Virus-Induced Recession: What’s in store for commercial property values?

Key Takeaways

• The speed and scale of this global shutdown and the response to counter and control it have not been seen before, leaving only speculation about the magnitude and duration of the change ahead.
• For US commercial property, the market uncertainty is a composite of a first-strike, fast-moving liquidity crisis and an industry-sculpting solvency fallout.
• The first piece of the crisis (liquidity crunch) significantly increases tenant risk (demand side). The second part of the crisis, the potential solvency aftermath, also poses a potential negative impact for commercial property values.
• Virus-related uncertainty clouds future expectations and may contribute to structural changes within both hospitality and retail – in some cases speeding up change that was already happening and in other cases introducing change that was given little pre-crisis consideration.

Every part of the US economy will be altered by COVID-19. Commercial property is no exception. Coordinated efforts to contain the spread of the COVID-19 have abruptly halted much of the global economy.

While the social, political, and economic impacts remain unknown, a theme has emerged for the current crisis: bigger and faster. This theme captures what we are seeing unfold day by day, week by week. The speed and scale of this global shutdown and the response to counter and control it have not been seen before, leaving only speculation about the magnitude and duration of the change ahead.

For US commercial property, the market uncertainty is a composite of a first-strike, fast-moving liquidity crisis and an industry-sculpting solvency fallout.

Fast-moving liquidity crunch

First, the halt in consumer discretionary spending has led many businesses to tap and burn through any cash reserves they had built up before. Because many “rainy day funds” were not large enough to last a rainy quarter or more, management teams around the country were forced to make dire and difficult strategic decisions – such as massive layoffs. At the end of the first quarter, less than three months since the first case of COVID-19 was identified in the US, the record-long run of job growth was ended by a record high rate of unemployment claims. Many economists and analysts fear that this is only the start and that unemployment may climb as high as 20 percent.

(Source: Department of Labor)

Insolvency fallout

The second part of the economic crisis is the feared defaults and bankruptcies that will occur if companies cannot stop the bleeding caused by the immediate negative impact of decreased consumer and client demand. Even companies that survive the initial liquidity crisis impact might be in a precarious position if the overall consumer or buyer demand for their product and services declines. If companies are no longer able to make their debt payments or secure needed additional financing, then they may be forced to close.

What does all of this mean for commercial property?

For commercial property markets the first piece of the crisis (liquidity crunch) significantly increases tenant risk (demand side). With companies and renters at risk of losing their revenues and income, respectively, property owners are at risk of being unable to collect rent. This interruption in expected cash flow will undoubtedly hurt property performance, decrease valuations (even if never realized), and perhaps increase legal or other costs.

The second part of the crisis, the solvency aftermath, also poses a potential negative impact for commercial property. However, rather than increased risk on the demand side, the potential result from this phase of the COVID-19 economic fallout is an outsized increase of supply. The potential valuation decrease would be driven by an influx of available space to be filled by fewer high quality, financially secure tenants. Additionally, as companies become insolvent, the price discovery that would result from distressed scenario sales may contribute to lower overall valuations.

Even though all property types will likely be affected, some are in better position than others, as we’ll discuss in the next section.

How do different property types stand to weather the crisis?

According to 50 years and seven recessions of Reonomy data, the historical average price decline of US commercial properties is 22 percent, but has varied across property types. As concerns of a potential recession in the US materialize, different property types appear to be better positioned to weather the storm ahead:

What are the potential paths forward?

While there is still so much unknown about the virus and COVID-19, the measurable impact so far has been clearly negative (spike in unemployment, weakened financial positions across industries, greater uncertainty around economic / social / political fragilities, etc.). I believe in the creative genius of groups and believe that a solution will be found, however the timing and permanence of the solution are unclear. Given that the seasonality and duration of the immunity are two of those unknowns, experts have outlined three potential paths forward:

1. All nations are able to simultaneously contain the virus
2. “Herd immunity” is achieved, but only after the virus has run rampant through the global population
3. The virus disappears and reemerges, similarly to the seasonal flu

Each of these potential future paths carries with it economic consequences. It is because of this potential for long-lasting economic change, that this crisis and the following recession will likely be more onerous and severe on the hospitality and retail property types than the average historical recession experience. Perhaps these property types most severe recession experiences are better guides – 1973 recession led to a 50% decline in hospitality prices and the 2008 recession led to a 39% decline in retail prices. This uncertain future will likely contribute to structural changes within many of the specific property types – in some cases speeding up change that was already happening (i.e., retail’s deleveraging and reduction of physical footprint), in other cases introducing change that was given little consideration before (i.e., consolidation in hospitality and lodging, or reduced office space use by industries proven to still be effective during social-distancing).