla, Director of Research, Yardi Matrix

Commercial real estate’s unusually long run of success over the past decade left many in the industry guessing when and how the cycle would end. Recessions aren’t inevitable, but nobody working in the industry today had ever before gone a decade without having to deal with a major downturn.

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All the guessing about the next recession is now over. The fact that nobody had the “global pandemic” box filled in their recession bingo card is of no consequence. The economic effects of COVID-19 have been transmitted to the entire population, even as many states enact social distancing measures to avoid spreading the virus.

As of late March, roughly half the U.S. population, including major economic centers in New York and California, are under orders to avoid all but emergency travel to avoid transmitting the virus, for which there is no vaccine. Large segments of the economy—travel, retail, restaurants, entertainment and most public facilities—have been ordered to shut down, while schools and office-sector businesses are closed or operating remotely.

The world hasn’t seen a global pandemic like this since 1918. As of Friday morning, the number of confirmed cases in the U.S. had topped 85,000 and the death toll had reached 1,296, according to Johns Hopkins University, but those numbers are expected to rise steadily as the virus spreads. The peak caseload might not come until May, and the unprecedented quarantine measures aimed at stopping transmission could last for weeks or months. The shutdown is sure be the economic story of 2020, but right now it is difficult to gauge the full impact. Not only is it unclear how long the quarantining will last and how extensive it will continue to be, but the quarantine measures are unprecedented in modern history, so there is no model to fall back on.

The social distancing started late enough in the quarter that first-quarter 2020 GDP is likely to be flat or slightly negative, but estimates vary widely on the impact on second-quarter GDP and unemployment. Estimated GDP declines for the quarter range from 10 percent to 50 percent. Nearly 3.3 million workers filed unemployment claims during the week ending March 21—a new all-time high—and more than four times as many claims as were filed during the previous record-setting week. More workers will file unemployment claims soon. Federal Reserve Bank of St. Louis President James Bullard said the U.S. unemployment rate could go as high as 30 percent.

End of the fundamentals cycle

Such broad economic dislocation is sure to end the long run of positive fundamentals and strong capital markets in commercial real estate, though the extent depends on the property type, location and effectiveness of the $4 trillion in monetary and fiscal stimulus that will be injected by the federal government in coming months.

On the property level, rent growth will take a hit, as demand for space weakens and occupancy levels flatten or fall. Multifamily rents have been above the 2.5 percent long-term average for five years, but that run is sure to end. Workers in service industries, among them retail, hospitality, transportation and entertainment, are losing paychecks and many will have a hard time paying rent. Temporary moratoriums on evictions and foreclosure actions are being put in place to minimize disruption, but multifamily properties will be dealing with the fallout for months. Multifamily deliveries will be delayed, but demand for new apartment units is likely to wane as consumers stay in place and job growth declines.

Other property types potentially could face worse problems. Many retail properties are already on the brink, and the closing of non-essential retail stores could push struggling retailers over the edge. In the office sector, mandated work-from-home policies are likely to exacerbate the long, slow reduction in demand for office space per worker. Hotels are closing or operating at a skeleton level. Lodging revenue is dropping precipitously and is not likely to spring back robustly even when social distancing is lifted.

Deteriorating capital forces

Commercial real estate’s extremely robust capital forces are another victim of the coronavirus. Deal flow is set to take a big hit due to the uncertainty about cash flow and a drop in institutional investor allocations. Pricing and underwriting are difficult in the face of uncertainty about when economic activity will restart. The huge drop in the equity market means that institutions’ allocations to commercial real estate have risen as a share of total allocations—which will force many to sell assets, or at least to stop new investments.

Meanwhile, the capital markets disruptions will severely curtail the amount of debt capital available. Securitized lenders, issuers of CMBS and collateralized loan obligations were hit by huge jumps in bond spreads as investor demand dried up. They will largely be on the sidelines until demand for bonds improves. Banks and insurance companies are still willing to do some deals, but only on the most stable assets with the best-capitalized borrowers. Any property with a hint of cash flow uncertainty will either be forced to wait or pay a high premium to get debt. Value-add property renovations are endangered.

Mortgages originated post-financial crisis have had very low default rates, but the servicing system is about to get tested as borrowers are sure to be late on payments. Banks are being told by regulators to hold off on classifying loans as delinquent over the next 90 days, but other loan types such as CMBS don’t have the same discretion.

The exception in the debt markets is multifamily, where Fannie Mae and Freddie Mac are still fulfilling their mission to provide liquidity in the event of a downturn. At the time of writing, spreads have gapped out by about 60 basis points, which leads to higher rates on loan quotes, but the agencies still have allocations to use and are open for business. Coming at a time when there has been discussion about privatizing the government-sponsored enterprises and opening the market to more competition, the pandemic illustrates why they were created and what makes them valuable.

The upshot for the property market: In the short term, owners will be focused on operational issues rather than raising rents and signing up new tenants. Property values will retreat from their all-time highs as acquisition yields will rise significantly.

At the same time, while many institutional investors have hit the pause button, other investors, including private equity firms, private sponsors and family offices, have become very aggressive in search of investment opportunities. While most owners are well capitalized with appropriate leverage, some will no doubt be caught in a liquidity squeeze. These opportunistic investors are ready to provide that liquidity.

Federal support coming

The good news is that unlike some prior market crises, the industry didn’t cause its own demise through overdevelopment or excessive leverage. It’s not clear when the economy will restart, nor is it clear how long it will take to get back to full speed, but there won’t be a lot of self-inflicted damage to repair when that happens.

What’s more, the federal government is not pulling any punches in its effort to limit the damage, having pledged an unprecedented $4 trillion of stimulus to date. Some of these measures include:

• direct payments to individuals, increased unemployment and health-care coverage
• unlimited quantitative easing, including purchases of Treasury securities, agency mortgage-backed securities and CMBS
• a $300 billion credit facility to provide financing to employers, consumers and businesses
• two facilities to stabilize primary and secondary corporate bond markets
• support for consumer credit, municipal finance and small and medium-sized businesses

All those initiatives—which will likely be joined by additional stimulus packages—are expected to ease the pain of the downturn caused by the global pandemic. After the crisis ends, commercial real estate should be able to bounce back well, relative to other sectors, due to the demand for space and the unprecedented federal commitment to backstop the economy.