By Hugo Dorta, Founder + Principal of Brickell Capital
COVID-19 has put the global economy at a halt as the efforts to contain the total deaths caused by covid-19 and new cases continues to rise daily. Every part of the economy will be affected as a result of the corona virus, and in this regard, the more prolong the “stay at home” orders and economy is on hold, the greater downside when can expect to commercial property values.
A crisis of this magnitude and the scale of the measures implemented to control the pandemic have never been seen before. Therefore, what lays ahead remains uncertain. While the full extent of its health, social, political, and economic impacts are uncertain, the velocity, extent and scale of the shutdown will have serious consequences on the value of commercial properties. There is no doubt that commercial properties in the US are subject to uncertainty caused by fast-moving pace and potential insolvency fallout.
Liquidity Issues During the Initial Phases of Economic Slowdown
As the crisis drags on and as consumer spending decreases, many businesses have already depleted through their cash reserves. As business owners’ drain their cash reserves, they are forced to tap into their personal savings. As these personal savings are exhausted, businesses around the country have been forced to make drastic decisions such as considerable layoffs. Not even three months after the first identified case of COVID-19 in the US, there was a record high rate of unemployment claims, which put a stop to the previous record-setting run of job growth. The unemployment rate, which was at a low of 3.5% in February, has reached an alarming rate of 15% in April and seems to be getting higher.
Insolvency Risks as COVID19-Related Uncertainty Continues to Halt the Economy
If decreased consumer demand continues, liquidity issues will only worsen and some companies may not be able to stay afloat. Generally, when companies continue to have a lack of demand beyond a considerable or expect period, they shall experience solvency issues which in turn shall cause companies to experience difficulty in meeting their long-term financial commitments, obligations and debts. It is feared that an extended recession will lead to many companies to default in their rental payments to landlord and lenders, obligations to creditors and general operating debts, and eventually, lead them into bankruptcies. At the present, the biggest concern is even if businesses get through the liquidity crisis and pay their short-term obligations, they may not be able to resume operating afterwards if consumer demand continues to decline. With decreased cash flows, many businesses may default on their debt payments, or they may not be able to secure additional financing. Unfortunately, this will cause many businesses to “shut their doors” or file for bankruptcy protection (i.e. Neiman Marcus Retail Store).
How will this affect the value of commercial properties ?
The liquidity crunch will significantly impact the demand side of commercial property markets. When tenants experience a loss of revenue, the risk of tenant defaults will increase. Logically,as we see an increase in rental defaults by tenants, landlords and property owners shall experience substantial legal fees and other related collection costs together with a loss of necessary cash flow to meet their own mortgage payments, real estate taxes, insurance premium and other related property obligations which in turn shall exert downward pressure on property performance and valuations, and increase other costs such as legal fees.
Another important factor is the insolvency which may result from a prolonged economic halt. Although liquidity issues will be hurt the demand side of properties (by increasing tenant risk), a potential solvency fallout will definitely hurt the supply side. Struggling to fulfill their long-term financial commitments, many tenants will go bankrupt which in turn will increase the supply of commercial properties in the market. As property valuation and demand decrease: (1)there will be an increase in available vacant space; and (2) landlord shall have to accept less financially secured tenants since they will need to will to fill the existing available spaces. Obviously, this will increase risk in all spectrums.
The downward pressure exerted by all these factors on less financially secured landlords and owners shall cause an increase in distressed asset sales which shall contribute to lower property valuations. Nevertheless,not all property types will be impacted in the same way. As it will be discussed in the next section, some property types will be less affected than others.
How have different property types and sectors been affected during previous recessions and what does this mean for the current recession ?
During the last 5 decades, the historical average price decline of US commercial properties during recessions is 22%, but it varies according to property type. According to historical data from previous recessions, some property types tend to be better positioned than others. Let’s explain the difference:
Generally, during past recessions, the property type that tends to suffer the least is industrial and retail. Industrial experiences a historical average price impact of -10% during recessions. This industry is typically negatively affected by global supply chains and consumer discretionary products. Manufacturers of durable goods such as automobiles, washing machines, and furniture are expected to get hit the worst since such purchases are a burden on most households during recessions. Moreover, constrained logistics and travel restrictions lead to difficulties for most manufacturing sub-sectors, which will be a big concern during this recession due to the halt in international travel. Nevertheless, the need for storage spaces will remain stable or even increase due to lost homes or closing down of businesses. Lastly, on the positive side, during this recession, industrial properties, such as distribution and fulfillment centers will be operating at full capacity as people stay away from physical stores.
Retail has a historical average price drop of 14%. Malls and shopping centers as well as entertainment retail stores, like restaurants and movies, usually take a hard hit. Grocery stores and pharmacies, however, do not suffer as much and neither do tenants with strong digital channels, such as online retailers with a limited physical presence. During this recession, this theory appears to hold true. Due to the nature of this recession, however, entertainment retail as well as shopping malls may suffer more than past recession since as current “stay at home” orders have extended for prolonged periods of time in order to avoid further contamination of the covid19 virus.
Generally, Hospitality has suffered an average decline of 15% in past recessions but this recession is not economic,it is a health crisis. Due to COVID-19, domestic and global travel has come to a complete halt. Most if not all hotels are closed or expected to close under Governor orders. Consumer and business demand for hotels, travelcenters, motels, etc. has almost completely vanished, and any hotel that remains open will be expected to operate at very low capacities for an indefinite amount of time. This health pandemic crisis will definitely devastate the hospitality sector and any rebound to normalcy is not expected until at least 2023.
During most recessions, vacant land is projected to decrease by 16%. This is mostly due to the fact that agriculture and more significantly, resource extractions are put at risk during crises.This holds true for this recession.
The Office sector seems to be impacted almost as much as multifamily, with a historical average price impact of -20%. Similar to multifamily, the severe risks are that this property type can be exposed to tenants in high hit industries. Typically, during recessions the value of office is also expected to decrease due to the increase in available shared workspaces. During this recession, this does not appear to be a concern but if the new “work from home” trend increases drastically it shall cause the demand for office space to decrease, and thus, adversely affect the value of office buildings in the next few years.
Multi-Family is the most affected property type during previous recessions with a historical average price impact of -25%. One of the more severe risks that will affect the value of rental properties is exposure to tenants in industries that are greatly affected by recessions such as leisure and hospitality. The second most severe risk is lower credit tenants, which can increase rent defaults. The value of rental properties is bound to be negatively affected as the risk of tenant default increases and lowers the expected cash flows from this type of investment. The less severe expectation is that properties’ tenants are in industries that are not greatly affected, like government or technology, which will not increase tenant risk as much. Similarly, some tenants may maintain credit scores that are not too low, which lowers default risk.
What can we expect in the future and how will different property types (sectors) adjust to the changes ?
The measurable impact of COVID-19 has been undoubtedly negative:unemployment has gone up drastically, stock markets values have plummeted, and uncertainty and instability surrounding health, economic, social, and political events have caused turmoil. The timing and durability of solutions are uncertain. For the time being, however, there are three potential paths forward: (1) the world is able to contain the virus through medication or a vaccine; (2) some form of human immunity is achieved after a substantial percentage of world population has been contaminated or infected (in some manner); and/or (3) the virus disappears to some extent and re-appears seasonally in some flu-like form.
Each of these paths has different economic consequences. Due to the fact that this recession not an economic recession buta health crisis due to COVID-19, long-lasting economic changes are likely. For examples, stores are already limiting capacity and office spaces are being occupied as people work from home. Both of these efforts are in line with new social-distancing guidelines. Due to the circumstances,the nature of this fast-spreading virus and the manner in which it spreads from human-to-human, this recession will definitely have larger and more devastating impacts on hospitality and retail sectors than previous recessions. These two property types will experience larger price drops than the historical average price impacts. Their price drops may be more in line with the price drops of isolated recessions. During the 1973 recession, there was an average 50% decline inhospitality prices, and during the 2008 financial crisis, retail prices declined by an average of 39%. These price drops are more in line with what is expected to happen to hospitality and retail during this recession. In the future, structural changes, such as deleveraging and reduction of physical locations are likely, and the hospitality industry may probably consolidate in an effort to reduce operating costs and plain and simply stay in business.
Hugo Dorta, the author of this article, is the Founder and Principal of Brickell Capital.
Brickell Capital is a Florida “private bridge” mortgage lender. We specialize in residential and commercial loans for (self-employed US borrowers and Foreign Nationals) New Construction Loans for Builders/Developers + Loan Servicing. Brickell Capital also focuses on investing and managing of distressed mortgage loans. We purchase seasoned performing (and non-performing) first and second mortgage lien loans; sub-performing mortgage loans; non-performing mortgage loans; mortgages in bankruptcy and foreclosure; home equity lines of credit (HELOC); investor fallout mortgage loans; scratch and dent mortgage loans; and aged mortgage loans on warehouse lines.
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