Friends and colleagues.
I’ve been getting a lot of calls from concerned clients. Rightfully so, as these are unprecedented times. I thought I’d share a letter I recently sent to a client with whom I’m consulting on a significant project. This client has stakeholders based in the U.S. and overseas, and I felt it important to share with them the current market temperature that could impact the deals we are negotiating. I’ve included the letter below (with client- and project-specific details removed). Transparency can help clear up murky situations, and I look forward to sharing more information, and hopefully hearing from you, as we navigate this new world.
As I shared, much of the analysis regarding the coronavirus impact has understandably been focused on the negative impact of the outbreak and downside scenarios. The situation is fluid, there remain many unknowns, but it makes sense to consider the increasing downside risks as it relates to potential transactions.
To summarize, note the following:
· The uncertainty associated with the impact on the economy will make developers move slowly when pulling the trigger on due diligence expenses like surveys and trips to the market.
· A developer’s underwriting will have to change as a result of the likely increase in construction costs.
· If the recovery is “V-shaped”, the commercial real estate markets are primed with historic low-interest rates and investor appetites for CRE-type returns.
First the not so bad perspective
1. On Friday, a JLL economist anticipated the long-term outlook for commercial real estate to improve. “While real estate yields may be marginally impacted in the near term, the long-term outlook remains positive. Growing calls for additional interest rate cuts could further support the low yield environment.”
2. CBRE economists expect that demand for real estate as an investment will increase. “While volatility in financial markets affects sentiment in property markets, it may also present an opportunity. A rally in bond markets has seen bond yields fall back to historic lows, this has helped reduce the cost of borrowing and in some instances increased the attractiveness of property as the spread on the risk-free rate continues to widen.”
3. Many types of industrial development will still be in demand. For example, e-retailers may benefit from increased demand in the short-term, although these platforms may face some pressure from a disrupted supply chain. CBRE points out that this disruption would further accentuate the already existing pressure on brick-and-mortar retail caused by the rapid growth of e-commerce.
4. The supply chain slowdown could also impact the retail development on some project sites. According to Marcus & Millichap: “coronavirus impacts could include loss of tourist traffic and fewer people visiting shopping, dining and entertainment venues as they avoid crowded places. But overall, the retail real estate demand should remain stable,” their economist said in a report out last week.
5. CBRE economists state the following pointing to a silver-lining for development. “If COVID-19 falls back this summer, which is what many say is the most probable scenario, then the CRE sector is primed to take off. If the impact of COVID-19 is ultimately a short-term shock, which is the consensus right now, meaning a first-half 2020 event followed by a rebound, then just consider the gusts of wind forming behind CRE. The 10-year Treasury yield – the most important benchmark for gauging property values– has fallen below 1.0% for the first time in history, a record low. Cap rates generally follow Treasuries, and when cap rates go down, CRE values go up. Pure math. Moreover, the cost of capital is cheaper than ever, leveraged returns are now the best in 20+ years, and based on the data that we do have in the first two of months of the year, we still have strong underlying economic fundamentals, with more fiscal and monetary stimulus likely to be injected.”
Now for the doom and gloom perspective:
1. CBRE expects the COVID-19 outbreak to have a negative short-term impact on certain sectors of the commercial real estate market. However, the further transmission and evolution of the virus remain difficult to predict.
2. Developers will move more slowly. Many businesses may hold off on signing new purchase agreements and leases until some of the uncertainty subsides.
3. If some of the fundamentals of growth are affected, the impact could be much more than a temporary hiccup in the economy and would cause a noticeable change in the industrial real estate outlook.
4. Underwriting for current projects will have to change. Lack of materials could result in significant project delays and cost escalations for developments that have not yet broken ground. A Colliers International report noted construction costs could surge as contractors must switch to more expensive American raw materials rather than importing them from China.
Finally, I’ll wrap this up on a positive note. James Thorpe of Cushman and Wakefield is a “glass half full” economist with the following observations posted on Friday, March 13th.
#1. Commercial real estate (CRE) is not immune to the coronavirus impact, but it is resilient
#2. The industrial markets are not overbuilt, which makes for a faster return to normalcy
#3. Labor markets remain in excellent shape.
Uncertain times indeed. But if we proceed with calm nerves and cool heads, the market will prevail, and deals will still get done.