With vaccine distribution beginning across the U.S., investors are wondering what commercial real estate (CRE) values will look like on the other side of the COVID-19 crisis. Ken Riggs, Vice Chair of RERC, a SitusAMC company, offered his forecast in a December 8 webinar, presenting investor surveys and other data from the latest RERC ValTrends Report, “Reimagining the Future.”
While the NAREIT index of publicly held real estate investment trusts have fallen around 12% year to date through the end of 3Q 2020, the private market, as measured by the NCREIF Property Index (NPI), has held steady. “We’ve struggled for the last eight months to truly understand what was going to happen from a value perspective, and it’s easy to forget that in March we thought we were falling off the cliff,” Riggs said. “No one had a playbook. Even Warren Buffet said, ‘I’ve had to live 89 years to see this.’”
Uncertainty remains, with the number of investors who prefer cash to the alternatives climbing to its highest level since the third quarter of 2008. It’s worth noting that by 3Q 2009 the desire to hold cash plummeted so we may see investor preference shift to CRE in 2021.
The extremely lower than expected 10-year Treasury rate is a primary market catalyst, Riggs noted. On the residential side, 30-year mortgages are priced below what the government was borrowing at only 12 to 15 months ago, fueling enormous demand for homes and driving prices to record highs. “Most of the interest rate advantage for single-family pricing has been squeezed out,” Riggs noted. “We haven’t seen that run-up in CRE except in industrial properties, which are red-hot.”
The allure of CRE is best illustrated by examining historical spreads between the discount rate (IRR/expected yield/total return) and 10-Year Treasurys (see chart). The third quarter mirrored the same period in 2008. “Two to three years after the financial crisis, most of the value gain in CRE was attributable to cap rate compression, cheaper capital, very available capital,” Riggs explained. “If you look at the income component, a cap rate of 4 to 6%, and total return of 7% to 8%, it’s very attractive. These are unlevered returns. If you add a little leverage, you’re now starting to see returns in the 10% range. We haven’t seen that investment dynamic play out in pricing of commercial real estate, but it’s coming and CRE investors will be rewarded, but we need to be patient through the first half of 2021.
Among the other highlights of the webinar:
The multifamily rental market faces the greatest dislocation in decades, with shortfalls in rental payments estimated to hit $24 billion by January. A moratorium on evictions by The Centers for Disease Control and Prevention expires December 31, and millions of Americans face eviction. Mom-and-pop owners are shouldering the brunt of the crisis, while institutional multifamily assets are less affected, Riggs noted. (At this writing, a bipartisan group of senators was close to unveiling a $900 billion relief package that would include stimulus checks of $600 per person, unemployment benefits and rental assistance.)
Residential flight from central business districts is boosting the suburban rental market. Downtown apartment rents have declined amid rising net completions and a flight to the suburbs by renters age 35+. Near San Francisco, for example, nearly 60% of new single-family renters came from downtown. Nationwide the single-family rental market has blossomed, with the largest three real estate investment trusts controlling up to $30 billion of the single-family rental pool.
Urban office will eventually stage a comeback. Although just one in five workers has returned to downtown offices, premier buildings are drawing bargain hunters, Riggs said, with more prospective tenants touring marquee office addresses in Manhattan than did before pandemic. Net absorption is down significantly, and Riggs expects more employees to work from home and more companies to swap long-term leases for flexible space. On the other hand, office has seen a significant downsizing in recent years, with space per employee falling by about 50 square feet. “Long term I don’t see the office market going away in the downtown urban areas, but there’s a rough road ahead,” he said. “Will there be higher structural vacancies? I would say yes.”
Retail and hotel assets are seeing “tremendous repricing,” while competition for industrial assets will inflate prices and depress yields. Quality will stand out amid a “Darwinian environment,” Riggs noted.