What will become of all these office buildings and retail stores?
The reformation the global commercial real estate market is currently enduring is unlike any experienced in modern history. The market has endured many calamities, sailing through health crises, environmental threats, geopolitical instabilities, and the prospect of financial devastation. Recovery has always been assured, although GRE recovery tends to trail behind the wider economy by about six months. This time is different.
The widespread transformation COVID-19 is spurring in several CRE sectors is likely to be permanent, and investors are fighting to find a path to recovery as the world continues to reel with no verifiable end of COVID-19 in sight. In the first six months of 2020, direct commercial real estate investment plummeted to $321 billion, a 29% fall from the first half of 2019, according to data from JLL.
Investment volumes in Asia-Pacific dropped 32%, with the Americas taking the biggest hit with a 37% decline. Pre-COVID deals sheltered the EMEA region somewhat, with a drop in investments of only 13% that carried into the first half of this year. Fundraising by private, closed-end real estate funds declined 26% in the same time period, but that sector is still flush with capital and is expected to have an easier time in the short term. Private equity investors are, as always, active and on the hunt for opportunity.
Bright spots include Japan, garnering a 7% increase in investments year-on-year; Germany, whose investments dropped by only a single percentage point; and South Korea, which performed better than its average for the first half of the year even though investments fell by 15%.
“Cross-border investment has slowed significantly with travel restrictions, in particular inter-regional investment which declined by 61% during the second quarter. Those markets that are more reliant on foreign capital are feeling the effects, resulting in steeper activity declines,” said Sean Coghlan, head of research for Capital Markets, JLL. Cross-border investors are hamstrung by travel restrictions keeping them from performing thorough due diligence. He noted that the most resilient markets to date are those with high transparency and abundant capital.
Eight major global REIT indices bottomed out in March but have since recovered a portion of those losses. They are still hurting deeply, with returns averaging a 24% slide as of the end of Q2. “While public valuations serve as a useful benchmark for the markets, they are not reflective of private market values due to differences in liquidity and risk premiums, among other factors,” Coghlan stressed. “A bid-ask spread is evident in the markets, and price discovery remains underway.”
Many REITs are conserving cash, according to Deloitte’s Jim Berry. “Some are delaying or suspending dividend payments; others are cutting dividend rates and giving a majority of the dividend as stock instead of cash. Companies have also drawn on their credit facilities and are exploring refinancing options, establishing new or expanded facilities, and debt offerings to maintain liquidity in the short term to midterm.” Many firms have also furloughed workers and suspended bonus programs.
Sectors that are “operationally critical” have benefitted despite uncertainty, particularly industrial facilities, self-storage, and data centres. JLL data found that “the focus on supply chains and the growth of e-commerce during lockdowns has spurred greater interest in the logistics sector globally. This was reflected in investment activity, with the sector’s investment volumes dropping only 13% in the first half of the year.”
What Remains, and What Changes
The long-term impact of the pandemic will vary across property types, and portfolios will be reshuffled in the new normal. Myriad factors are giving us clues about what that new state of existence will mean for investors, in particular the behavioral response of workers, renters, and property owners to immersion in an uncertain existence.
“Strategic review processes aim to understand how real estate usage might change going forward. However, rather than relying on traditional economic or customer-survey-driven approaches, real estate leaders are looking to psychologists, sociologists, futurists, and technologists for answers. Will employees demand larger and more enclosed workspaces? Will people decide not to live in condominiums for fear of having to ride elevators? While uncertainty currently reigns, by employing a range of creative personnel and using new methodologies—such as deep design interviews—business leaders may find new and more predictive insights,” said a recent analysis by McKinsey.
The behaviors most likely to endure after COVID-19 will have the strongest impact on the industry’s reinvention. Researchers at Barings Real Estate (BRE) recently surveyed global CRE investors to get a handle on which behaviors will outlast the pandemic, noting that those related to fear and risk will fade as the disease loosens its grip on the world, and that those behaviors related to financial reward will persist and be levers for lasting change.
Consider occupancy costs and the new realities of remote work. BRE found that companies that can lower their building occupancy costs without sacrificing innovation, productivity, and efficiency can widen their margins by embracing remote work, which may also help them compete in a more extensive geographical talent pool.
The progress of e-commerce will continue, hastened by consumers’ reticence to mingle in crowded settings. “The combined effect of the economic toll from the pandemic and accelerated e-commerce growth will hasten the demise of secondary physical retail. As the economy reopens, however, the shrinking universe of retail space will provide additional support to the positive demand outlook for warehouse and distribution space, especially modern, ‘last-mile’ space in close proximity to large, affluent populations—the same trade area metrics that have always applied to the retail properties that e-commerce fulfillment centers are threatening to replace,” BRE declared.
The ability to stay resilient will significantly impact warehousing, which had already been adapting pre-pandemic as companies worked to meet increasing demand while making their supply chains more transparent and flexible. BRE expects near-term demand to give warehouses a boost, but stresses, “A more interesting and potentially more impactful approach to improve resilience involves ‘re-shoring’ or ‘near-shoring’ to shift production of certain goods to domestic or proximate markets. Even on a small scale, such a manufacturing renaissance would have a multiplier effect in terms of industrial demand.”
No matter what changes will fade and what will endure, reinvention will be the clearest path for a stronger, more resilient, and triumphant industry.