*ADDENDUM 3/25: The Short-Term and Long-Term Effects of the Coronavirus (COVID-19) on Commercial Real Estate

By Norm Miller, PhD, Hahn Chair of Real Estate Finance, University of San Diego School of Business
March 12, 2020

No one can accurately predict how long the Coronavirus will last or when effective vaccines can be rolled out, so all we can do is speculate, based on some logic and our past experience with SARS, which seems less serious and less deadly than this new potential pandemic. Logic and history suggest that the most immediate effects will be 1) significant interruption of all supply chains, 2) significantly less travel and a fear of all crowded venues, 3) likely overreactions in the capital markets, affecting stocks and our estimation of wealth, 4) possible government interventions to assist affected industries, especially in China.

How will each of these affect real estate markets? Starting with the most obvious:

• Hotel occupancy will drop along with conference center utilization. Tourist cities will be more impacted than other metros.
• Flights will be canceled. Too many travelers on a flight will cancel which will impact scheduled flights and therefore impact our ability to meet business commitments. This may cascade into even more cancellations of meetings and events. One beneficiary of these cancellations will be more use of video conferencing and alternatives.
• Sporting events at large venues will be canceled, which will in turn, further dampen hotel occupancy. How long that will last will depend on when the virus peaks out. If history is any guide, the worst impacts will last no more than two quarters.
• Supply chains will interrupt production all over the world, and while manufacturing will be delayed, we will make it up eventually. It is not the percentage of parts that matters, but rather the inability to replace critical parts with domestic/local suppliers that matters. The same is true for physical retail goods. These purchases will be delayed and most will be made up, however some business will be lost forever, like fitness centers, movie theaters and restaurants.
• Work will be disrupted if childcare centers and schools close down. This would be the most severe signal that the virus could drive the U.S. into a recession. The U.S. is unlikely to hit recession (defined as two quarters of negative GDP), if schools do not close, but could easily dip to a negative GDP for one quarter and/or a very low GDP for all of 2020. Again, school closings for more than a few days will be the signal that work will be seriously disrupted and a recession not too far behind. The office market will likely see an increase in flexible work scheduling and more telecommuting from home. To the extent, firms resistant to telecommuting, accept and learn to manage remote workers, this will result in a larger permanent home-based workforce, now at 10-12 percent and perhaps reaching 15- 20 percent over time. If managers learn how to better manage telecommuters via video conferencing and frequent online meetings the office market vacancy rate, now at around 10 percent could rise to 13 percent or more. Co-working will continue, but with far fewer social functions.
• In 2021, the U.S. economy will also be negatively impacted as the stock market pullback will delay new or secondary stock issuance, which will delay investment and expansions and slow new hiring. The unemployment rate will climb starting in Spring 2020.
• The stock market decline will also impact the high-end housing market, which is tied closely to overall wealth and has already been hit by state and local tax limitations under the last tax revision. Some retirements will be delayed as people watch their 401ks and IRAs decline.
• After hotels, the next most impacted property type in the short-term will be bulk port warehouses that deal with imports of construction materials and car parts and electronics, while local warehouses servicing the last mile will benefit from a surge in e-commerce as people shop more online and less in person to the extent that inventories are produced locally. Grocery shopping online, which has been resisted by most of the population, will surge and this may have long-lasting effects on one property type that has been considered e-commerce resistant, the neighborhood shopping center anchored by groceries and pharmaceuticals. Thus, retail property will be affected. While it may be temporary, with much shopping simply postponed, some effects will linger on forever.
• Construction will be delayed as new replacement supplies are sought. This will hurt construction efficiency as starts and stops do not allow for streamlined project management.
• Low interest rates will make refinancing and new acquisitions attractive and the volatility of the stock market should steer more capital into real estate, supporting most values, especially in the multifamily market and the last mile industrial market.
• Retail and office cap rates might witness higher cap rate spreads, but the low treasuries will likely keep cap rates down.
• Unemployment uncertainty and business investment delays will cause some delays in home buying. The low rates will likely offset this among those who can move up and have not been hit too hard by stock market declines.
• The next several months will be a good time to pick up property or homes from those in panic over-reaction mode. The best advice is don’t panic and do anything rash. If you get sick you have at least a 97 percent chance of regaining your health. That brings up the property type most benefitting from the virus—funeral homes—but that is a dying business, so it is best to steer clear.

*ADDENDUM: March 25, 2020

Preface: The discussion above on the short and long-term effects of the Coronavirus on commercial real estate were written prior to the shelter-in-place mandates and quarantines that have now caused much of the service sector to shut down. Only three weeks old, it seems somewhat out of date. Here is an update, written on March 25, 2020, with more specifics.

When will the virus peak out?  Based on the research presented in a REMI webinar by Patrick Finley and Vanessa Vargas, of the Sandia National Laboratories on March 23, 2020, titled “Epidemiological and Economic Modeling of a Pandemic” based on history, we can expect the coronavirus to peak out about 153 days after the initial spread with the last 20 days by far the worst. Using Feb. 9^th as a starting date for the U.S., this would give us a peak in the number of infections around July 5^th.  If the quarantine really works to slow the spread, that peak might come much earlier, as soon as sometime in early May, but not likely much earlier. This suggests our service economy will be significantly impeded for much of at least two and a half months. The infected death rate depends entirely on the availability of ventilators, and could range from .4 percent to 2.0 percent in the worst case, depending on ventilator access. Fear and stress add to the death rate, especially for those with diabetes, asthma and other chronic health issues, and economic stress can add to the suicide rate.

How is the economy affected?  Approximately 50 percent of the workforce can work effectively from home. With some 20 million working in retail related services, and delays in construction, and manufacturing we can expect from five to nine million people to lose their jobs, temporarily by the end of April. The two trillion in federal aid, along with some state and local assistance will help but not stop a recession.  Quarter two and three GDP will likely be negative. Deutsche Bank estimates the U.S. GDP in the second quarter at -13 percent Pantheon estimates it at -10 percent, UCLA estimates it at -6.5 percent, and Moody’s at -1.6 percent. Among the states hit hardest are Hawaii, CA, MI, NY and by metro, New York, Las Vegas and Boston. These states and markets will have larger economic shocks and require longer to get back to normal. Part of the reason for a short-lived recession is simply the economic uncertainty that delays so many decisions, from selling or buying a home, to travel, buying a new car or any discretionary type consumption.  Some businesses and households, especially those without health insurance, will go bankrupt and those smart enough to have significant cash reserves will be economic survivors. Every time we see layoffs, even with a short recession, not everyone is immediately hired back.  The economy will likely accelerate in early 2021 as delayed decisions are ramped up. Above average healthcare costs will continue for up to a year or more. Cruise ship travel companies may take several years to fully recover.

Specific impacts on commercial real estate: In addition to an increase in rental payment defaults, requests for rental concessions and some mortgage defaults, we can examine the recent REIT prices from mid-March to estimate the implied discount or premium for specific property types.  Based on figures from Nuveen presented at PREA, generated by Green Street, we see data centers, health care and some last mile industrial property increasing in value. In terms of other property types losing value as of the current date, are hotels (-37 percent), regional malls (-19 percent), offices (-16 percent), strip centers (-15 percent) and apartments (-8 percent) but as these are based on REIT prices, the declines are over-stated and many will rebound towards the end of 2020.  Those looking for distressed bargains will need to act fast and find some over leveraged owners without sufficient liquidity to ride this out. In the long term, we should see increase asset allocations to real estate which will lower long term yield requirements and maintain or increase values. Fundamental trends in retail towards e-commerce, and office sharing that lowered space per worker, which were all present before the virus will continue. The volume of sales for all commercial real estate will go down by 30 percent to 60 percent as the market freezes up during a time of uncertainty, during the second and third quarters of 2020, but should rebound significantly in the last quarter of 2020.

Norm Miller, PhD is the Hahn Chair of Real Estate Finance at the University of San Diego School of Business and is affiliated with the Burnham-Moores Center for Real Estate. He is a highly-regarded expert in the areas of real estate, valuation, automated valuation models, data mining, real estate market forecasting, sustainability, mortgage risk analysis, sustainable business strategies, public policy issues, real estate financial market outlook, commercial and residential real estate trends, office space and workplace trends. He teaches in the master's in real estate program at USD. He has published a vast number of papers and has received numerous awards for his contributions to real estate.