Commercial real estate investments have always been a stable source of income and portfolio diversification for investors. This asset class holds tremendous potential for value appreciation, tax benefits, equity building, cash flow and much more. However, investors also need to recognize the risks of commercial real estate investment. The illiquid nature of real estate often leads to asset mispricing, risky locations, foreclosures, interest rate risks etc. The current coronavirus pandemic and incessant lockdowns have led various commercial properties like hotels, offices, retails, restaurants and others to remain shut for a long time. Moreover, the crisis has caused people to migrate to other states and cities. As a result, now more than ever, investors should evaluate the risks and rewards of investing in properties that would withstand the impacts of the pandemic. Hence, commercial real estate investments amid COVID-19 requires a proper outlook of the underlying fundamentals of different asset classes and their current state.
Return to Normalcy?
With the arrival of vaccines and the gradual, yet slow return to normalcy, its time that investors evaluate how commercial real estate has changed due to the onslaughts of the pandemic. It has affected each asset class differently. Broadly speaking, it has upset the commercial properties of retail and hospitality the most. The dynamics of industrial, office and multifamily still have the potential for recovery in 2021. That being said, we believe that the market for office and hospitality is still highly unpredictable and volatile this year. Multifamily and industrial properties have the highest chances of rapid growth and higher returns and are worth capitalizing on.
The asset classes beneficial for commercial real estate investment amid COVID-19
Multifamily property types have always been in demand due to the growing population and the need for places to live. The situation seems to be unchanging in 2021 as well with commercial real estate investments amid COVID-19 continuing to prove valuable.
The pandemic has had several short-term impacts on the sector especially, low rent collections and high vacancy rates. It caused millions of people to lose their jobs due to the shutdown of the national economy. As a result, the federal Government and Government-sponsored enterprises (GSEs) such as Freddie Mac and Fannie Mae provided relief and stimulus. These included one-time payments, moratoriums on evictions etc. As a result, the National Multifamily Housing Council reports that approximately 95% of tenants have paid rent throughout the pandemic.
However, the expiration of these relief programs led to a slow-down in rent payments. According to CoStar, as of Q3 of 2020, apartment vacancy was reported at 6.8% nationally. The year-over-year rent growth shrank to 0.0%. It also reports that cap rates have remained steady at 5.6% as of the end of Q3 in 2020. Therefore, higher vacancy rates and an overall decrease in the overall multifamily apartment values can be predicted.
Another major factor for multifamily investors in 2021 will be evaluating the migration to suburban housing in the post-pandemic world. However, besides, affordability, location and spaciousness of apartments, the submarket is mispricing lease-up risk. Class B apartments have a slightly better chance of growth with economic recovery. Moreover, the Class A assets which are recently built and occupied by developers may see opportunities for growth in lease-up. There are also potential in ground-up development properties. Since these are already covered by sponsorship, these have fewer issues of entitlement and pre-development risks.
The COVID-19 crisis has forced companies to adopt work from home arrangements for their employees indefinitely. Deutsche Bank AG is considering two days of work from home. Facebook Inc. has said that half of its workforce could be remote in the next decade.
However, companies are anticipating the work locations and conditions from the office as well. While some companies are looking at combining in-office with work from home arrangements, some have relocated to the suburbs from the urban cores for a short-time. Goldman Sachs Group Inc., for instance, has scouted for offices in South Florida in a potential relocation from Wall Street. Oracle Corp. and Hewlett Packard Enterprise Co. are also moving their headquarters to Texas. As a result, the companies are executing short-term leases and also subletting their unused spaces. Therefore, it is clearly faring better for the suburban office markets due to lower density and car-dependency like in Los Angeles and Dallas. Further, larger office spaces and lesser workforce will enable the suburban offices to easily adopt the COVID protocols of physical distancing.
But, investors should weigh several factors like the viability of the unused space and tenant credit before facing risks and eventual losses. The evaluation of the factors relating to the location, office space, industry diversification, growth potential etc is necessary for investors. Hence, although unpredictable, office properties have high chances of attracting commercial real estate investments amid COVID-19.
Industrial real estate has held up significantly better than the other asset classes during the pandemic. This is because of the unprecedented spike in online shopping and the requirement for warehouse and logistics space. By Q2 2020, eCommerce penetration increased to over 15% of total retail sales from slightly above 10% in 2019. The growth in eCommerce has led to the decline of brick-and-mortar retail, and it is here to stay. Hence, commercial real estate investments amid COVID-19 for industrial properties continue to be lucrative.
Projections from real estate services firm CBRE Group Inc. suggest that the warehouses and logistics centers that have gained value for investors who are capitalizing on the properties essential to the delivery economy.
However, investors should keep in mind that slow economic recovery could weaken the demand for international and domestic goods. As a result, this would potentially disrupt the supply chain. But, the overall demand for warehouse, distribution centres and other industrial properties will accelerate with the growth of e-commerce. Further, service-oriented industrial and flex space may not perform as well as distribution centers.
Upgrading and repositioning of existing buildings as new distribution centers can attract greater investment opportunities. According to CoStar, the national vacancy rate for industrial real estate for Q3 of 2020 remained steady at 5.7%, with 3.3% year-over-year rent growth. It also reports that Cap rates averaged 6.7% for the same period, which is almost similar to the pre-pandemic leevels from Q4 of 2019. As a result, it is evident that net absorption and rent growth has been stable even in during the pandemic.
Here as well, the opportunities for ground-up development projects remain the most lucrative for the investors. The readymade availability of finance from sponsorship, limited pre-development and entitlement risks, make smaller industrial projects suitable in terms of time, cost and risk-lessness.
Risky asset classes for commercial real estate investment amid COVID-19
The retail sector is perhaps the one of the most affected real estate asset class due to the pandemic. The “retail apocalypse” is triggered by the shift from brick and mortar businesses to e-commerce. According to Nareit (National Association of Real Estate Investment Trusts) Equity Real Estate Investment Trust (REIT), the mall component index was down around 50% year-to-date. The Mall of America, with its broad variety of retail, food, entertainment, hospitality, and even office space suffered a revenue drop of 85% since the lockdown began. As a result, the owner was three months behind on its $1.4 billion loan, and it ultimately led to the closing down of the mall. The rise of ecommerce trend has also led to the closures of small businesses, due to the prolonged stay-at-home restrictions.
It is unlikely that the retail sector will recover in the first half of 2021. Investors and mall owners can reposition their retail spaces into offices and multifamily apartments to preserve cash flow. In some cases, well located properties can also be leased out or sold to source-ecommerce retailers as their last-mile distribution and fulfillment centers.
COVID-19 pandemic has sharply plummeted the hospitality sector to challenging levels. Research by McKinsey & Company shows that recovery of the hospitality sector to the pre-COVID-19 levels could take until 2023 or later. Therefore, commercial real estate investments amid COVID-19 in the hospitality sector is still quite unpredictable and challenging.
As travelling restrictions are easing, travellers are preferring brand-affiliated hotels that can accommodate safety protocols and preparedness for the virus. Therefore, costly yet trusted and renowned brands of hotel chains can see a rise in their demand. However, this also depends on the fares, location and the type of the property. Hotels with spacious rooms and touchless technology for checking-ins, food ordering and other services that ensure physical distancing will see chances of growth. Moreover, hotels with strict cleaning protocols will be quick to attract more check-ins. JLL reports, that brands like Mariott announced investing in sanitation technology, while Hiltion partnered with the maker of Lysol and Dettol for cleaning practices. However, smaller economy hotels will continue to remain stable over luxury properties and large destination resorts.
Further, regional hotels that are within drive-in distances may recover faster than their cross-country counterparts. However, corporate and business travels will be slow to rebound than leisure trips.
Decline RevPAR(revenue per available room) has also led to the foreclosure of several high-profile properties. S&P Global Ratings estimated in a November 2020 report, that RevPAR fell by 50 per cent in the US in 2020. It also reports that although there will be a growth in the revenue, it will still ve 20 to 30% lower than that of 2019. However, investors can seek to acquire these properties at high discounts. They can also invest in recently renovated hotels, which would require fewer maintenance expenses. Hence, they can easily save up on executing a repositioning strategy right from the scratch. Further, investors should also stick to mid-sized properties with high demand in the regional markets. But, it will be prudent to partner with seasoned revenue and expense managers and marketing experts to maximise their profits.
The current crisis has put commercial real estate investment operations to a halt. However, there are bright chances of recovery in 2021. The federal government stimulus, intelligent evaluations, proper risk assessment and patience will help the businesses and investors to stay afloat in 2021. With vaccines hitting the streets and easing lockdowns and travel restrictions, the commercial real estate sector will certainly reach new heights of recovery in the post-pandemic world.
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