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January 29, 2021 RE Capital Markets Insights: Into the unknown

 

In Disney’s 2019 animation hit, Frozen II, Princess Elsa sings a harrowing song called “Into the unknown,” as she heads into a world that she has not seen before.

Similarly the real state capital markets are headed “into the unknown” in 2021, a year that is framed by polarizing optimism and pessimism as we manage through a continuing global pandemic that no one has (thankfully) experienced in their lifetime.

We closed out the year with positive news of FDA approval of several Covid—19 vaccines providing hope and optimism that once distributed to the population in mass, life could return to some form or normalcy. The timing and the new definition of “normal” will certainly have significant ramifications, both positive and negative, to the commercial real estate landscape and the real estate capital markets.  So how will those potential ramifications affect each of the major real estate sectors?

The Office sector is already contending with the unknown of what the new normal will be for companies and their employees. A case can be made for more space, particularly if businesses opt to abandon the open space concept and revert back to a more private office environment. There is also evidence that companies are choosing to relocate from the 24/7 urban environments to more suburban locations in order to provide their employees access to more affordable housing options. Will companies continue to allow remote working there by significantly reducing their office space requirements? We just don’t know if these trends will materialize or how long they will persist.

The hospitality sector is deeply reliant on business travelers that are less rate sensitive and spend significant numbers of days throughout the year traveling on weekdays. US hotel occupancy dropped from an average of 66 percent in 2019 to 42 percent in 2020 according to data from Smith Travel Research. The pandemic forced us to adopt new technologies and changed the way businesses work and communicate with one-another. As we return to “normal” the question of if and when we go back to in-person meetings, pitches, and conferences is unknown. Will families travel more as a result of work flexibility and cost of living savings? All these factors will bear a significant impact on the demand in the hotel sector and ultimately the health of the industry. 

The Multifamily sector has proven to be more resilient than most other asset classes.  The biggest fear that collections would drop dramatically did not occur, due largely to the governmental relief programs and the extension of unemployment benefits.  The pandemic did serve to accelerate a trend we were beginning to see in 2019, the migration of renters from urban center to less dense suburban areas in search of higher quality of life and lower cost of living. As a result, we have seen some disparity in rent growth and both Cap rate depression and expansion depending on the market. One more trend of note has been the growing number of rent control laws and eviction laws that add another level of risk and inhibit value appreciation.  This too has driven investors into mostly secondary/suburban markets and thereby driving down cap rates in those submarkets.

Senior Housing, similar to the hospitality sector, has been greatly impacted by the pandemic.  In addition to the operational challenges created by the pandemic, the industry as a whole witnessed a decline in demand as older Americans opted to remain at home longer in order to maintain social interaction with loved ones and increased safety from infection. It is unknown when demand will return and at what levels. The big questions to be answered in the coming months are what additional amenities and programs are needed for people to return and restore viability to the sector.

Industrial has been the clear winner in the pandemic, but seems to be relying on a few major tenants, Amazon and Walmart, to continue to drive demand. At some point their thirst for space will ebb or change. As they seek to pull in additional consumers by offering decreased delivery times, these companies figure to focus their efforts on last-mile distribution solutions rather than distribution hubs.

The retail sector has been going through a decade-long transformation, impacted by technology and online shopping activity. Retailers have had to either adapt or close brick and mortar locations as consumers have changed how they shop. The pandemic, with lockdowns throughout much of the country in 2020, exacerbated the trend as previously unscathed retail segments such as restaurants, service providers, and gyms were forced to close for extended periods of time and in some cases closing for good. The transformation in how consumers shop has given rise to the repositioning of retail space with buildings being converted into everything from office and medical space to even industrial warehousing and distribution. We are seeing the integration of technology with the physical, as retailers reach consumers through changing digital platforms. The return to “normal” in retail will provide opportunities for those investors that can best navigate this technological trend.

As we progress into 2021, these ramifications, combined with the low interest rate environment and ongoing government stimulus, will create a perfect storm for commercial real estate transaction volumes, both healthy and distressed. In this market environment, commercial real estate investors simply cannot sit idle if they want to create value.