The Economist June 27th 2020 pp57-59 Finance & Economics Commercial Property “Like a ton of bricks” “Over the past 20 years the. Investment world has fallen in love with property. Is it the end of the affair”?
Facts presented in the article charts.
Looking at snapshots of 2000, 2010 and 2020 Investible stock in commercial property has increase progressively in the U.S. from ~$4T, ~$6T and ~$12T in 2020 or 38% share, Europe ~$2T, ~$5T and ~$8T in 2020 or 25% share, China <$0.1T, 0.1T to ~$4T in 2020 or 13% with the ROW holding about 24% of the ~$32T in 2020. These investments were attractive for steady returns with rates easily beating bonds. Internal rate of return (IRR) overall rose from ~3% in 2007 to a peak of ~16% in 2011 to ~10% in 2017 with even the bottom quartile doing well with an IRR of 5%.
These commercial real estate portfolios consists of retail, restaurants, lodging, offices and warehouses. Over the years a more diverse group of investors became involved in commercial real estate. As of June 2020, about 500 insurance company owned 19%, 1,200 private pensions owned 44% and public pensions owned 37%. Having experienced remarkable gains since 2007 these investors are now bracing for the damage inflicted by COVID-19. Even before the pandemic, retail rents peaked in 2018 and other sectors were experiencing a leveling off.
Enter COVID-19. “Transaction volumes in May were down by about a third in the West and two-fifths in Asia..”. Offers in American fell out seven-fold. Real Estate Investment Trusts (REITS) “cratered in March”. Since then “benchmarks have recovered only about half their losses”. Besides the decline in new deals, and falling rents (see below), most of the losses are from tenants that immediately stop paying rent. Even more problematic, future performance is hard to predict. When, if at all, will these businesses start trending back to pre-COVID levels? Such a momentus event, at this point in time, will foster more ecommerce and the corresponding demand for warehouse and data center space. Some of this needed space will come from converting existing retail space.
“Hotels have been worst hit: with borders closed and travel restricted, average occupancy fell from 70% before the pandemic to 15% in early April”. Average American revenue per room fell from $100 to $16. The impact on office space is less clear. Will all workers return to office and, given the need for social distancing, will there be more space provided per staff? Overall, offices have fared better with the exception of co-working spaces which have shorter leases. Some feel half of independent restaurants will fail in America and that 15,000 retail stores may close. “A third of America’s 1,100 malls could end up being demolished”. Without effective therapies or a vaccine and without ongoing government support, banks may be forced into starting more enforcement actions.
“Coface, a trade credit insurer, expects insolvencies to jump by a third worldwide by 2021”. Commercial-mortgage-backed-securities (CMBS) delinquency rates are now ~10% overall but nearly 25% for lodging, about 18% for retail and less than 2.5% for industrial and office. “The Economist reckon property values will fall by less than 20% in 2020 and rents by 5-10%. Luckily CMBS account for only 15% of property debt and the Federal Reserve has been propping these up with purchases. Banks are better positioned now than in 2007 because they have more capital in hand and more equity “with Loan-To-Value ratios at 60% versus 70% in 2007". Having said that, some funds are already struggling to “repay the short-term debt they have raised against these long-dated assets (Commercial Real Estate). Harder times are ahead when these loans mature. Firms will be looking to refinance up to $2T in America alone.
In troubled times, having dealt with unexpected losses, some investors will head to the exits. Meanwhile, large Private Equity firms have billions of dollars ready for acquiring properties at bargin prices. Firms that also have capabilities to develop properties, to suit the ecommerce trend for example, will in the long run lock-in higher rents.