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A Look at How Covid-19 Is Impacting the Commercial Real Estate Industry

July 6, 2020 8 mins

Below is an article authored by Dianne Crocker, principal analyst, LightBox that was just published in the Summer edition of the EBA Journal. The article focuses on the impact that the COVID-19 pandemic has had on the commercial real estate industry. Offering perspectives from both commercial real estate lenders and environmental due diligence consultants, the article offers a look into how the industry is faring during the pandemic and how the path to recovery may look. Thanks to the Environmental Bankers Association for permission to reprint this article here.

Literally as I wrote this, it became official: The National Bureau of Economic Research declared that the U.S. economy officially slipped into a recession in 2020—thus ending the longest U.S. expansion on record. If the global economy shrinks 5.2% this year, as predicted by the World Bank, this will be one of the worst downturns in 150 years.

The task of forecasting commercial real estate activity in the second half could not be more challenging given the pressures brought to bear on our market by the COVID-19 pandemic and the unknowns surrounding just how damaging the second quarter’s prolonged business closures will prove to be.

This article summarizes how rapidly the COVID-19 pandemic brought commercial real estate property market to a much different place than it was at the start of the year, how the lender and consultant communities are responding to this challenging market environment, and how it might all shake out.

COVID-19 hit the brakes

At the start of 2020, commercial real estate fundamentals were strong, capital was widely available for commercial property investment and optimism was fairly strong. My previous Winter Journal article closed with: “Unless the economy falters more than we expect, there will continue to be attractive opportunities for redevelopment in metros that offer the potential for strong demand and returns on investment.”

Clearly, the market faltered more than we expected. Phase I environmental site assessment activity across the U.S., based on output from the LightBox ScoreKeeper model, grew by 8% and 13% in January and February, respectively, compared to 2019. Beginning in mid-March, the COVID-19 pandemic escalated in a matter of just a few short weeks. By early April, nearly every state had stay-at-home directives in place, collectively accounting for a staggering 95 percent of the population. Even with the pandemic taking the winds out of the sails of an active market, March Phase I ESA activity was up another 5%  year-over-year as deals with financing already in hand continued. The most immediate impact was a slowdown in transactions that were in progress when the pandemic hit, as well as requests for repricing and a falloff in new properties being listed for sale.

By April, the collapse of business activity took a toll on commercial real estate transactions, and as a result, environmental due diligence activity which fell by 37%. Market forecasters were predicting that the industry would be back to business by May 1st. Yet, in May, a more severe 44% decline in Phase I ESA activity. As the weeks passed and the pandemic continued, forecasters became less sanguine and extended the duration of recovery in their modeling scenarios. May conferences were canceled. Then June ones. And now events as late as September and October are switching to virtual formats. The good news is that economic barometers are beginning to suggest that after bottoming out in April and May, the market could be entering the early stage of recapturing some of spring’s losses.

The Lender Perspective

The rapid and dramatic directives by government agencies in response to the escalation of COVID-19 triggered a variety of rapid responses from commercial real estate lenders. The most common immediate reaction was to limit in-person client meetings in favor of using technologies like Zoom for virtual sessions and directing employees to work from home indefinitely. In response to the rapid federal stimulus, many institutions realigned their real estate teams in April to help process loan relief through the CARES Act and PPP (the federal Paycheck Protection Program) and get loans to small businesses applying for a much-needed influx of capital. The shelter-in-place restrictions also forced lenders to consider protocols that allowed for virtual site visits and dealing with data gaps in Phase I ESAs due to inaccessibility of buildings or consultant access to government agency files and records.

Certain lenders are still lending (mostly to trusted borrowers), but their risk aversion is amped way up given the uncertainty of vacancy rates, tenants’ cash flow, unemployment, and the economic forecast. One of lenders’ biggest challenges today is how to price deals given the intense market instability. Some lenders are picking and choosing what asset classes they are willing to lend on based on their perception of potential COVID-19 impacts going forward. For example, general office space or industrial property loans are generally perceived as lower-risk than a loan on a strip mall or hotel. Many lenders are also pulling out the playbooks they used during the Great Financial Crisis back in 2008-2010.

The near-term focus will likely be on addressing tenant issues as landlords scramble for debt relief on

hotels, stores, office buildings, and other commercial properties that sat mostly vacant over the past two months. Lenders are also assessing their loan portfolios to identify any high-risk exposure. Loan sales are not likely to begin for several quarters, however, after the process of restructuring loans and other measures of working with borrowers. It will also take time for more certainty to emerge on how to adequately price note sales.

The Consultant Perspective

Some consultants experienced an immediate slowdown in work in March but for others, the impact was more pronounced in April and May, leading some to reallocate staff to meet new areas of demand while others were forced to furlough or lay off employees. In addition to similar work-from-home requirements implemented by lenders, some consultants faced strict no-travel policies or restrictions that prevented face-to-face meetings or travel to target properties. This meant consultants were immediately challenged to conduct due diligence work without being able to conduct site visits or access libraries the way they are used to. This triggered more widespread adoption of drone technology to conduct virtual site visits or including provisions in Phase I ESAs to conduct complete site visits down the road when conditions permit. Others quickly set new standards of practice in place that, for example, limited the types of properties or number of units at a multifamily property that could be visited, or the number of people allowed into a building at one time during an inspection. The difficulty of obtaining property data, especially for file reviews, given the closure of libraries and federal, state and local government agencies across the U.S. also led to data gaps in Phase I ESA reports.

Consultants worked with lender clients to address gaps, post-closing if necessary. While most consultants are still operating at capacities well below normal, a growing number are reporting that clients are getting more active. Some consulting firms are also actively assisting with asset management services, portfolio risk analysis, and other services related to managing commercial real estate assets through the pandemic.

The Crystal Ball: What to Watch

The latest market data suggest that we could be at the bottom of the “corona ditch,” looking down a road to recovery that has yet to be built. While the shock of April and lack of activity in May is giving way to cautious optimism, even the most hopeful know there is no panacea to what’s ailing the market right now. The relaxing of shelter-in-place orders that have disrupted our lives will not immediately end COVID-19’s disruption of the U.S. economy. As states phase in the reopening of businesses in early June, ten states (e.g., Arizona, Texas, and Florida) are already reporting a record number of new daily COVID-19 cases.

The unfortunate truth is that no one knows for certain as none of us have faced a market shock quite like this one before. As noted by Moody’s chief economist Victor Calanog in the LightBox PRISM market update last month: “The issue is that this is a public health crisis, so the outlook needs to account for the fact that without a reliable and widely-available vaccine for COVID-19, we are unlikely to see a fast recovery.”

It should come as no surprise that there are widely differing opinions on the pace of recovery from here. The forecasts are an alphabet-soup mix, ranging from the most dire L-shaped trajectory where activity remains depressed over the near-term, to an optimistic U-shaped or V-shaped recovery that takes us quickly back to pre-pandemic levels to a more complicated W-shaped recovery that assumes a second wave of COVID-19 infections in the fall followed by a period of renewed lockdowns.

The LightBox Market Confidence Index, now in its second month, is based on a survey of environmental consultants, lenders, brokers, and investors to gauge how prevailing business conditions across the commercial real estate sector are changing. In the May survey, the results pointed to a lengthening in the expected horizon for the market’s expected return to pre-pandemic levels. In the April survey, 36% of respondents expected to recover in 4Q20 or later, but by May that percentage increased to 47% or nearly half of respondents.

The April and May declines in CRE activity and Phase I ESA activity were universally dramatic, but expect to see some significant variations in recovery rates from state to state and metro to metro given differences in pandemic impacts. Areas with lower impact rates will return to normal much more quickly than areas like the tri-state NY/NJ/CT areas that were hit especially hard.

There are several factors worth mentioning here because they lend some optimism to whatever forecast scenario you choose to believe. Prior to the pandemic, there was a wide range of available capital sources for property investment. Investors with pent-up demand are already trolling the waters for investments to target once it is safe to wade back into deal-making. Longer term, distressed opportunities are certain to surface, but not until the end of 2020 and into 2021. Over the near term, expect to see investors focusing on the stronger asset classes including industrial/warehouse, multifamily, and agricultural/vacant land.

The market will favor real estate that supports the booming e-commerce business, the need for housing in healthy metros, and the opportunity to buy land at a time when site access is challenging. The commercial real estate sector will also experience many new realities when it emerges from the other side of this pandemic. Some trends, like the death of malls, will accelerate and others, like the magnetic draw of living in big cities, could lose steam.

Office vacancies could also increase as companies adopt long-term work-from-home policies and reduce their square footage requirements. What we do know is that recovery will take shape over the next few quarters. It will happen in waves. In phases. We will return to offices and we will travel again whenever that seems appropriate. Over the summer months, analysts like me will be closely watching barometers and COVID-19 case data.

Environmental consultants will continue to serve their clients as best they can to assess property risk using all avenues available. There will be demand for reassessing properties through a new post-COVID lens and conducting valuations that take into account new assumptions about cash flow, occupancy and rent rolls that will support price discovery and eventually close the bid-ask spread between sellers and buyers. Risk managers at financial institutions will make capital available where it makes sense, and will be scrutinizing collateral and future cash flows more closely, as well as working with their borrowers to find middle ground in their attempts to get loans repaid and avoid widespread foreclosures.

Regardless of which forecast you believe, it is clear that commercial real estate professionals should be ready for a long, sustained recovery that continues well into 2021. Prepare for the worst, but hope for the best!

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