Understanding Best-Case & Worst-Case Scenarios in the CRE industry

Whether you’re a veteran in commercial real estate (CRE) investing or are thinking of adding this asset class to your portfolio, you must be looking for some guidance on positioning yourself in light of the pandemic and its effects on the market.

What does the future hold for commercial properties?

Is it a good time to buy now or wait until there are more clarity and direction?

In this blog, we’ve rounded up what CRE experts think about what’s ahead. The gist? Everything is up in the air, but the health crisis could bring good and bad news for different asset categories.

Risks & Uncertainties

The COVID-19 crisis brings with it an extraordinary combination of unknowns.

There are uncertainties about whether an effective vaccine will ever be discovered if there will be new waves of infection as the weather changes and if various government levels can provide financial support and economic stimulus.

When and how well the industry will recover depends on all these, and ultimately on job creation.

Best-Case Scenarios        

Industry experts say that this corona-virus economic downturn will resemble previous recessions, for the most part. The property sector as a whole will come under stress, but sound assets with solid fundamentals should survive.

• There is a consensus that apartments and e-commerce warehouses will outperform other sectors.
• The pandemic may boost suburban multifamily performance. A good number of city-dwellers (specifically those in the millennial age group) may seek alternatives to dense urban environments, which are now seen to heighten the risk of infection spread.

As more and more people embrace remote work, there may be a drive for apartments with home office spaces. Millennials are expected to exit urban neighborhoods to seek homes with more elbow room. Experts predict intra-metro “migration” to suburban areas—and it will likely happen sooner than later.

The recent performance of multifamily properties seems to indicate that the shift is already happening. According to the National Multifamily Housing Council, June rent collections in this sector reached 94.2%, nearly the same as the last year’s figures.

• The apartment sector should also see minimal rent compression and continued leasing velocity. Demand and fundamentals are looking strong and should stay that way. Paycheck protection programs and supplementary federal unemployment insurance helped renters pay their rent during the early months of this public health crisis.

• The pandemic has accelerated the shift to online shopping. In fact, according to the US Department of Commerce, non-store retail sales rose by more than 25% year-over-year in May. This is great news for last-mile industrial properties.

Last-mile facilities are industrial warehouses e located close to densely populated areas and used to distribute goods along several routes and via multiple channels. Industrial properties that have the features and the capacity to accommodate e-commerce demands will do particularly well, such as warehouses with durable floors and high ceilings required by last-mile distribution activities. More than ever, consumers who buy goods online are expecting super fast deliveries, increasing the demand for such distribution facilities.

• There may also be an uptick in demand for suburban offices. Technology is enabling broad-based shifts to remote work arrangements for millions of people. Many companies plan to make this arrangement permanent for at least a portion of their employee population. This trend may boost the suburban office market as CBD tenants add satellite locations for employees who live in the suburbs.

If a viable vaccine emerges, uncertainties in the office sector may prove to be relatively short-lived.

Most companies want (and need) to bring people back into offices, but they also need to ensure their workforce’s safety.

CRE landlords are advised to tell their office tenants to think long term and remain flexible.

Worst-Case Scenarios

The first three months of the pandemic saw property prices drop by 11 percent. Lodging and mall prices fell by 25%. Most industry predictions assume that it will take several years for the job market to rebound fully, and CRE investments reflect these concerns.

• Particularly vulnerable are assets that were struggling even before COVID-19. These include over-leveraged projects and properties in overbuilt areas where supply has always outstripped demand, to begin with.
• The hotel sector is one of the most susceptible and problematic, as most hotels go from full occupancies to virtually no business. Year-over-year occupancy plummeted from 52.1% to 33.5% in the second quarter. Revenue per available room (RevPAR) fell to $27.98—that’s a 69.9% decrease.
• Some initial numbers indicate that the office sector's recovery will vary widely by city/metropolitan area. In mid-July, the occupancy rate of Los Angeles office properties was 32.3%. New York City metro area occupancy rates stood at 10.1%. The number is 18.1% in Chicago.
• The pandemic will end the weakest retail sector properties. Well-located assets with tenants who are not affected by e-commerce were gaining ground initially, but even they are struggling now. There is no telling how quickly the general public will think it’s safe enough to visit those establishments again.
• Cautionary notes are also for multifamily properties. Experts predict a repeat of the 2008 to 2009 recession. The average rental rate for renewals and new leases declined by 0.8 in April and by 1.4% in May.

All in all, CRE analysts say the pressure on industry fundamentals may continue into 2022, as underway projects are completed. New developments may drop by 50%.

We might need to wait until 2023 to see favorable market conditions.

What investors should be thinking about is this: How much occupancy and the rent they might lose in the next two years, versus how much they might gain two years after.

There are some opportunities in the multifamily sector for the bullish investor, at least in the midterm. But as usual, everything depends on job creation.