In mid-March, we reported expectations for real assets to experience a relatively muted response to the COVID-19 crisis compared to stocks and bonds. That expectation has not changed over the last few weeks. The relative illiquidity of real assets, infrequent appraisal pricing, long-duration leases, modest new construction in lease-up, and generally moderate debt burdens are together slowing the response of real assets to economic and financial market turmoil. For example, during February, US commercial property values increased 0.6% according to Real Capital Analytics.1 By the end of March, some weakening was noted per the -0.5% appreciation component of NCREIF ODCE funds which are open-end core property vehicles.2 This contrasts with the 120%+ blow-up in B-quality corporate bond spreads and the 20% drop in the S&P 500 stock index during February and March.3,4 The still positive price performance of US real estate in an environment of mounting financial market volatility reinforced the notion that property investments are slow to respond to financial markets distress.
Economy swooning, property revenues at risk
While real estate investors are sitting tight so far, the economic consequences of the virus are accelerating and impacting property assets. In the US, "stay at home" orders are in force for the majority of states with non-essential businesses temporarily shuttered. The freeze on public gatherings, on top of cratering energy prices clobbering energy metros, are devastating the economy as shown in the 16+ million unemployment insurance claims over the three weeks ending April 4.5 This is in addition to the 701,000 decline in jobs shown in the regular monthly employment survey which was conducted during the March 12 pay period.6 Anticipating the deepening in the slump, consumer confidence has dropped as of March 19, according to the Conference Board, especially the short-term expectations component.7 During the last week of March, the NPD Consulting Group calculated a 28% drop in general merchandize sales and a 42% drop in restaurant sales versus the same week in 2019.8
The Federal Reserve (Fed) is attacking the deepening recession with all policy guns blazing. The federal funds rate is zero, liquidity is pouring into the marketplace; quantitative easing purchases of securities is underway now to include high quality CMBS; lending to states and localities is starting and banks are encouraged to lend. Fiscal policy is gearing up as well with a US$2 trillion federal aid package, CARES Act, signed March 27 to provide some income replacement for individuals and easy credit for small and medium-size businesses. The first payments to individuals were direct deposited on April 10. It also includes a 120-day moratorium on evictions for properties with federally-insured mortgages and a 60-day moratorium on foreclosures. Some states are banning apartment evictions for those affected by the virus with landlords tasked with validating the virus as responsible for inability to pay rent. California's protection is through the end of May.9
While policymakers are pushing against recessionary forces, signs of distress in the real estate sector are becoming evident. Apartment rent delinquencies popped in April. According to the National Multi-Housing Council; 31% of rents due April 1 were unpaid as of April 5 versus 18% for the same period last year.10 Delinquencies are said to be concentrated in the C-quality segment of the apartment market where tenants are more likely to be losing income. Retailers are similarly delinquent as revenue has taken a hit and subsequent illiquidity is setting in after the extended stay at home orders take hold of local economies. Reflecting homeowner woes, the Mortgage Bankers Association reports a surge in mortgages seeking forbearance from 0.26% to 2.66% between March 2 and April 1.11 In addition, CMBS issuance is now on hold as spread pricing exploded in mid-March. At the same time, we are observing that some office and industrial tenants are seeking concessions from landlords.
These indicators offer only hints of the impact of COVID-19 on real estate. Ultimately, the impact will be manifest on net operating income (NOI) performance, occupancy, rent levels, rent payment behavior, transactions and cap rates. These performance elements typically lag the macro-economy and reporting hard data lags further. So far, we know that hotels, entertainment, and retail space are under the most stress because these businesses have lost most or all of their revenue flows. Risks associated with other property types depend on tenants' ability and willingness to pay rent and borrowers' ability and willingness to keep up mortgage payments. Ability to pay will depend on the depth and duration of the recession and how it affects various businesses and apartment renters. Willingness to pay is quite a different matter reflecting a "moral hazard" that may prompt tenants to seek rent relief and property owners to seek mortgage relief given that evictions and foreclosures are unlikely.
Wishing for a "V", expecting a "U", fearing an "L"
The virus itself will determine the depth and duration of the global recession. Economists are expecting or perhaps hoping that the virus will be contained after an average lock-down of 3.3 months as reported in the Blue Chip Economic Survey released April 10, which polled 45 economic forecasters, whose range of forecasts were wide. Timing aligns with economic re-opening in June and an assumed return of positive GDP growth in the third quarter. For 2020 as a whole, real GDP is projected to contract 4.1% followed by positive 3.8% growth in 2021. This is essentially a V-shaped path. The most pessimistic ten forecasters surveyed are projecting a negative 7.4% GDP outcome for 2020 and a weak 1.5% rebound in 2021 which would be a U-shaped outcome. The most optimistic of those surveyed expect a negative 1.1% in 2020 and a strong 6.4% rebound in 2021, a super V-shaped path.12
If the virus does not allow economic re-booting in June and a fast return of economic activity, a U-shaped outcome is more plausible. As of mid-April, signs of peaking in US new virus cases, hospitalizations, and deaths are appearing and stoking hope of economic re-opening sooner rather than later. Some countries are already cautiously returning to work. However, the pre-requisites for re-opening are not uniformly in place across the US; which includes abundant availability of testing and ability of public health officials to quickly identify new cases, track contacts and impose quarantines. Geographical disparities in preparedness imply risk of new waves of virus contagion as re-opening is attempted. Extensive new contagion and rolling return of lockups would prolong economic weakness and result in an L-shape path rather than a U-shaped one.
The economic path ahead will also be affected by behavioral changes associated with the experiences of consumers and businesses over the last few months. While so many questions remain unanswered, this unprecedented time may certainly leave its mark. Will consumers return to spending behavior of the past or adopt more frugal behavior? How quickly will businesses reopen, how quickly will workers be recalled, and how many businesses have been crushed out of existence? Will behavior remain subdued until effective virus treatments and ultimately a vaccine are widely available? Finally, how will lessons learned play out particularly in the US. Will more resources be devoted to public health; will universal health insurance be implemented; will higher value and higher wages be allocated to those essential workers who are at risk as they do their jobs? These are the uncertainties that we are assessing now as we prepare for after-the-virus.
The global real estate sector is facing all these uncertainties while hoping for a return to pre-crisis "normal". Perhaps "normal" will need to be redefined.
1Real Capital Analytics. March 28, 2019.
2National Council of Real Estate Fiduciaries. March 31, 2020.
3Bloomberg Barclays. April 13, 2020.
4S&P Dow Jones. March 31, 2020.
5Department of Labor. April 9, 2020.
6Bureau of Labor Statistics. April 3, 2020.
7The Conference Board. March 31, 2020.
8NPD Consulting Group. March 29, 2020.
9State of California Press Release, "Governor Newsom Take Executive Action to Establish a Statewide Moratorium on Evictions," March 27, 2020.
10The National Multi-Housing Council. April 8, 2020.
11Mortgage Bankers Association. April 7, 2020.
12Blue Chip Economic Survey. April 10, 2020.
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