Thinking back to this time last year, there was some concern about how much longer the decade-long economic expansion could continue, but recessionary red flags were few and far between. Yes, the yield curve did turn negative briefly in 2019 and there were some signs of weakening in the manufacturing sector, but the labor market was incredibly strong and capital was flowing into public and private markets alike. In the final months of 2019, most economists and market participants were anticipating some volatility in 2020 to be driven by the ongoing US-China trade talks and the 2020 presidential election – but almost none were anticipating the year to be one of major disruption and certainly not a time for a black swan event like the global pandemic that did take place.
In this article we are going to take a quick look back at the past year – the major trends and events that shaped the US economy and commercial property markets.
The year in review
The virus known as SARS-CoV-2 and cause of COVID-19 made landfall in the US in January. It was only a matter of weeks before a public health emergency had been declared, travel restrictions were put in place, and markets began selling off, panicked by the implications of a pandemic. The US economic, health, and social systems were shocked like never before. Rapid speed and significant magnitude were two key themes in terms of both the initial shock of the pandemic and corresponding response by government authorities and market participants.
The highly contagious virus and dangerous disease seemed to be the perfect enemy, particularly for the US in 2020. The social, economic, and political environment of the US in 2020 certainly did not help to mitigate the devastating blow that the virus dealt. At a time when our international profile was connected economically, but largely decoupling politically (i.e., backing out of new and renegotiating existing policy agreements) and our domestic situation was one of a booming economy (both sharing/gig and traditional), building social tensions, and increasingly ideological politics – the addition of COVID-19 was catastrophic.
1Q2020: (Shock) Wait… what did you think was going to happen?
In retrospect, the first quarter of 2020 started off with relatively little excitement and ended in panic. During this quarter, the country painfully learned firsthand what COVID-19 was and the total disruption that it would bring. Healthcare systems were brought to near breaking points, people and governments mad-dashed for protective equipment and supplies, employers and educators abruptly shifted to remote models, and calendars were wiped clean by cancellations of nearly all travel and events for 2020. Even though these events felt highly personal, they were shared by millions in the first quarter.
Despite the US government’s pandemic relief and emergency response being multiple times larger than the entire response to the Global Financial Crisis (GFC) and approved in a fraction of the time – the US economy suffered a near complete economic shutdown. Overall mobility at the end of March was down to levels not seen since the days following September 11th terrorist attacks.
With the rapid change of events and tone for the year, it is no wonder that investor expectations and economic projections sharply soured as the macroeconomic fundamentals weakened and uncertainty obscured the forward path. This was true for both the public as well as private markets.
Starting off strong, but ending on a weak note, this same theme was emblematic of the commercial property markets. While commercial property market activity did not drop off completely through the end of March, and many deals continued to close, there were increased delays and cancellations, and very few new deals being lined for the second quarter. Lenders began to tighten underwriting standards and began to slow down overall origination volume – particularly to new sponsors / borrowers and hard hit property types (hospitality and retail). Perceived risk increased at the end of the first quarter as property owners, lenders, and investors were more uncertain about the overall impact to commercial property performance and valuations.
Transaction activity for commercial property, gradually slowed through March, before falling significantly in April and beyond. With transaction volume down and tighter underwriting, it is no wonder that the mortgage data shows a similar drop-off after the first quarter for new mortgages originated to finance purchase transactions. Lenders were generally more focused on serving existing borrowers with good credit risk and history. This preference for existing/higher-quality sponsors, coupled with falling rates meant that refinancing activity was decently protected from the pandemic, and began to play a proportionally larger role in the aggregate commercial property debt data.
2Q2020: (Awe) Distorted data and the not-so-predictable bounce back
The second quarter macroeconomic recap can largely be characterized by distorted data and disagreements over what the recovery might look like.
Shutdowns, quarantines, and rapidly changing business plans across the country were highly distortive to the descriptive and regularly referenced macroeconomic data – including unemployment, GDP, home sales, broad stock market, etc. Much of the data reported in the second quarter were so dramatically different that it made for difficult historical comparisons. The times really did seem unprecedented by many measures.
Unemployment spiked, trillions of dollars of emergency government relief was allocated, markets collapsed, and it seemed as though the world would never be the same again. And yet, most knew that the pandemic was temporary. However, what was debatable was when the recovery might start and what it might look like. During the second quarter, economists, analysts, and market commentators all seemed to differ on what letter or shape the recovery would look like (i.e., V, W, U, L, K, square root, swoosh).
During the second quarter, commercial property attention largely turned to focus on signs of distress, as CMBS delinquency and special servicing rates climbed and the number of criticized CRE loans at bank lenders begins to get attention from investors and analysts. Even though most of the early signs of distress appeared to be isolated in retail and hospitality properties, almost all property types experienced a dramatic decline in the transactions during the second quarter. And as a result there was very little price discovery during this time period.
While overall commercial property transaction activity dramatically slows, it doesn’t stop fully. And like so many other trends during the pandemic, the second quarter was a time of acceleration. Many of the commercial property investment narratives that were in vogue in 2019 got more attention and a boost from the pandemic behavioral changes and really came to the surface in the second quarter – such as ecommerce’s dominance over the retail landscape, the increasingly popular use of remote work, and the relocation of many coastal millennials to cheaper cost-of-living cities in the South and West.
3Q2020: (Refocus) Resetting near- and long-term expectations
Heading into the third quarter, counts of new cases and related deaths were climbing across the country. Unlike the first wave of infections which largely hit the Northeast and West Coast, this wave of infections was completely national.
On the macroeconomic data front, the data generally slowly started to normalize, as new ex post pandemic trends emerged. While the third quarter was generally a time period of improving data, there were still persistent pockets of weakness. In terms of economic data, many of the improvements made during the third quarter can be thought of as “qualified improvements” – this is data which showed an improvement over the second quarter, but was still well off from the prior year and any recent historical trend.
It was clear by the third quarter that the US clearly did not have a good handle on controlling the virus through behavioral changes as some countries had, and as a result, the virus was not going away soon. Despite the continued health crisis, market focus seemed to shift away from COVID-19 during the third quarter and look towards a post-pandemic world. Both near-term and long-term expectations were reset during the third quarter and risk appetite returned to the markets in a big way.
Seemingly with the collective mentality “we’ve made it past the worst and are still standing” the debt and equity markets roared back to life in 3Q2020. The broad stock market not only regained all lost ground from the pandemic crisis but posted new highs in the third quarter and saw a resurgence in IPOs. The corporate debt markets also clocked all-time record levels of issuance – as many companies took advantage of the ultra-low rate environment for lowering their financing costs. And even private label CMBS issuance came back in a significant way, despite still trailing the agency issuance which was on pace to surpass 2019 levels.
During this quarter, the market was still reacting to big COVID-related news, but was largely looking past health crisis. Positive progress on a vaccine was tangible, but still in the development stage. A second round of stimulus had been proposed, but nothing agreed to. Additionally, the presidential election was ramping up, and so garnered greater attention.
Expectations within the commercial property markets in the third quarter, also seemed to be looking past COVID, as market activity resumed, albeit at a subdued level. The initial shock from the pandemic in the first quarter put nearly 60% of transactions on hold – and contributed to the cancellation of over 15%. However, as expectations began to change, more transactions got completed. By the end of the third quarter the majority of CRE transactions were back on schedule – even if there were overall fewer of them.
Despite the broad market sentiment turning positive on hopes for greater stimulus, many of the commercial property narratives from this quarter seemed to be quite negative. These negative narratives also seemed to extrapolate some of the pandemic trends into the future in an extreme way. In some cases, the shift in expectations seemed to treat COVID-19 as a game changer. Examples of these extrapolations seemed to include:
- Remote work will become the permanent feature for many employers and will significantly contribute to office obsolescence
- Consumer trends will continue to shift online, until brick-and-mortar retail is nothing more than a past memory
- Hotels are largely outdated and if they survive the current crisis and will face more challenges from alternative hospitality options such as Airbnb
- Renters are moving out of high-cost major cities and flocking to lower cost of living markets and buying single family homes if they can
These negative narratives are largely hyperbolic but seemed to be key explanations for differences in performance across property types in the quarter – as industrial outperformed multifamily and office, and hospitality and retail underperformed significantly. The niche pandemic-themed property types were noticeably in demand, including refrigerated storage, self-storage, and data centers. Select service hotels outperformed full-service hotels. Additionally, medium and smaller markets outperformed the largest markets.
4Q2020: (Recover) Vaccine progress fuels (rocky) recovery
The last quarter of the year certainly was no let-down in terms of major exciting events. Apart from a highly contested presidential race, the final quarter of 2020 also saw significant advances in the COVID-19 vaccine, large-scale social unrest and multiple natural disasters (wildfires and hurricanes).
Despite all the drama in preceding quarters, the capital markets seemed set to end the year on a high note. During the fourth quarter, the broad equity markets rebounded fully (and then some) and saw a resurgence of IPO activity and mega-mergers. Unfortunately, though, the last quarter of 2020 didn’t look to have such a strong broad-based rebound for commercial property markets.
Financing and transaction activity have largely returned to certain property types and markets, while others remain slow to rebound. Many of the trends seen in the third quarter continued in the fourth, in terms of property and geographical performance.
It was clear in the fourth quarter that the commercial property market recovery was going to be an uneven one. Delinquency rates continued to fall through the quarter, but lenders and investors remained risk-oriented and generally cautious. Debt and equity financing was concentrated in a handful of property types and geographies.
One of the key reasons for the slower bounce back for many commercial property markets is because of the greater amount of uncertainty with regards to cash flow certainty and timing across different property types and markets. For property types with more certain and predictable cash flows during the pandemic (e.g., industrial, self-storage, multifamily) – pricing in the fourth quarter largely was in line with pre-pandemic in terms of spreads and all-in rates and transaction activity picking up momentum. Meanwhile, for those property types with more disrupted pandemic cash flows (e.g., hospitality and retail), the pricing on financing remained elevated and transaction volume subdued.
The hunt for yield, demand for inflation protected / hedged assets, and increased significance of non-bank players will likely play out in the year ahead and benefit commercial property markets; however, the fallout from the pandemic is not over. While a lot of pain has been felt in commercial property markets already, the distressed opportunities that so many funds raised for earlier in 2020 are likely to surface in the coming quarters. This combination of pockets of tightly priced performing assets and growing markets, along with a significant amount of under- or non-performing properties and weakening markets, was seen in the last quarter of 2020 and will likely continue through 2021.
Comparisons between 2020 and the 2008-09 crisis, might be tempting to make, but should be done so very carefully. Even though many of the 2020 period-to-period changes in terms of market activity seem in line with levels seen during the GFC, the root cause of these crises and specifically the role that commercial property played in each, differed dramatically. Unlike the GFC, the 2020 crisis was not triggered by a decline in property prices and did not lead to a banking crisis. The financial system was significantly shocked in both crises, but as a result of lessons learned from the GFC, was more prepared for the 2020 crisis in terms of overall infrastructure and response. Given these major differences, one should expect the recoveries from these two crises to also differ. While many of the headwinds facing commercial property coming out of the GFC were supply-side oriented (i.e., too much construction, too little financing), the headwinds facing commercial property coming out of the COVID crisis look to be mostly on the demand-side (i.e., change in use of properties, migration to different markets).