Commercial real estate: it's always darkest before dawn

While there’s been significant disruption to commercial real estate due to the pandemic, many parts of the sector have been surprisingly resilient. Here we examine the damage, the recovery, and—most important—the opportunities.

A spring of dramatic change and uncertainty

Commercial real estate suffered during the pandemic: Hotels were shuttered, malls and retail tenants had to adapt quickly to online shopping as brick-and-mortar stores were closed, office buildings emptied as working from home went mainstream, urban apartment complexes lost occupancy as people fled to suburbia, and demand for industrial properties soared as online shopping overwhelmed shipping networks. Uncertainty soared in the early spring of 2020 as echoes of the Great Recession resonated in the media. Property owners wondered how they'd pay their debts with minimal income. Price deterioration mirroring or exceeding prior recessions seemed likely, as the economy collapsed in a manner unlike anything since the Great Depression of 1929.

But this time around, the feared real estate implosion wasn’t based on excessive building or leverage. Confidence remained, and financial institutions were willing to work with borrowers to avoid defaults and foreclosures. Consensus was that the pandemic would eventually pass; still, investors wondered how much carnage would be left behind. Thankfully, most of the worst fears don’t appear to have become reality. 

Prices fell—or did they?

Real estate prices did fall, but less than had seemed likely. Experiences have varied widely by subsector: Industrial and apartment prices remained relatively steady and have begun rising to new highs again. Hotels and retail properties were the hardest hit, with prices falling anywhere from 10% to 50%, depending on property and location. These two property types may forever be changed as travel habits shift and shoppers get more comfortable with e-commerce. The decline in retail has been occurring for years and accelerated during the pandemic.

The office sector is a tough call from here. The success of working from home was probably one of the pandemic’s biggest surprises, and noncommuting is unlikely to stop even after the pandemic is well under control. The percentage of people working from home remains to be seen. It’s likely that demand for office space may shrink in the future as companies seek to cut costly real estate expenses. 

Distressed sales have remained low in the pandemic, unlike in the global financial crisis

Chart comparing distressed real estate sales and prices in the financial crisis and the pandemic.

Source: RCA and Property Data, Ltd. Commercial Property Price Index (CPPI), Morgan Stanley, as of March 31, 2021. LHS refers to left-hand side, RHS refers to right-hand side.

The real pain was in debt, but the picture has improved

While property prices held mostly steady, debt exhibited more price volatility and typical recession patterns. Loan defaults eventually soared, primarily in hotel and retail properties, as most were forced to close or sharply curtail business. With virtually no income from hotel travelers and with retail tenants not paying rent, it was only a matter of time before loans defaulted. The commercial mortgage-backed securities (CMBS) market endured a sharp rise in delinquencies consistent with the Great Recession, and even conservative life insurance underwritten loans experienced similar deterioration. 

Delinquencies (%) spiked early in the pandemic but have been steadily falling

Chart of real-estate delinquencies at the onset of the pandemic and in subsequent periods.

Source: Mortgage Bankers Association, Trepp, Morgan Stanley, as of December 31, 2020. CMBS refers to commercial mortgage-backed securities. REO refers to real estate owned by lender after unsuccessful foreclosure auction.

While the headline default numbers seem large, the true permanent defaults may be lower as the pandemic recedes and the economy returns to life as usual. We may be able to see this in the amount of distressed loans available for sale. Given the magnitude of the hit to the economy, many would have expected the fallout in asset prices to be larger and longer lasting. This didn’t happen. Banks are better capitalized than in the last global financial crisis, and the government poured seemingly endless stimulus into the economy, sponsoring a wide range of rescue lending. The amount of distressed loans following a recession is usually high, but we’re sitting on the lowest amount of distressed sales in a decade. This wasn’t a typical recession, and banks weren’t left with poorly underwritten loans to liquidate like in the Great Recession. Real estate underwriting is far more conservative today, and billions of dollars of capital remain on the sidelines, prepared to be invested in commercial real estate. 

Substantial assets are available for securitized debt investment

Chart of "dry powder," assets available for buying securitized debt.

Source: Preqin, Morgan Stanley, as of July 24, 2020.

Where do we go from here?

Spring is here and so are the green shoots in commercial real estate. Securitized debt investors typically take a different approach to the sector than equity investors, with less emphasis on forecasting property price direction and more on debt coverage and principal protection. While larger opportunities presented themselves last year, investors are once again left navigating through a low-yield environment and searching for relative value opportunities. Areas of interest include CMBS, single-asset deals, multifamily transactions, and a variety of structured bonds with unique characteristics. Investing in structured commercial real estate provides a diversified approach to gaining exposure to many properties in multiple locations and may provide the opportunity to earn attractive risk-adjusted returns. 

Information in this document may be sourced from Real Capital Analytics. © 2021 Real Capital Analytics, Inc. All rights reserved.

A widespread health crisis such as a global pandemic could cause substantial market volatility, exchange-trading suspensions and closures, and affect portfolio performance. For example, the novel coronavirus disease (COVID-19) has resulted in significant disruptions to global business activity. The impact of a health crisis and other epidemics and pandemics that may arise in the future could affect the global economy in ways that cannot necessarily be foreseen at the present time. A health crisis may exacerbate other preexisting political, social, and economic risks. Any such impact could adversely affect the portfolio’s performance, resulting in losses to your investment.

Investing involves risks, including the potential loss of principal. Financial markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. These risks are magnified for investments made in emerging markets. Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a portfolio’s investments.

The information provided does not take into account the suitability, investment objectives, financial situation, or particular needs of any specific person. You should consider the suitability of any type of investment for your circumstances and, if necessary, seek professional advice.

This material is intended for the exclusive use of recipients in jurisdictions who are allowed to receive the material under their applicable law. The opinions expressed are those of the author(s) and are subject to change without notice. Our investment teams may hold different views and make different investment decisions. These opinions may not necessarily reflect the views of Manulife Investment Management or its affiliates. The information and/or analysis contained in this material has been compiled or arrived at from sources believed to be reliable, but Manulife Investment Management does not make any representation as to their accuracy, correctness, usefulness, or completeness and does not accept liability for any loss arising from the use of the information and/or analysis contained. The information in this material may contain projections or other forward-looking statements regarding future events, targets, management discipline, or other expectations, and is only current as of the date indicated. The information in this document, including statements concerning financial market trends, are based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. Manulife Investment Management disclaims any responsibility to update such information.

Neither Manulife Investment Management or its affiliates, nor any of their directors, officers or employees shall assume any liability or responsibility for any direct or indirect loss or damage or any other consequence of any person acting or not acting in reliance on the information contained here.  All overviews and commentary are intended to be general in nature and for current interest. While helpful, these overviews are no substitute for professional tax, investment or legal advice. Clients should seek professional advice for their particular situation. Neither Manulife, Manulife Investment Management, nor any of their affiliates or representatives is providing tax, investment or legal advice. This material was prepared solely for informational purposes, does not constitute a recommendation, professional advice, an offer or an invitation by or on behalf of Manulife Investment Management to any person to buy or sell any security or adopt any investment strategy, and is no indication of trading intent in any fund or account managed by Manulife Investment Management. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Diversification or asset allocation does not guarantee a profit or protect against the risk of loss in any market. Unless otherwise specified, all data is sourced from Manulife Investment Management. Past performance does not guarantee future results.

Manulife Investment Management

Manulife Investment Management is the global wealth and asset management segment of Manulife Financial Corporation. We draw on more than a century of financial stewardship to partner with clients across our institutional, retail, and retirement businesses globally. Our specialist approach to money management includes the highly differentiated strategies of our fixed-income, specialized equity, multi-asset solutions, and private markets teams—along with access to specialized, unaffiliated asset managers from around the world through our multimanager model.

This material has not been reviewed by, is not registered with, any securities or other regulatory authority, and may, where appropriate, be distributed by the following Manulife entities in their respective jurisdictions. Additional information about Manulife Investment Management may be found at manulifeim.com/institutional.

Australia: Hancock Natural Resource Group Australasia Pty Limited., Manulife Investment Management (Hong Kong) Limited. Brazil: Hancock Asset Management Brasil Ltda. Canada: Manulife Investment Management Limited, Manulife Investment Management Distributors Inc., Manulife Investment Management (North America) Limited, Manulife Investment Management Private Markets (Canada) Corp. China: Manulife Overseas Investment Fund Management (Shanghai) Limited Company. European Economic Area Manulife Investment Management (Ireland) Ltd. which is authorised and regulated by the Central Bank of Ireland Hong Kong: Manulife Investment Management (Hong Kong) Limited. Indonesia: PT Manulife Aset Manajemen Indonesia. Japan: Manulife Investment Management (Japan) Limited. Malaysia: Manulife Investment Management (M) Berhad  200801033087 (834424-U) Philippines: Manulife Investment Management and Trust Corporation. Singapore: Manulife Investment Management (Singapore) Pte. Ltd. (Company Registration No. 200709952G) South Korea: Manulife Investment Management (Hong Kong) Limited. Switzerland: Manulife IM (Switzerland) LLC. Taiwan: Manulife Investment Management (Taiwan) Co. Ltd. United Kingdom: Manulife Investment Management (Europe) Ltdwhich is authorised and regulated by the Financial Conduct Authority United States: John Hancock Investment Management LLC, Manulife Investment Management (US) LLC, Manulife Investment Management Private Markets (US) LLC and Hancock Natural Resource Group, Inc. Vietnam: Manulife Investment Fund Management (Vietnam) Company Limited.

 

Manulife, Manulife Investment Management, Stylized M Design, and Manulife Investment Management & Stylized M Design are trademarks of The Manufacturers Life Insurance Company and are used by it, and by its affiliates under license..

MF536843

Peter M. Farley, CFA

Peter M. Farley, CFA, 

Senior Portfolio Manager, Securitized Assets

Manulife Investment Management

Read bio
David A. Bees, CFA

David A. Bees, CFA, 

Associate Portfolio Manager, Securitized Assets

Manulife Investment Management

Read bio