This article first appeared in the June-July 2020 issue of Northeast Real Estate Business magazine, written by Taylor Williams.
Decreased acquisition activity across virtually all asset classes is among the most visible impacts that COVID-19 has had on commercial real estate, but capital markets professionals say there’s reason to believe deal volume will rebound sharply toward the end of the year.
For most property owners, the net result of the economic disruption and job losses has been a decrease in cash flows. With net incomes faltering or dissolving for property owners, many prospective investors have temporarily hit the pause button on new acquisitions.
As the pandemic has unfolded, bureaucracies have taken action. The federal government appropriated hundreds of billions in small business loans and stimulus payments to taxpayers, and state coffers have been gutted by disbursements to the unemployed. While this activity was designed to stimulate consumer spending and help businesses stave off permanent closures, it has done little to fuel sales of commercial properties.
Numbers Tell All
Real Capital Analytics (RCA) tracks investment sales activity across the country, including in nine major markets in the Northeast region. The New York City-based research firm recently released its findings for the second quarter.
Per RCA, the total volume of commercial sales during this period clocked in at approximately $44.7 billion, a staggering year-over-year decrease of 68 percent and the lowest quarterly total in more than a decade.
In May, the most current period for which monthly data was available, industrial, office, hotel, retail and multifamily properties in the United States all experienced year-over-year declines of 70 percent or more in total sales volume. Total monthly sales volume across those asset classes, which stood at roughly $50 billion in May 2019, fell below $10 billion in May 2020 as investors took a wait-and-see approach to new acquisitions.
RCA’s May report also found that 3 percent of deals that had already closed in May ended up collapsing by the end of the month, compared with just 1 percent in April.
Lastly, the firm identified the aggregate value of “potentially distressed” commercial assets in the United States as $81 billion. However, the report noted that 92 percent of those properties fell into the retail, restaurant or hotel categories. Industrial assets are still performing well due to elevated demand for e-commerce, while office and multifamily owners have frequently received forbearance or restructured loan terms from lenders.
So why the optimism?
Beyond the fact that commercial real estate professionals typically carry glass-half-full mindsets, the answer lies in the fundamentals that existed pre-pandemic, namely a highly liquid marketplace with ample competitors that needed to deploy capital and achieve yield for their stakeholders. Now, however, that capital is tasked with navigating highly uncertain markets.
“The money and demand for commercial real estate that was there in February is still there, on both the debt and equity sides,” says Michael Riccio, senior managing director for CBRE’s capital markets debt and equity finance team. “The problem has been investors’ lack of clarity on what they’re actually buying because tenants’ ability to pay rent has been so uncertain.”
Riccio, based in the firm’s Hartford office, notes that CBRE’s total volume of investment sales was down significantly in April and May relative to those months in 2019. However, he says that activity began to improve in June, with the firm’s debt and equity teams also getting busier with demand for refinancings in lieu of acquisitions.
“Our loan production was down about 70 percent from last year’s numbers in April and May,” he says. “We had a very strong first quarter, so year-to-date the numbers aren’t too bad, but it’s hard to come back from two historically bad quarters. So, we’re going to be down for the year overall, but we expect a very strong fourth quarter of 2020 and first quarter of 2021.”
Daniel Monte, senior managing director at the Buffalo office of independent mortgage banking firm Gantry, also expects lending volumes to increase in the second half of 2020 and into the first part of 2021.
“We are optimistic that volume will grow as the financing market gains a better grasp on economic conditions amid COVID-19,” he says. “We also expect lenders to apply more structure to deals to help mitigate disruptions, such as adding interest reserves, being more selective about which markets and asset types they pursue and closely tracking factors such as rent collections.”
In Monte’s view, investors, particularly those targeting well-located assets with stable rent rolls, are itching to get back into the game after several months on the sidelines. At the same time, a number of lenders, particularly big banks that are exposed beyond commercial real estate — car loans, credit card debt, etc. — are still hesitant to resume lending aggressively. This creates opportunities for other lenders to step in and win new deals.
“The fundamentals of financing quality assets haven’t changed, but there are fewer lenders in the game today, and they’re looking to fund better-quality assets than they were pre-COVID-19,” he says. “That means owners and borrowers need best-in-class lenders that are good fits for their deals.”
Sources agree some stabilization is expected later this year but grant that there will still be winners and losers.
“We expect deal volume to increase as the year progresses, and as the overall environment normalizes, commercial real estate will too,” says Paul Fried, executive managing director at the New York City office of Greystone. “That said, some assets like offices and hotels, may take longer to get past the disruption and to re-establish their tenant and customers bases.”
Fried adds that the future of office properties is especially uncertain, with many firms now adopting formal work-from-home plans and reconsidering how much square footage they need based on social distancing.
Other Factors at Play
Traditional factors and metrics that are often used to gauge the health of commercial real estate markets may have some bearing on the pace and magnitude of a fourth-quarter recovery as well, according to sources.
For example, short-term interest rates, which were already historically low before the pandemic, remain close to zero, and there have been no indications of late that rates are set to rise. Granted, this factor is likely to bolster refinancing activity more so than acquisition, but the fact remains that for borrowers who have ample cash on hand and want to remain active during a recession, debt is incredibly inexpensive.
“Every economic down market includes a fall in acquisitions,” says Fried. “But acquisitions are voluntary, and refinancing is not. Assets with maturing loans require the owner to seek new financing options, regardless of whether it’s an up or a down market.”
“Borrowers that have the opportunity to refinance right now should be exploring the market in great detail,” adds Monte. “With the 10-year Treasury yield below 1 percent and most lenders’ 10-year, fixed-rate product now hovering around 3 percent, borrowers in a position to refinance have a prime opportunity. These conditions may not hold, but a borrower who locks in for 10 years can realize significant profitability over the long run, depending on the deal and the leverage.”
The 10-year Treasury stood at a mere 0.61 percent in late July, down roughly 150 basis points from this time a year ago. And with some states now experiencing new surges of COVID-19 and pausing their reopening plans, it’s also conceivable that 10-year Treasury rates will remain low through the year.
Low yields on government-issued bonds reflects a flight by investors to a safe-haven security. However, it stands to reason that this rate of return will not satisfy many stakeholders for long, says Tom Fish, managing director at Walker & Dunlop.
“Lenders and capital sources try to budget what and how they’re going to invest because they have to generate returns for their stakeholders,” he says. “The need for yield has never been more acute than it is now with the 10-year Treasury yield under 70 basis points. Everybody is hunkered down, so you should see a bounceback from that toward the end of the year as people realize they have to get money out the door.”