The commercial real estate industry has been increasingly climactic by a triggering event, known worldwide as the COVID-19 crisis. This article is a follow up to a previous post. Nearly all deals have scrapped or put on hold. The Federal Reserve has made an emergency cut to interest rates, slashing the federal funds rate by 1 percent to a range of 0-0.25 percent. Cheaper rates encourage more money to get into the economy, inducing businesses to invest, and consumers to spend and borrow by lowering their capital costs. Federal backing is predicated on the belief that lenders are still active – many of which are not. There is still some speculation around what the future holds. There are many macroeconomic factors that companies need to be attuned to. Activity will largely depend on the property type and geography.
Here’s a look at what we’re seeing in the debt and liquidity markets as of today.
Where are the capital markets today?
The commercial real estate capital markets have basically ‘pumped-the-brakes’ on deals so-to-speak, for the time being. The sales that have been funded and closed were in underwriting for weeks (or months) before the coronavirus crisis. Transactions that are looking for capital sponsors during these times are in much higher flux.
One of the hurdles is ascertaining property value. The scarcity of M&A and deal activity due to COVID-19 has made it challenging to access the cost of a property. These are the valuation anxieties of COVID-19. Given the ambivalence concerning the span and severity of COVID-19 and its related economic impacts, it is likely that sponsors will need to employ even more careful reflections and wisdom as they work through impairment assessments on assets. Absent transaction value, most capital will stay on the back burner and defer until the time is right.
We see this taking shape in both the debt and equity markets.
Equity capital is almost entirely not involved right now. Those with dry powder are pausing to see how this crisis unwinds before initiating any moves. It might be three to six months or more before equity capital ramps up again.
Debt capital is also refraining from critical decisions with a few anomalies. Life insurance companies, major banks, and CMBS lenders are the most nervous right now. The added risk is being baked into deals and causing spreads to rise slightly (50+ basis points). Nevertheless, there is still debt to be had to some degree but depends on the product type and location.
Liquidity by Product Type
Here’s a glance at how liquidity has been affected by each of the major product types:
Hospitality: Hospitality is grappling more than any other segment right now. Travel, for all intents and purposes – domestic and international comparatively – has practically stopped. Many hotels are operating approximately at a 10% occupancy rate, assuming they haven’t shuttered their doors altogether as we speak. It could take twelve months or more for hospitality to pick back up again due to reductions occupancy due to phase-in seating, and as a result, we’ve seen liquidity for hospitality deals erode entirely. Nobody is lending or putting equity into the service industry right now (or for the foreseeable future). This is an active topic, and a survival guide can be found here.
Retail: Retail is muddling through at levels close to the hospitality industry’s plight, but with a few incongruities. Properties anchored by a grocery store, pharmacy, hardware store or an essential big-box retailer are still performing and, as a result, may be able to access capital. Otherwise, retail has been clobbered. Movie theaters, clubs, bars, and other non-essential retail anchors at malls have gone dark for an extended period and are beginning to reopen. Retail was already struggling before the COVID-19 crisis. Capital for retail deals will be tough to come by moving forward. This is an active live topic, and refreshed information can be found here.
Office: We do not see any despair in the office sector just yet. Office tenants typically sign longer-term leases (e.g., 7-10 years or more), so most are not seeking capital right now. Those who need money are still able to find it; although not fungible, there is capital available in the office sector, just not much. The elephant in the room is the long-term impact this crisis has on the office market: will tenants sign lease renewals? Will they invest in costly fit-out jobs with ‘sneeze-guards’ and reconfigured workspaces more suitable to counter interoffice COVID-19 spread? Or will more people start working remotely? Or will folks be reluctant to come back to work over COVID-19 transmission fears? The future of the office will determine the availability of capital for these deals moving forward.
Industrial: There’s a healthy appetite for industrial right now, driven in large part by Amazon, Walmart Delivery, and other distribution facilities that have had to ramp up activity to satisfy consumer interest as more folks shop from the comforts of their own homes. Both debt and equity continue to be available for industrial, especially for logistics and last-mile distribution centers.
Multifamily: Multifamily is unparalleled in that Fannie Mae and Freddie Mac, the two government-sponsored entities (GSEs), are still contributing tremendous liquidity for the sector. Unlike other product types, when there’s a downturn in the economy, the GSEs are typically mandated to draw more capital into this sector. As a consequence, the availability of resources (debt and equity) for multifamily remains stable. Beyond the GSEs, private equity remains attracted to multifamily given the durability of the underlying economy and the reality that people will perpetually require someplace to live, despite the duration of this public health emergency.
Interpreting the Relationship Between Equity Market and Debt Market
There’s a comparatively weak correlation between the equity market and the debt market. In the equity market, stocks, futures, bonds, and other securities can be traded online with a few clicks and a tap. When coronavirus first appeared as a crisis pandemic, equity investors moved quickly to sell. The stock market whipsawed some but has since started to improve.
The debt market adjusts much more slowly and usually linger behind the equity markets by a few quarters. Commercial real estate cannot be traded so hastily or efficiently; there’s a long lead time before we’ll start to see an adjustment or realignment in either pricing or transaction volume. Most CRE investors seem to be confident about the long-term health of the CRE sector, given the power and nature of the economy, although not readily apparent.
As such, we don’t envision seeing the panic selling that we’ve seen in the equity market. Worst case, now that the equity market has started to improve (and recover faster than anyone foresaw), we expect this will give a lift of spirit to the debt market. People regularly seem confident that the market will recover in 12-18 months since being put on hold, strictly due to public health challenges. Beyond that, investors will continue to invest and/or hold onto property selectively. We aren’t anticipating seeing the identical superabundance of distressed real estate or collateralized paper that we saw throughout the last recession, which was a staggering and painful 43-months in duration, including 18-months of official recession and the years for the economy to recover to pre-crisis levels of employment and output.
Conclusion
The above is a flash of what we’re seeing in the commercial real estate markets today. Investors need to understand that things are changing rapidly. The debt and equity landscape appear to be evolving little by little, week by week and could look completely different come end of May after another round of collections takes place.
Overall, investors seem to be tabling and postponing while waiting to see how things shake out. They’re looking for more direction from state and federal government. They want to have a more transparent comprehension of where we’re headed and when — to shape a better investment picture. Will the federal government motivate the economy with a public works program? Will it introduce massive dollars into long-overdue infrastructure projects? When will the masses be released to go back to work? Once there’s a discernible game plan in place, investors will have the guidance they need to invest moving forward. Assume that both equity investors and debt providers to pull back until then.