U.S. commercial real estate outlook: uncertainty following COVID-19
The U.S. economy is currently experiencing a sharp downturn in both the consumer and business segments. Even though the impact of the COVID-19 pandemic was only partially felt in the first quarter of 2020, GDP fell by 4.8%¹—the second largest one-quarter decline since the 1980s, signaling a second-quarter drop-off unprecedented in its size. If there’s a silver lining, it’s that the shock hit an economy demonstrating solid fundamentals, including strong domestic demand and secure consumer confidence. The shape and timing of a recovery remain uncertain and will depend on how fast the virus can be contained, the actual impact on consumer and business confidence, and the effectiveness of accommodative monetary policy and fiscal stimulus.
Shock to consumer confidence
How great of a shock to consumer confidence and spending we can expect is one of the biggest unknowns currently hovering over the U.S. economy. The headlong pace of jobs disappearing is expected to push unemployment to levels not seen since the 1930s. As of the end of April, over 30 million Americans had filed for unemployment benefits and the unemployment rate rose to 14.7%.¹ Again, if there is good news, it’s that U.S. consumer fundamentals up until the pandemic were solid. As recently as February, unemployment was at a 50-year low of 3.5%, and last year wages rose steadily at an average rate of 3.2%.² As a group, households have been saving more in recent years and entered the crisis with relatively low debt levels. All else being equal, a continuation of low interest rates should help support consumer spending.
Weakness in manufacturing and business investment
Manufacturing and business investment had already been under pressure and the COVID-19 pandemic has only added to the investment impasse. In fact, with corporate revenues likely to take a short-term double hit from supply-side and demand-side shock, a sizable pullback in business investment for the rest of the year is highly likely.
Stimulus: 0% rates, $700 billion in quantitative easing, and $2 trillion in economic relief
To contain further economic fallout, the U.S. Federal Reserve announced a historic stimulus package on March 15: a 100 basis point (bps) cut to the federal funds rate—effectively taking it down to zero—and a new quantitative easing program worth at least $700 billion, along with forward guidance indicating no rate hikes over the next few years and a number of other measures providing liquidity to the market. In addition, the Coronavirus Aid, Relief, and Economic Security (CARES) Act provides over $2 trillion of economic relief to families and small businesses. The adequacy and effectiveness of the government stimulus remains an open question, but the package does provide some semblance of hope at a time when it’s needed.
Following the COVID-19 outbreak, market participants reacted with a capital flight to safety and a repricing across a wide range of assets. Commercial property won’t be exempt. However, with transaction flows essentially cut off, we cannot yet point to specific evidence of repricing in the private real estate sector.
It’s still unclear what the COVID-19 pandemic will mean for commercial real estate investment portfolios. It’s possible that historically high occupancy in most U.S. real estate markets will provide a buffer, absorbing some foregone demand before severe supply-and-demand imbalances can materialize. The long-term nature of commercial leases may also act as a property income shield against short- to medium-term market fluctuations. As for property valuations, many appraisers are limiting conditions and assumptions in their appraisals that specifically address the COVID-19 pandemic, which may produce even greater-than-normal uncertainty about a given asset’s intrinsic value.
All real estate sectors will be affected to some degree, with some stabilizing and recovering more quickly than others. On the one hand the multifamily and industrial sectors benefit from exceptionally strong property fundamentals and solid long-term demand drivers and might remain better protected; on the other hand, retail, hotel, and some segments of the office market could see more pronounced effects.
Demand for office space is set to shrink in the short term, as businesses adjust their office employment and business investment plans in response to the new economic conditions. While market fundamentals began to weaken in the first quarter, the full impact of the COVID-19 pandemic will no doubt become more evident as 2020 progresses. However, over the long term, the impact to demand would likely be more neutral as businesses reevaluate the density of office space in light of heightened health concerns.
Nationwide office net absorption for the first quarter of 2020 fell to 3.5 million square feet (SF), notably the lowest level since 2011. With 13.1 million SF of net new market supply arriving onstream, average national vacancies rose by 10bps quarter over quarter to 9.9%.
Office rental has been growing steadily over the past few years—average annual national office rent growth was 2.4% during the first quarter of 2020. Increased vacancies can put pressure on rents, but high-quality well-located assets are expected to remain more resilient.
Construction activity has been trending upward over the past 12 months and is currently at 160 million SF of office space, equivalent to 2.0% of the total market. New projects are highly concentrated in the tech hubs—Austin, San Jose, San Francisco, and Seattle—which are better positioned to return to growth and absorb new supply once the economy starts on the road to recovery. The ban on some construction, as well as logistics limitations, will inevitably push completion dates further out, which should also help reduce the impact of new supply.
Although not immune to the negative fallout of the COVID-19 pandemic, we believe industrial real estate is positioned to perform better than other segments during this downturn. The slowing economy will dampen short-term demand for industrial space, but current events will likely have the opposite effect on the long-term demand drivers in the sector for two reasons. First, the pace of e-commerce penetration will likely accelerate, with current social distancing requirements encouraging more online retail transactions. While this trend may only be temporary, its effects could prove longer term as consumers explore online shopping and become more comfortable making purchases online. Second, companies will likely rely more heavily on local sourcing to build buffers in supply and inventory, as current events reveal vulnerabilities in global supply chains and just-in-time delivery systems. Both of these trends would involve additional warehousing and logistics space, which could increase demand for industrial real estate in the long term.
Despite the constraints social distancing had on leasing activities during the month of March, first-quarter industrial space net absorption reached 30 million SF. With net completions of 64 million SF, average national vacancies expanded by 20bps quarter over quarter to 5.4%.
Although industrial rents maintained a relatively healthy growth rate during the first quarter, a slowdown seems inevitable, coinciding with the decelerating economy and rising market vacancies. Industrial rent growth in the first quarter of 2020 was back to Q1 2015 levels at 4.9%.
With robust demand and solid rent growth fundamentals, construction activity was, until recently, on the rise, reaching a record high of 326 million SF—equivalent to 1.9% of total market as of the first quarter.
While demand for multifamily accommodation tends to be less cyclical than other property types, sizable job losses and social distancing measures should put a check on leasing activity in the short term.
Reduced demand was already evident in the first quarter, and with net absorption of 65,000 units—well below net new supply of 108,000 units—the average vacancy rate increased by 20bps to 6.6%.
The federal government’s relief package includes direct payments to low-income households, which should help cushion the impact on multifamily rental income. Multifamily rental also benefits from several secular demand drivers that can help reduce occupancy volatility—an overall shortage of housing options,⁴ ownership affordability challenges, and demographic trends, such as increases in both the median age of marriage and the number of single-person households.
Even though multifamily rental rates have been rising steadily over the past few years, escalating vacancies have begun to put pressure on rents. The annual growth rate for multifamily rental stood at 1.7% as of the first quarter of 2020, the least impressive since 2012.
Although construction activities have slowed over the past year, they remain near historic highs. As of the first quarter, there were 612,000 units under construction, which is equivalent to 3.6% of existing stock. Given dampened demand, some of the new projects could face longer lease-up periods.
1 U.S. Bureau of economic analysis, as of April 29, 2020. 2 Federal Reserve Bank of New York, as of January 2020. 3 All market fundamental statistics, including vacancy, absorption, completion, under construction, and rent growth, are sourced from CoStar, as of Q1 2020. All capital market statistics, including transaction volumes, cap rates and price index, are sourced from Real Capital Analytics, as of Q1 2020. 4 “The state of the nation’s housing,” Joint Center for Housing Studies of Harvard University, 2019.
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