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March 3, 2020 RE Capital Markets Insights: The Coronavirus—the Prognosis for U.S. Real Estate and Real Estate Finance Given Current Market Conditions

 

Coronavirus,  which first emerged in Wuhan, a port city in the central Hubei province in China in late December, has since emerged on every continent except Antarctica. As health officials work to stem the spread and impact of the health epidemic, which has infected close to 90,000 people and killed more than 3,000 to date, the global business community is grabbling with a potential crisis of its own.

Over the last decade, the world’s economies have become intertwined. This is especially the case with the United States and China, despite recent trade tensions between the two superpowers. A slowdown caused by the devastating virus in China—which leads the world in manufacturing output—will certainly cause repercussions here.

While we can only speculate about the virus’ long-term impact on the U.S. real estate and real estate finance markets, we can anticipate the short-term consequences the epidemic will have on real estate, starting with construction projects.

Our country is extremely dependent on China for everything from raw materials to finished goods needed for both residential and commercial  development. Around 30 percent of building products imported to the U.S. come from China, making it the largest single supplier of such material to this country, according to Dodge Data & Analytics, which tracks the construction industry.

But with Chinese factories forced to close due to the virus, imports from China have been constrained. Recent port numbers indicate shipments from China are down 25 percent — the same level that occurred at the onset of the recession in 2008.  As a result, materials needed by builders to complete projects are dwindling.

Just-in-time delivery and the optimization of the supply chain over the last decade, which has significantly reduced inventories, is compounding the current situation as there is virtually no slack in the system. There are no longer warehouses stocked with inventory in the United States awaiting customers. We have become so dependent on China for production, it’s unclear if the U.S. manufacturing industry can produce the materials needed in lieu of Chinese imports. The result could be significant project delays, and cost escalations for ventures that have not broken ground.

Even for projects that have a GMP (guaranteed maximum price) construction contracts, the crisis caused by the virus would like fall under force majeure event excluded by the guarantee. Thus, any schedule delays or cost increases attributed to the Virus will fall on the shoulders of project developers.

In an attempt to mitigate an economic slowdown here in the US, the Federal Reserve slashed interest rates by half a percentage point on March 3 to stem fallout from the epidemic, The New York Times reported, with bank officials voting unanimously for their biggest single cut—and first emergency rate move— since the depths of the 2008 financial crisis. Jerome H. Powell, the Fed chairman, also indicated during a news conference in Washington, D.C., a willingness to continue to “use our tools and act appropriately, depending on the flow of events.”

With Fed Funds Rate currently set at the 1 to 1.25 range following the announcement, the Fed has limited capacity remaining to stimulate the economy through continued reductions in short term rates.

Looking at the treasury yields, we have seen them drop about 30 basis points in the last week and a half and yet our long-term rates are still higher than many other developed nations. The upside for real estate investors is that you can currently obtain long term fixed rate financing on most commercial buildings in the 3 percent range. The cost of long-term fixed-rate capital has come down and will likely remain low for the foreseeable future, until the U.S. economy is back on solid footing and growing again.

Despite all the uncertainties, there is some good news when it comes to overall capital market trends. Capital market participants we spoke with over the last several weeks are still open for business and lending capital is still available for the most part.

In addition, two trends we’ve noted this year, unrelated to the coronavirus, still point to select opportunities for real estate investors.

1) Many debt funds have raised capital that is focused on lower risk types of value-add execution. For deals with minor lease up risk—nothing involving heavy renovations—there is a lot more capital. Financing for those deals is being priced in the 100s to 200s over Libor.

2) Meanwhile, the debut funds that have focused on heavier renovation bridge financing have amassed allocations for construction financing. Given that, there should be additional capital beyond just what the banks can provide for construction financing this year. Initially, of course, funding will focus on the primary product types for real estate investment—apartments, industrial and office projects in major metropolitan areas.

While not a complete salve for the current situation, these capital market trends and the proactive work Federal Reserve are engaging in should stem some of the economic fallout from the coronavirus.