Pockets of Opportunity in Times of Uncertainty

Introduction

The COVID-19 pandemic profoundly impacted the commercial real estate market, specifically occupancy levels, transaction volume and capital flows. Transaction volume nearly froze in 2Q20, driven in part by the uncertainty of asset performance and increased scrutiny in the debt markets. Despite these challenges, many tailwinds set commercial real estate up for a healthy rebound, including Government stimulus, monetary policy, tempered return-to-work plans and a near-record amount of dry powder waiting to be deployed in the sector.

Alliance Global Advisors believes managers must keep their ear to the ground for new opportunities during market dislocations. Proactive managers will be able to generate a positive outcome for both current and future Limited Partners via opportunistic transactions.

Sector Snapshots

Hospitality

An immediate and visible impact on the hospitality sector resulted from an abrupt halt of travel during the pandemic. Hotel operators were forced to lay off or furlough hotel staff as occupancy dropped, and in some instances, hotels closed temporarily due to the prohibitive cost of remaining open. According to Marcus and Millichap Research, U.S. hotel occupancy reached a low of 21.0% in mid-April. As of the end of July, occupancy recovered to 47.0% as compared to occupancy run-rates in the mid-60% range before the pandemic. Hotels in drive-to locations have also experienced a rebound in occupancy during the summer months as leisure travel resumed. The recovery will be slow as business travel has yet to commence. Industry experts forecast a return to pre-COVID levels of occupancy and rate in 2023. Due to the nightly lease structure and visibility of cash flow, hospitality assets will likely experience a swift and steep devaluation in 2020, unlike other major property types. This is one sector where investors may find and capitalize on distress. A potential spot to look for near-term outperformance is the select-service hospitality space, as these assets have less overhead (due to the limited food, beverage and service components) and consumers and business travelers will look to cut expenses through lower rates.

Retail

Total Retail Sales (excluding automobiles) declined 8.1% in 2Q20, the most significant decline since 2Q09. The impact of lockdowns and store closings was amplified by an 11.2% decline in nonfarm payrolls during the quarter. The impact of the pandemic could be felt almost immediately, with several large occupiers filing for bankruptcy, including Neiman Marcus, J. Crew, Pier 1 Imports, Brooks Brothers and JCPenney, to name a few. Though it will likely take time for the dust to settle, COVID-19 is likely to accelerate several trends in retail that predate the pandemic, including the decline of Class B malls, the shift to e-commerce and the outperformance of grocery-anchored centers.

Office

The office sector also faced uncertainty in 2Q20 as employers were forced to close offices in reaction to statewide lockdowns. According to JLL, global office leasing activity declined 59.0% year-over-year as the disruption created uncertainty for office tenants. It remains to be seen if demand for office space will increase as employers aim to give employees more personal space, though it is likely that the pandemic will hasten the trend of large corporate occupiers streamlining their real estate footprints. Lastly, flex-office space, which was a key driver of CBD occupancy pre-crisis, has slowed dramatically. However, employers will likely continue to explore the use of flex-office as they seek to optimize their footprints and provide optionality for employees.

Multifamily

Longer-term demand drivers for multifamily have remained relatively unchanged. Increasing homeownership costs and an undersupply of workforce housing continue to act as stabilizers for multifamily consumption. The multifamily sector experienced an infusion of federal stimulus to aide tenants and tenant-friendly policies such as eviction moratoriums, which helped mitigate any potential near-term declines in Net Operating Income (NOI). These policies had a greater impact on Class B and C product as opposed to Class A. Class A apartments saw an 80 basis point increase in vacancy to 5.7%, whereas, vacancy decreased 10 basis points in Class C apartments according to CoStar. With respect to geography, secondary and tertiary markets that had strong fundamental growth prior to the pandemic such as Austin, Raleigh and Columbus were among the best performers while dense, gateway markets such as San Francisco, Boston and New York were among the worst performers.

Industrial

The industrial submarket has continued its long-term trend of strong performance despite the pandemic. Consumer preference for e-commerce retail increased substantially during the quarter as statewide lockdowns necessitated an overnight change in shopping habits. The sector experienced an average rent increase of 6.3% compared to last year and has an overall vacancy of 5.0% according to CBRE Research. This is approaching record lows despite the pandemic. New supply continues, with a consistent development pipeline of nearly 300 million SF of industrial space planned in the U.S.

Transaction Activity & Valuation Implications on Private Real Estate

Transaction Volume

Unsurprisingly, transaction activity screeched to a halt in 2Q20 as the pandemic began to cause shutdowns and introduce uncertainty into the U.S. economy. The decline in activity was driven in part by investors’ desire to take a “wait and see” approach to determine the NOI reduction resulting from lockdowns as well as difficulty in obtaining new debt financing for acquisitions. Investment sales volume in 2Q20 decreased by 68.0% to $40 billion as compared to the previous year, according to Real Capital Analytics. The month of May saw the lowest volume ($11.7 billion); however, June was down 73.0% year-over-year despite having more sales volume than May ($12.9 billion).

The sharp decline in transaction activity was seen across asset types. Hotel and retail were hit hardest (down 91.0% and 74.0%, respectively to 2Q2019); however, even property types that have outperformed since the Global Financial Crisis, such as industrial and multifamily saw sharp reductions in capital flows (down 50.0% and 73.0%, respectively).

Capitalization Rates

The decline in transaction activity led to capitalization rates remaining stable in 2Q20, trading within 10 basis points of the same quarter last year. As transaction activity returns in the second half of the year, it will be important to watch transaction pricing to see whether valuation changes are driven by impacts to NOI resulting from lockdowns and bankruptcies or if cap rates expand and pull back from their downward trend over the past decade. It is likely that cap rates remain lower in the near-term as interest rates remain at record lows.

Private Real Estate Returns

As a result of the pandemic, returns for the NCREIF Property Index (NPI) and Open-End Diversified Core Equity Index (ODCE) slowed substantially in the first half of 2020 driven in large part by the appreciation component of the returns turning negative for the first time since 2009. Income returns have remained constant, implying assets are well-capitalized and are still generating enough NOI to cover both debt service and preferred returns. Sector-specific returns also decelerated in the first half of 2020, especially in hotels and retail (declines of 18% and 6% respectively). The lone bright spot was the industrial sector, which saw returns of 10.0%.

Secondary transaction volume dropped 53.4% year-over-year as average pricing has dropped from 83.0% to 72.0% of NAV, according to Setter Capital. Demand for secondary trades is likely to increase in the second half of 2020 as core investors may seek to exit more liquid investments due to portfolio-wide liquidity concerns, or a recognition that certain open-end fund positions may underperform in the near-term. Though there is less evidence of actual transactions (due to wide bid-ask spreads), investors have recently expressed interest in executing open-end fund trades on the secondary market.

Source: NCREIFNote: 2020 figures are shown as trailing-four quarters ended Q2 2020 — Source: NCREIF
Note: 2020 figures are shown as trailing-four quarters ended Q2 2020

REIT Returns (NAREIT)

Often, private capital markets can be slow to recalibrate to economic shocks. Despite the pandemic, overall private capital returns remained positive thanks in part to the income component of the indices, as shown in the above NPI and ODCE charts. In turbulent times it can be helpful to look to the public equity markets as a signal to where private valuations may be headed. As seen in the below table, REITs have yielded a negative 15.4% total return in 2020. REIT asset composition typically favors gateway and coastal markets (especially in residential and office assets), so there is likely some negative bias / public overreaction to the impact of the pandemic on the future of dense cities such as New York and San Francisco. In periods of volatility in public equities, the lack of liquidity in real estate private equity can also benefit Limited Partner’s portfolios as the long-term nature of the investments creates added stability and predictability.

Capital Markets Observations

Debt

In 2Q20, underwriting standards became increasingly conservative as lenders aimed to shore up their balance sheets. As seen in the chart below, lending activity declined to $242 billion in the first half of 2020, driven in part by a freeze in March and April as the 10-year treasury approached historic lows. Since then, activity has begun to steadily increase driven mostly by owners who would have otherwise been sellers capitalizing on historically low-interest rates to refinance their properties. Underwriting standards remain conservative, as loans are being originated at lower LTVs, with higher coverage requirements and wider spreads than pre-COVID-19. The increase in risk spreads has been partially offset by the Federal Reserve’s decision to cut rates and inject liquidity into the market via $80 billion in Treasury bond purchases each month. Another governor on activity is high debt service reserve requirements by lenders, especially the agencies in the multifamily space, who are asking borrowers to escrow 12 months of debt service at closing.

Equity

Despite the volatility and uncertainty of recent months, remains near-record amounts of dry powder waiting to be invested in real estate, as seen below. Real estate continues to be an attractive alternative asset for investors who are yield-starved in a low-interest-rate environment.

Key Takeaways

COVID-19 will continue to have a profound impact on real estate fundamentals as the sharp downturn has only accelerated preexisting trends across sectors.

Investment sales activity declined sharply year-over-year, falling 68.0% in 2Q20 as the debt markets froze and the bid-ask spread remained wide.

Private capital markets were slower to react than the public markets, signaling that there may still be more downside risk in private real estate in the second half of the year.

Lenders continue to remain conservative, though owners with healthy assets will continue to take advantage of favorable refinancing terms.

Distress will bring about buying opportunities for funds with ample dry powder, leading to a potential outperformance in future years as markets stabilize and return to growth.

About Alliance Global Advisors:

Alliance Global Advisors is a women-owned consulting firm focused on empowering the institutional investment community to elevate best practices. Advising clients with approximately $70 billion in assets under management, Alliance partners with organizations to provide an independent perspective and innovative approach to critical strategic initiatives. Our partnerships allow senior management teams to focus on what matters most: diligently managing client capital, creating value and delivering exceptional returns in a performance-driven market.

Disclaimer: This blog was originally published on August 31, 2020 and will be updated periodically to reflect changes in the industry. The content may contain or cite personal and/or professional opinions that differ from the views of Alliance Global Advisors.