“Preparing for the worst, but hoping for the best…”
On Wednesday, May 6, 2020, I had the pleasure of moderating the LightBox Virtual PRISM market keynote, “Thinking Through What Comes Next: COVID-19, the Economy, and What’s Next for U.S. Commercial Real Estate.” Our keynote speaker, Moody’s head of Commercial Real Estate Economics, Dr. Victor Calanog, shared his insights into what today’s health crisis means for commercial real estate performance. After a provocative presentation, Calanog fielded questions from our audience, hundreds of risk managers from banks and due diligence consulting firms from across the country. The questions on everyone’s minds boiled down to two key areas: “When will the commercial real estate markets return to a state of normalcy?” and “How bad will it be until then?” Audience questions were too numerous to handle in the time permitted, so below you will find Calanog’s answers to each question submitted during the live event.
Question: The Covid-19 pandemic has impacted the way we work, teach, learn, shop, and even the way we exercise! What do you see as the long-term impacts on the entrepreneurial attitude for innovations that has long existed in the U.S.? and how would these impacts affect the long-term outlook for brick-and-mortar real estate?
Victor Calanog: I’m not sure the pandemic will affect the entrepreneurial spirit negatively. I think the changes brought about by the pandemic are fueling the fires of those who want to make money out of this. I suspect that any kind of change, like war, for example, where institutions are forced to change their habits will have those looking to taking advantage of it—for good or for ill. I do think that a lot of economic activity has shifted—and will shift—to online channels. There are a lot of folks out there looking for opportunities.
Question: What have you heard about the status of April and May rent payments for landlords and borrowers as that will tell us a lot about the severity of the impact?
Calanog: It really depends on the sector. Let’s start with the good news. Many of our clients were expecting a 30% rent collection loss in April in multifamily. As it turns out, the actual number was closer 5-15% so at least for households the help they’ve been given appears to be resulting in lower levels of rent collection losses than expected, at least for now. In areas like the NYC metro, however, the rates are higher. For retail, it’s the opposite. Due to massive store closures, you just don’t have a lot of retailers earning incomes. Where you’re going to see a lot of distress is in retail and hospitality/hotels. When people ask me for my forecast for hotels, I literally just send them a skull and crossbones. It is going to be bad.
Consider this: Italy is not even going to reopen to tourists until March of 2021, and that’s if everything goes well. Fifteen percent of Italy’s GDP is tied to tourism so they’re shooting themselves in the head, but this is the difficulty in execution to think about if we’re way too optimistic about reopening the economy and expecting everything to bounce back to the way it was. I’m not sure that’s going to be true.
Question: What happens with a rebound? When will things open up for purchasers, finance, foreclosures, and distressed assets up for sale?
Calanog: What’s interesting about commercial real estate is that unlike housing, commercial properties are income-generating so if tenants are in place and paying rent, then you can literally afford to sit on your assets and keep collecting rent even if you don’t think values are right for a good sale. That has been true in the past, but now in this current pandemic situation, if it lasts a little bit too long, it’ll knock that that first assumption out of orbit. If your tenants aren’t in place then and aren’t earning income, then you are in a distress situation. I believe we will a see lot of delinquencies and potential losses reflect themselves in unsupported credit markets. I’m going to giving a little bit of credit to fiscal and monetary policy for offering support to bridge distress during this time. I think that will blunt the worst of what could happen. Over the next three months, there will be a real shakedown where if your balance sheet just wasn’t strong entering this downturn, you might be forced into a fire sale. I suspect that will happen as soon as the next one to three months, especially if reopening just isn’t smooth for your business.
Question: Are malls dead?
Calanog: We will find out. Simon is reopening close to 50 of their mall locations over the next month or so. Interestingly enough, the stronger malls have gone to the experiential side of things to draw consumers into the mall to, for example, visit an indoor water park. But now, due to the pandemic, that type of experience, which used to be a strength is now a liability under social distancing guidelines. Without a credible treatment or vaccination protocol for COVID-19 that is made widely available, that type of experiential mall experience is not coming back anytime soon. Let me give you some numbers: Vacancy rates for malls in 1Q20 were 9.7%, an historic high already and we haven’t even seen the worst of it.
I suspect that it will be split into a world of haves and have nots. There will be very good malls that are dominant in their trade areas that will be just fine. The vacancy rates for Simon and GGP REITs are around the low 5% range, but the national avg is 9.7%, and the “have nots” are breaking 12%. So the have nots were dying before the pandemic, and I expect this health crisis will just accelerate that process.
Question: How will COVID-19 affect cap rates?
Calanog: I expect the pandemic will likely prompt a net increase in cap rates through 2021 and into 2022, given the kind of distress we are seeing in the economy.
Question: I work in commercial lending. What industries would you consider still lending into during COVID vs. which industries would you take more of a wait-and-see before lending?
Calanog: Industries less affected by the slowdown in personal and business travel are your best bet. However, given the economic shutdown of large swaths of the economy, the most conservative play is to wait-and-see to establish which sectors bounce back soonest upon reopening.
Question: Can you comment on the ability of consumers and small businesses to pay rent and how that might, in turn, impact CRE mortgage default rates?
Calanog: Those that get support from various government programs will likely fare better. As I mentioned earlier, individual households that get rent support, for example, have not been defaulting on multifamily as much as feared. Retail tenants – and/or landlords – have often gotten little support. That is where the risk lies.
Question: What’s the key barometer you’re watching MOST closely? What’s the greatest risk you see?
Calanog: I’m watching the duration of whether jobs keep getting lost, or the unemployment rate remaining high. That is the biggest risk here.
Question: What do you see as the timeline for starting up transactions again? And how long until distressed assets wind up on the block? I have real estate investor clients starting to circle like sharks.
Calanog: All will depend on the economy reopening, and whether that process is smooth or not.
Question: What’s your best guess on how long it will be before banks open back up for CRE lending? What has to happen first…beyond the obvious?
Calanog: The biggest banks continue to lend, but often with more stringent standards. I don’t see new CMBS issuances coming back, nor am I forecasting new construction loans to pick up significantly until wide-scale confidence returns.
Question: What do you see as the forecast for office buildings? How will empty office towers look unless they have long-term leases? And what’s the level of distress you expect from tenants not paying rent/high unemployment?
Calanog: Even in the immediate term when offices reopen, before credible treatment and vaccination protocols are made widely available, firms are already thinking about what the “new normal” might mean: Will there be a limit on the number of people riding elevators or attending meetings in enclosed areas? Will there be a staggered workforce schedule where teams A, B, and C take turns heading to the office? Why even bother with all this if lingering uncertainty remains? Why not simply continue working from home?
And this leads us to the bigger risk for the office sector, the longer the COVID-19 situation persists, will there be a significant drop in space usage intensity? Will employers simply choose to use less office space, shifting activities to remote or work-from-home arrangements? The evolutionary processes prompting change in the office sector—demographic shifts, economic development, and technological change—will be kicked into high gear by the COVID-19 pandemic. One trend may reverse (suburban office may come back into favor, versus CBDs) but the decline in the intensity of office space usage may accelerate significantly.
About Victor Calanog
Dr. Victor Calanog is currently the Head of Commercial Real Estate Economics for Moody’s Analytics based in the NYC metro area—also known as the epicenter of the COVID pandemic. He is a well-respected expert on the commercial real estate market and submarket forecasting, a property level analytics researcher, and a prolific writer, speaker and presenter on economic trends and emerging issues. Prior to the acquisition by Moody’s Analytics in October 2018, he served as Chief Economist & Senior Vice President of REIS, leading a team of economists to build the firm’s market forecasting, valuation, and real estate portfolio analytics services.