Quarantine at a Cost: COVID-19’s Potential Impact on Commercial Property Markets

Key Takeaways:

• While the magnitude of COVID-19’s economic impact is still speculative, the directional impact is undoubtedly negative. Estimating the impact of COVID-19 on private commercial property markets is a two-part challenge that requires estimating the near-term impact from the virus and virus-related containment efforts, and then estimating the longer-term impact from any economic fallout that follows.
• Supply chain disruptions, travel bans, and social distancing pose threats to owner-occupiers and tenants of commercial property. While a pause in dealmaking and potential temporary credit freeze pose a threat to financing and future dealflow. Recent declines in public valuations suggest that private valuations will also take a hit.
• Over the next year, COVID-19 will lead to a 7% decline (19% in severe scenario) in the number of transactions and a 16% decline (32% in severe scenario) in total dollar volume transacted, when compared with 2019 numbers. The COVID-19 impact will push commercial property transaction activity back to levels not seen since 2015 for transaction count and 2012 for transaction volume. These estimates suggest that COVID-19 will cost the commercial property market 25 thousand transactions and $100 billion in deal volume.

What has happened?

Economic outlooks for 2020 were positive at the end of 2019, however, that has changed and economists now expect the first half of 2020 to mark the end of the longest economic expansion on record.

In late January, the World Health Organization (WHO) declared the novel coronavirus (COVID-19) a global health emergency. In February, as new cases of COVID-19 surged and the list of affected countries grew, the news reported drastic government reactions and global financial markets fell. In March, the WHO declared the outbreak a pandemic, central banks implemented crisis policies and programs, and markets continued to tumble.

While the magnitude of COVID-19’s economic impact is still speculative, the directional impact is undoubtedly negative. The severity of the impact is largely uncertain because the required length of and overall effectiveness of the initial response by governments, businesses, and consumers to contain the virus is unknown.

Initially, the economic impact was thought to be a supply shock driven by a temporary disruption in global supply chains. When COVID-19 made landfall in the US, the anticipated economic impact darkened, as expectations became concerned with both a supply shock and a demand shock driven by reduced consumer and business activity. Concerns have been raised over the potential longer-term implications the abrupt halt of business activity might have on local and national economies.

Estimating the impact of COVID-19 on private commercial property markets is a two-part challenge that requires estimating the near-term impact from the virus and virus-related containment efforts, and then estimating the longer-term impact from any economic fallout that follows.

Near-term impacts

The situation continues to develop and the economic environment remains fluid, but some trends are starting to emerge that will have implications for the commercial property markets.

• Supply chains: The virus-related economic halt has severely impacted companies with Asian supply chains, particularly Industrials and Consumer Discretionary. Despite not being able to fully measure the impact yet, more companies have issued downward earnings guidance than those who have held guidance the same or positive. In the near-term, weaker company financial performance may translate into financially weaker tenants, potentially more turnover, and lower near-term rent growth.
• Travel bans: As governments put in place travel restrictions in an attempt to curb the spread of COVID-19, hotels and lodging property owners suffered. Some of the largest hotel companies have been forced to furlough large portions of their staff and close hotels altogether. Decreased travel will likely reduce occupancy at hotels, which will reduce the revenue per available room (RevPAR), and decrease hotel valuations.
• Social distancing: As the pain from the travel restrictions have fallen disproportionately on hotels, the social distancing containment practices have hit brick-and-mortar retail properties. National anchor tenants and inline tenants retailers continue to announce store closings, in line with the guidance from government health agencies. The temporary store closings come at a time when many retailers are already struggling. If these companies did not have sufficient cash cushion to weather the storm, they will likely have to close shop, which would mean a surge of retail space and properties coming to the market as part of the COVID-19 fallout.
  • Bigger problems for smaller businesses: Homebase, which provides solutions to small businesses with hourly workers, released data that show hours worked by employees in retail were down over 31% from January. The same data show that the total hours worked by restaurant employees dropped by 55% in mid-March. Many small businesses with only physical presence and no established online channel will likely struggle the most.
• Rising unemployment: The recent surge in unemployment filings has been alarming and caused many economists to raise concern over a rapid rise in the unemployment rate. A continued rise in unemployment may lead to a longer-term decrease in consumer spending (potentially another hit to retail and hospitality properties) and slowed rent growth in areas most affected (hit to multifamily properties).
• Temporary freeze: Given the rapid change in climate and challenges that come with a near shutdown of many aspects of the economy, many would-be commercial property transactions are being put on pause. While the future is uncertain, the current environment does not encourage lenders or risk managers to immediately take added risk.
• Public valuation hit: Investor uncertainty and decreased earning prospects were factored into publicly-traded real estate investment trusts (REITs) trading in March. As of March 20, year to date performance of US REITs trailed the S&P 500 (-35% vs -28%):
  • Lodging / Resorts: -62%
  • Retail: -50%
  • Health Care: -46%
  • Office: -35%
  • Residential: -29%
  • Industrial: -24%
  • Self Storage: -16%

Implied declines in 2020 commercial property transaction activity

Despite the difficulty of incorporating the unknown in their estimates and projections, analysts and economists have begun to reissue their forecasts adjusted for COVID-19. Wall Street has revised estimates of gross domestic product (GDP) for 2020 down from the 2% year-on-year growth to a range of -0.5% to -3.8% (average -1.4% full year). The revised estimates generally show a slight contraction (average -2% quarter-on-quarter) in the first quarter of 2020, and a more severe contraction in the second quarter (average -13% quarter-on-quarter).

Using the relationship between quarterly nominal GDP and two metrics of commercial property market activity (transaction count and transaction dollar volume), the impact to the commercial property market can be derived from these revised forecasts. Over the next year, COVID-19 will lead to a 7% decline (19% in severe scenario) in the number of transactions and a 16% decline (32% in severe scenario) in total dollar volume transacted, when compared with 2019 numbers.

Following a similar pattern as expected for GDP, the second quarter of the year is expected to be more negative than the first quarter. During the first half of 2020, the number of transactions in the first quarter is expected to fall by 13% year-on-year and then decline again in the second quarter another 20%. Total transaction volume for commercial property in the first half of 2020 is expected to fall by 20% year-on-year in the first quarter and then decline again in the second quarter by 25% year-on-year. These estimates suggest that COVID-19 will cost the commercial property market 25 thousand transactions and $100 billion in deal volume.

Looking at these declines another way, the COVID-19 impact will push commercial property transaction activity back to levels not seen since 2015 for transaction count and 2012 for transaction volume.

While these estimates are at the national level, the story will likely differ greatly at the local level. Metropolitan statistical areas (MSAs) with higher exposure to the travel industry (such as Hawaii, Las Vegas, and Orlando) will likely see more severe contractions in market activity. As well as those MSAs with stricter social distancing and containment policies (such as San Francisco and New York). Finally, MSAs with already weak or weakening economies would likely also see more severe declines in market activity in 2020 (for example, MSAs which have above average exposure to energy-production and were negatively impacted by the coincidental oil price shock).

Expect revisions

The drastic actions taken to date have been put in place with the intention of saving lives and containing the virus outbreak. However, these actions come at an economic cost. While neither the depth nor the duration of the crisis at hand is currently clear, the coordinated actions of governments, businesses, and consumers suggest that society as a whole is willing to pay these economic costs. However, as the situation evolves from day to day, one should expect to see revisions to initial estimates and changes in attitudes.