- Commercial real estate – hotels, shopping malls, offices – faces huge post-pandemic challenges.
- We can all see the work from home and ecommerce trends coming and the CRE disaster looks like a slow motion shipwreck.
- And this sinking could take the rest of the US economy with it.
- This is an opinion column. The thoughts expressed are those of the author.
- See more stories on the Insider business page.
In 2016, a colleague of mine, Michelle Wuc ker, published a terrific book called “The gray rhinoâThe title alludes to humans stalking the gray rhino, a species widely known to be nervous and prone to charging and maiming. Yet awareness of their likely behavior doesn’t deter the curious from stepping closer to watch.
Much like stupid humans trying to approach a gray rhino, Wucker writes about events that are not in themselves random surprises, but that occur after a series of warnings and visible evidence. The gray rhino is a situation that stares you in the face, that you have a deep understanding of while still proceeding as if there is little risk.
And right now, there’s a two-ton gray rhino watching the US economy: more specifically, $ 6.5 trillion in assets in the commercial real estate industry (CRE) in the United States. This upcoming CRE threat, across the industry’s top three non-residential sectors, sniffs loudly and padding its front paw, as we all stand and watch.
So let’s open our eyes and watch carefully. And just like with loading animals, being prepared is essential to protect against loss – not life and limbs in this case, but systemic safety and soundness.
The “Big Check-out” is not over in the hotel industry
First, the hotels, which have been hammered by COVID-19
. Since hotels do not have leases to protect their revenue stream, up to 10% of the area was fully closed during the 2020 lockdowns and 3% of locations remain closed, according to STR, Inc. Even hotels who remain open during good parts of the pandemic grapple with bills and debt arrears even as incomes rebound. National revenue per available room – a key metric for the industry – fell 29% through April from 2019 levels.
Given the likelihood that the American consumer will engage in a good deal of “revenge spendingâAs the economy fully reopens, the hospitality sector is expected to experience substantial improvement over the summer. But the improvement could be short-lived as there are obvious issues that are likely to wreak further havoc in the fall. .
Hotel room rates and occupancy are dependent on business travel and conference room demand, which accounts for about 30% of demand under normal circumstances. This company, often booked well in advance, provides hotels with a baseline on which to base prices for other rooms. In some of the larger conference destinations, the size of the business may be closer to 50% of the total business.
What will happen when many hotels attempt to rebuild their business volume all at once? Big discounts. In addition to this timing issue, this critical element of the hospitality industry also faces an existential threat. Numerous business meetings that required travel before COVID have been shown to turn out to be
or other video calls. What this means for future levels of travel is, frankly, unknowable. But this is unlikely to be positive.
Finally, the value of many hotel properties has been decimated by the pandemic. 23% of all hotel loans have become past due and billions of dollars in loan interest has gone unpaid – whether as a result of defaults or forbearance by lenders – and will need to be paid. And the ability of other hotel owners to continue repaying their debts has been made possible by Payment Protection Program (PPP) to over 19,000 of the 54,000 hotels in the United States totaling nearly $ 11 billion (and that excludes loans under $ 150,000). Even more alarmingly, $ 1.65 billion of those PPP loans were made in March and April of this year, demonstrating that the PPP still acts as a lifeline for the industry. And that program ends this month.
As a result, the âBig Check-outâ in the hotel industry will echo until the end of 2021 and 2022.
Do not buy at retail
The second part of the commercial real estate market facing a crisis is that of shopping centers. This struggling industry was already facing pressures before the pandemic – growing losses of major referral tenants and an increase in online shopping. But the COVID crisis has plunged commercial real estate issues into the stratosphere, reaching far beyond the commercial space. Street shopping centers and, more particularly, urban convenience stores are also in difficulty.
Consider the very expensive storefronts of Manhattan, where available unoccupied retail space averaged over 25% of total square footage at the end of the first quarter of this year.
As with hotels, commercial real estate is also facing a change in corporate culture that has been accelerated by lockdowns. In Q1 2021 online purchases (excluding groceries and gasoline) now represent 15% of retail, and seems to be increasing. As the convenience of clicking and buying becomes more prevalent, the need for brick and mortar retail space will naturally continue to decline.
We also have a surplus of PPP loans in the retail sector – non-chain stores, franchisees and restaurants – which introduces an additional unknown regarding the number of merchants able to survive the withdrawal of these advances.
Commercial real estate was already âfor saleâ and now faces the prospect of âliquidationâ in many markets.
Go back to the bedroom?
Finally, the sector that is both the least clear and the most problematic of commercial real estate is that of offices. The cultural changes that will follow 15 months of working from home will be slow to manifest in terms of the decrease in demand for space. But it should be obvious to everyone that the #WFH genius isn’t the one that can be put back in the bottle.
Aside from industrial property owners, office owners typically enjoy the longest lease terms, ranging from an average of eight years in the country’s largest cities to five years and more elsewhere. Thus, the pain of tenants’ decisions to reduce their office space will spread over a longer period of time. And while the above changes aren’t dramatic, homeowners may have the chance to ride a good chunk of the recession in their industry. However, I wouldn’t hold my breath.
In this case, we need to look at availability as a guide, not how much office space is currently vacant. Nationally, job vacancies climbed more than 18% in the first quarter of this year. But availability rates (including vacant space but still subject to leases) are much higher than vacant positions. In Chicago, vacancy is just over 16%, while availability is 22.3% of the total space. In New York, even with its high percentage of large creditworthy tenants, availability already exceeds 17%.
Kastle Systems 10-City Return to Work Index only suggests 28% of workers returned to the office at the time of this writing. And with around 15% of office leases expiring each year, 2021 and 2022 are likely to see a bloodbath in downsizing and outright giving up of space.
A bigger problem?
There is a winner in the CRE industry: industrial property. Specifically in the warehouse and logistics sector, which is now overwhelmed by the increasing volume of online shopping and distribution of medical equipment. Multi-family rental real estate in major cities that experienced massive out-migration during the pandemic will have real challenges, but the rest of this industry should be fine as everyone needs a place to rest at night.
But the challenges facing the three major commercial real estate sectors discussed above are very real and could turn more in a negative direction over time. And a major revaluation in these sectors could create a more systemic problem among the holders of loans secured by the impacted properties, not to mention loss of wealth among the shareholders.
The last time the country experienced a specifically commercial real estate recession (more like a depression in some markets) was in the late 1980s through the early 1990s. Mainly due to overuse of mortgage debt (rather than sudden drop in rents and incomes), it spilled over into what became the savings and loan crisis and forced the government to undertake wholesale asset liquidations. In addition, it caused a recession that took Real GDP per year and a quarter to recover.
It has also created buying opportunities of a lifetime for some.
Today, properties are generally less leveraged, but face unprecedented revenue challenges that threaten substantial loss in value. And the one thing that bailed out commercial property the most from the devastation of the early 1990s and the Great Recession – a substantial drop in interest rates (which still serves to boost property values) – cannot really happening now with market costs of financing approaching their practical limits on the low side.
So beware of this particular gray rhino. Because when this one comes, it’s going to be a bumpy race.