How COVID-19 might affect the commercial real estate market
Friday, May 22, 2020
COVID-19 has negatively impacted every industry, including the commercial real estate sector. Whether or not this industry can bounce back — and to what extent — is dependent on several factors. “COVID-19 will usher in a form of real estate Darwinism where only the financially strong will be able to survive,” warns Michael Gevurtz, CEO of Bluebird Lending in Philadelphia.
When tenants can’t pay their rent, landlords can’t pay their mortgages. “Income and valuations will drop, credits will tighten and many of the original investors who own commercial real estate will be forced to sell,” Gevurtz says. However, he doesn’t have a gloom-and-doom, all-is-lost attitude. “It is important to remember that the spirit of America is entrepreneurial, and we will bounce back from this.”
But, if so, it’s going to be a huge bounce. “At least 40% of commercial tenants did not pay their April 2020 rent to their landlords,” says Samuel Evan Goldberg from New York City real estate firm Goldberg & Lindenberg. He expects that number to rise by the end of May. “This will certainly result in numerous eviction proceedings, as well as bankruptcy filings by these commercial tenants.”
Charles A. Hewlett is the managing direct at RCLCO, a real estate consulting firm in Bethesda, Maryland. The company recently conducted a COVID-19 Real Estate Sentiment Survey intended to answer this very question. Survey results indicate that found the impact of COVID-19 on real estate varies depending upon the respondent’s perception regarding the length of the economic downturn, and the respondent’s real estate segment.
Few survey respondents expect to see a relatively quick “V-shaped-curve” bounce back. “Nearly two-thirds of survey respondents expect the economy to bump along the bottom for some period of time before beginning to recover sometime in late 2020 or early 2021 — looking more like a narrow or even wide ‘U-curve’ trajectory,” Hewlett explains. “However, just over 20% of survey respondents expect the economic recovery to be longer and more painful, with some characterizing the shape of the recovery to be a ‘Nike-swoosh’ curve.”
We already know that shopping malls are struggling to survive the pandemic — and they were struggling long before the novel coronavirus. “Shopping malls will see some of the biggest changes as major retailers are on the verge of bankruptcy,” says real estate attorney Jim Bond at Fennemore Craig in Phoenix. He says that many small tenants will not be able to survive. “In order to fill the vacancies, shopping mall owners will need to creatively select new tenants to diversify their mix of uses beyond traditional retailers.”
The RCLCO survey reveals that lifestyle and big box/power center retail will likely experience “severe” impacts. However, convenience/necessity retail will fare much better, with only “moderate” (5% to 9%) or “minimal” (<5%) impact. “Perhaps not surprisingly: in many of our conversations with owners and operators of grocery-anchored neighborhood shopping centers, the grocery stores have seen a 20%+ increase in sales, while sales in the balance of the centers are down more than 50%,” Hewlett says. “Collections range widely between 50% and 80%, and many tenants are reaching out to landlords seeking primarily deferment, but also forbearance.”
Social distancing has severely limited the ability of many nonessential retail stores to operate. “Shopping malls are closed, and the restaurants that aren’t closed are limited to takeout and delivery,” Bond says. “Grocery stores and other major retailers are limiting the number of customers allowed in the store at any one time.”
And when restaurants open, Bond says they’ll look radically different, since tables will need to be removed to create more distance. This results in fewer customers and decreases the ability of these establishments to pay rent. “Also, many restaurants may want to add or expand drive-thru and pick-up windows, and these changes will require creative space planning and flexible landlords to accommodate the necessary modifications.”
Office space was once considered essential, but those days may be over. “Office is likely to be hit hard with the work from home trend that is likely to persist beyond any shutdown,” says Kevin McGowan, president of McGowan Corporate Real Estate Advisors. And it doesn’t help that a lot of office buildings embraced the open-concept floor plan. “We think the offices will be smaller, and more private offices will be the trend.”
Co-working space and office-sharing companies were gaining steam, but Bea Drechsler, a partner at the Drechsler & Drechsler law firm in New York, says this trend will slow significantly as more employees work from home. “Many of these spaces have been leased on a short-time basis, making it easier for occupants to leave, but also providing alternatives to other tenants who do not want to commit to long-term leases in other buildings,” she says.
“Owners of office buildings will need to take steps to show that tenants, employees, and guests feel safe in their buildings — improving air filtering processes, enhancing cleaning efforts, and instituting additional security measures relating to the health of those in their properties,” Drechsler says. These changes are costly, and she says the landlord may want to pass these costs to the tenants through common area maintenance contributions.
“The big question floating out there right now is: will the office sector have huge losses in the last two quarters of the year?” says Michelle Mumoli, CEO of The Mumoli Group, and a realtor at Triplemint in Hoboken, New Jersey. “Both offices and co-working spaces may suffer some losses as it’s unknown how our daily co-mingling will restart once shelter-in-place orders are lifted and until a vaccine or treatment is proven effective.”
However, Mumoli does predict a bright spot for some commercial office areas. “The medical office sector will have a huge surge, with a backlog of patients and growing medical needs that will need to be met.”
And that’s what Hewlett’s company found. “Our survey reveals that the healthcare and medical office segments are expected to experience only minimal or no impacts,” he says.
“At the other end of the spectrum, industrial is expected to have minimal impact, with nearly 20% of survey respondents anticipating that this segment will experience no impacts at all,” Hewlett says.
One reason for this expectation is the increased demand experienced by many industrial tenants. “As online shopping becomes more prevalent as a result of the virus, more industrial space will be required to house inventory at distribution centers,” Bond says. However, he says more employees in close proximity to each other can impact operations.
While COVID-19 is expected to cause significant disruptions in commercial real estate, Gevurtz believes that new investors will come in and purchase properties when original investors are forced to sell. “When considering the financial lending side of COVID-19 effects, this is going to cause a lot of firms to become more conservative, and maybe won’t be able to stay in business.” However, Gevurtz says this will present opportunities for smaller lending institutions.
And in places like New York City, Goldberg doesn’t believe the commercial real estate markets are affected by short-term emergency issues. “Instead, commercial landlords usually look five to 10 years down the road as commercial leases are for an extended period of time.”
So, even though the coronavirus might cause a slight short-term slump, Goldberg says it will have a limited effect in the long run. Obviously, conventional brick-and-mortar stores that rely on daily revenues to pay their expenses will indeed be affected. “However, hopefully, commercial landlords will be willing to renegotiate short-term rent reductions to their existing tenants to allow them to continue to have possession.”
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