Is commercial real estate is stuck in a slow-motion train wreck?

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Although this post focuses on the troubles in the US this is a worldwide issue and South America will have the same if not more severe adjustments in value. However, as people always need somewhere to live the residential sector will not suffer in the same way.

  • Commercial real estate, large hotels, older shopping malls in low growth regions and low-grade office buildings are all facing down massive post-pandemic problems.
  • Remote-work and e-commerce trends are coming, and it seems commercial real estate is like a slow-motion train wreck.
  • And that train wreck could drag many national and local economies down with it.

In the US alone there is $6.5 trillion of assets in the US commercial-real-estate industry. This coming threat will affect the three major nonresidential sectors of the industry. In South America, many of these assets are in the low-grade categories meaning the hit will be harder.

The ‘Big Checkout’ is not over in the hotel industry

First is hotels, which have been hammered by the COVID-19 recession. Since hotels have no leases to protect their revenue stream, as much as 10% of the sector closed entirely during the 2020 lockdowns, in the US and 3% of locations remain closed, according to STR Inc. Even hotels that remained open throughout good portions of the pandemic are struggling with bills and debt backlogs as revenue bounces back. Nationwide revenue per available room — a key metric for the industry — was down 29% through April compared with 2019 levels.

In South America the situation is more serious with long lockdowns in major cities like Buenos Aires and Santiago over the past 12 months, coupled with poor vaccination rates and little or no real help for businesses.

Given the likelihood of the American consumer engaging in a fair amount of “revenge spending” as the economy fully reopens, the hotel sector is likely to see substantial improvement over the summer. But the improvement could be short-lived because there are obvious issues that are likely to wreak renewed havoc come autumn.

However, this is not the case in South America where apart from the Chinese aid with vaccinations there has been little international help to reduce the misery which will get worse as the Southern Hemisphere heads into winter.

In the US Hotel-room rates and occupancy are built on business travel and conference room demand, which makes up roughly 30% of demand during normal times. That business, often booked far in advance, provides hotels with a baseline to build on when pricing other rooms. In some of the biggest conference destinations, the size of the corporate business can be closer to 50% of total business.

What will happen when many hotels try to rebuild their business volumes all at once? Big, fat discounts. On top of this timing issue, this critical piece of the hotel business also faces an existential threat. Many business meetings that were thought to require travel pre-COVID-19 have been shown to be efficiently conducted on Zoom or other video calls.

What that means for future levels of travel is, frankly, unknowable. But it is not likely to be very positive.

Finally, the value of many hotel properties has been decimated by the pandemic. Twenty-three percent of all US hotel loans became delinquent, and billions of dollars of loan interest went unpaid — whether as the result of outright defaults or forbearance by lenders — and will need to be dealt with.

And the ability of other hotel owners to continue to make debt payments was enabled by Payment Protection Program (PPP) loans to over 19,000 of the 54,000 hotels in the US totalling nearly $11 billion (that excludes loans under $150,000).

Most alarmingly, $1.65 billion of those PPP loans were made in March and April, which demonstrates that the PPP is still acting as a lifeline for the industry. And that program ends this month.

Accordingly, the “Big Checkout” in the hotel industry will echo into late 2021 and 2022.

Not buying retail

The second part of the commercial-real-estate market facing a crunch is retail malls. This beleaguered industry was already facing pressures before the pandemic — mounting losses of big anchor tenants and the rise in online shopping. But the COVID-19 crisis has taken retail property woes into the stratosphere, going well beyond the mall space. Strip shopping centres and, most particularly, urban street-front retail are struggling, too. 

As in the case of hotels, retail property is also facing a business cultural change that was accelerated by lockdowns. In the first quarter of 2021, online shopping (excluding groceries and fuel) comprised 15% of retail sales, according to the US Department of Commerce, and it appears to be rising.

As comfort with clicking and buying becomes ever more prevalent, the need for brick-and-mortar shopping space will naturally continue to diminish. The stunning success of Mercadolibre and Amazon are evidence of this trend.

In the US they also have a PPP-loan overhang in the retail sector — nonchain stores, franchisees, and restaurants — which introduces an additional unknown regarding the number of merchants able to survive the withdrawal of those advances.

Retail property was already “on sale” and now faces the prospect of “liquidation” in many markets.

The other trend will be the increased demand for Class A office buildings as those in growth industries demand superior space than is normally available:

Class A buildings are generally either new developments or properties that have had significant improvements and renovations in recent years. The building’s common areas will have high-quality finishes and amenities such as covered parking, fitness centers, leisure areas (putting greens, pool rooms, spa center), on-site mailing office, restaurants or cafeterias.

These buildings are also typically conveniently located, either in the epicenter of central business districts or along major streets, highways or transit centres.

New or near new skyscrapers and prominent office campuses are typically Class A properties.

Return to the bedroom?

Finally, both the least clear and the most substantially problematic sector in commercial real estate is large older office buildings. The cultural shifts that will follow 15 months of working from home will be slow to manifest themselves in terms of declining demand for space. The bottom line many of these offices will need to be converted to residential apartments.

But it should be readily apparent to all that the work-from-home genie is not one that can be put back into the bottle therefore well located spacious apartments will still be in demand.

Other than industrial property owners, large office landlords typically enjoy the longest lease terms, averaging between eight years in the nation’s largest cities to 5-plus years elsewhere. So the pain of decisions by tenants to reduce their office space will be spread over a longer period. And if the foregoing shifts are not dramatic, landlords may be fortunate enough to straddle a good deal of the recession in their sector. But I would not hold my breath.

In this case, we must look to availability as a guide, not the amount of office space vacant. Nationally, office vacancies spiked over 18% in the first quarter of this year. But availability rates (inclusive of space that has been vacated but still subject to leases) are running much higher than vacancies. In Chicago, vacancy is just over 16%, while availability is 22.3% of total space, according to a Colliers International report. In New York City, even with its high percentage of large, creditworthy tenants, availability already exceeds 17%, according to a first-quarter report from Savills. 

Kastle Systems’ 10-city Return to Work Index suggests only 28% of workers had returned to the office as of this writing. And with about 15% of office leases expiring each year, 2021 and 2022 are likely to see a bloodbath in downsizing and outright abandonment of space.

Industrial Property a clear winner

There is one clear winner in commercial real estate it is industrial property. Specifically, in the warehouse and logistics sector, that is now overwhelmed with all the increased volume of online shopping and medical-materials distribution. The stunning success of Mercadolibre and Amazon are evidence of this trend in the America’s.

The Larger Problem

But the challenges facing the three major commercial-real-estate sectors discussed above are very real and could turn more in a negative direction with the passage of time. And a major repricing in these sectors could instigate a more systemic problem among holders of loans secured by affected properties, to say nothing of loss of wealth among equity owners.

The last time the US saw a specifically commercial-real-estate recession (more like a depression in some markets) was in the late 1980s through the early ’90s. Mostly because of the overuse of mortgage debt (rather than a sudden drop in rents and incomes), it spilled over into what became the savings and loan crisis and required the government to undertake wholesale asset liquidations.

Moreover, it caused a recession that took real GDP a year and a quarter to recover from.

Today, properties are generally less leveraged but face unprecedented challenges on the income side that threaten a substantial loss of value.

The Good News is it is presenting yielding buying and added value opportunities of a lifetime for those with investment capital

If overseas experience is any guide many of the lower grade office buildings and hotels will be converted into residential units addressing the imbalance and provide excellent development opportunities.

However, the older lower grade malls and hotels will need to be refurbished to survive.

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