COVID-19: Research Update XI

Contributors

Will McIntosh, Ph.D
Global Head of Research

John Kirk, CAIA, CCIM
Senior Director, Research

Mark Fitzgerald, CFA, CAIA
Executive Director, Research

Karen Martinus
Senior Associate, Research

Chenchao Zang
Senior Associate, Research

Jane Zheng
Associate, Research

September 15, 2020

As the economic and real estate conditions continue to evolve in the wake of COVID-19, many questions persist among market participants. The following includes several of the issues that we have contemplated in recent weeks:

What does the recent labor market data suggest about the U.S. economic recovery?

Labor conditions have performed better than expected in recent weeks, but the economy has a long way to go before it fully recovers. Weekly jobless claims reached 884,000 for the week ended September 5th, marking the second consecutive week in which they were below the one million threshold. At the same time, the employment market added 1.4 million jobs in August, and the unemployment rate declined to 8.4% from 10.2% in July. However, more than 29 million workers are still receiving some form of unemployment benefits, and this figure has consistently ranged between 27-32 million since early May. From a broader economic perspective, the Moody’s Analytics & CNN Business Back-to-Normal Index, which measures the economy against its pre-pandemic level, suggests activity bottomed at 59.2% in mid-April and is currently at 78.8% – or about 21% below where it was before the pandemic. While it appears that the worst of the economic slide has passed, significant downside risks will persist until the virus is under control.

Have inflation expectations changed given the reopening of state economies in recent months?

U.S. consumer price inflation continued to trend in a healthy direction in August, though the initial bounce from state economies reopening appears to be fading. The core CPI recorded its third straight month-over-month increase after declining for three consecutive months from March to May. Thus, the odds of a deflationary spiral appear less threatening now that economic activity has begun to rebound. Still, the most intriguing news regarding inflation has to do with the Fed’s decision to change its policy framework by adopting average inflation targeting.  While the move is dovish and signals that more stimulus is likely to come, it also implies that the Fed will allow (or possibly push) inflation above its target of 2% over the cycle. Moreover, because of the new change in the Fed’s policy framework, Capital Economics predicts that the first rate hike of this cycle will not occur until 2024 at the earliest. Thus, the impact of a prolonged low interest rate environment will reverberate through the financial markets, including the commercial real estate sector, as investors search for yield.

What are near term return expectations for commercial real estate?

The Pension Real Estate Association (PREA) third-quarter consensus survey forecast indicates pension fund investors expect the overall NCREIF Property Index (NPI) total return to decline by 2.7% in 2020, which is a 130 basis point improvement from the second-quarter survey. PREA survey responders remain optimistic that the NPI will rebound over the next few years – delivering a 2.5% total return in 2021 and 7.3% in 2022. As one might expect, retail properties are projected to be most severely impacted by the pandemic, declining by 11.4% this year and 1.1% in 2021 before eventually rebounding to 5.8% in 2022. The office sector is expected to plunge into negative territory in 2020 with a -2.6% total return. However, positive growth is expected over the next two years, at 1.0% in 2021 and then 7.0% in 2022. Apartment properties are forecast to slide by 0.9% in 2020 before rebounding back to 4.9% in 2021 and 7.9% the following year. The industrial sector remains the only major property type forecast to post positive total returns this year, at 3.5%, followed by 6.2% next year and 8.9% in 2022. Ultimately, we agree with the overall sentiment of the survey that suggests the commercial real estate market will be on a healthy footing by 2022. However, survey participants may be underestimating the impact that the increased capital flows chasing real estate will have on returns over the next few years, especially given the slow growth and prolonged low interest rate environment.

Does the increase in delinquencies suggest that distressed buying opportunities are on the horizon?

CoStar estimates that the amount of delinquent commercial real estate loans now tops $64 billion, after increases occurred across every major capital source in the second quarter. While the total volume of delinquent loans is relatively small when considering the more than $3 trillion in loans outstanding, it essential to remember that most lenders do not count loans that are in forbearance in their delinquency totals. Thus, the delinquency numbers could go much higher as the COVID-19 forbearance periods come to an end.  For instance, there are currently $41 billion in delinquent CMBS loans today, but the amount of CMBS loans currently in COVID-19 forbearance is even higher at nearly $56 billion, according to DBRS Morningstar. Forbearance periods have generally ranged from 90-180 days during the pandemic. Thus, we expect delinquencies to rise in the coming months, which could potentially lead to distress buying opportunities, particularly for hotel and retail properties.

Notable Property Sector Updates

  • Retail: Colliers Fall 2020 Retail Spotlight Report highlights the impact that COVID-19 and the rising popularity of e-commerce have had on the retail sector. Retail sales per square foot came in at $396 in 2014.  By 2019, that figure had slipped to $383. There has been an even more profound decline in retail productivity since the pandemic.  Sales per square foot of retail have plummeted 13% in 2020 to $338, and this trend will likely continue due to the structural shift toward online shopping. However, on a positive note, retail rent collections have improved significantly according to Datex Property Solutions, which tracks major brands that lease a minimum of 10 locations or have a gross monthly rent of at least $250,000. Major chains paid 83% of August rents, a new post-COVID high, up from last month’s 80% collection, and only 14% below the nearly 97% paid during the same time the previous year.
  • Multifamily: Rent collections in the apartment sector have been substantial throughout the pandemic.  From April to August of this year, approximately 95.16% of multifamily households paid rent compared with 96.54% in 2019, a difference of only 138 basis points, according to the National Multifamily Housing Council.  However, it is unclear what impact the government’s recent eviction moratorium, which runs from September 4 to December 31, will have on rent collections in the future.  While the moratorium will provide some financial relief for the nearly 30-40 million households that are at risk of eviction,[1] it potentially leaves landlords without the means to collect rents to meet their financial obligations (e.g., property taxes, insurance payments, and utility service). Notably, the mandate applies only to individuals expecting to earn less than $99,000 and couples expecting to make less than $198,000 in 2020. Thus, the upper price range of the multifamily housing spectrum is less likely to be materially impacted by the eviction moratorium.

Concluding Thoughts

September marks the sixth month since the fallout of the COVID-19 pandemic in the U.S., and the impact on the nation’s economy has been substantial. The unemployment rate remains elevated at 8.4%, though it has improved from the 14.7% peak in April. All state economies have at least partially reopened, though some restrictions are still in place for select industries.  Work-from-home persists for many businesses, and the process of returning to school has proven to be a challenge.  The stock market continues to hover near record highs, mainly due to the Fed’s seemingly unlimited liquidity and support.  Still, the federal budget deficit topped $3 trillion in the first 11 months of the fiscal year 2020, which is higher than any annual figure on record and almost three times the amount compared to the same period last fiscal year. The last half-year has undoubtedly been challenging for the country as a whole. Still, while there are significant downside risks to the outlook, we are hopeful that the next six months will continue to bring about positive improvements in containing the virus and stabilizing the economy.

[1] https://www.aspeninstitute.org/blog-posts/the-covid-19-eviction-crisis-an-estimated-30-40-million-people-in-america-are-at-risk/

Disclosures

These materials represent the opinions and recommendations of the author(s) and are subject to change without notice. USAA Real Estate, its affiliates and personnel may provide market commentary or advice that differs from the recommendations contained herein. Certain information has been obtained from sources and third parties. USAA Real Estate does not guarantee the accuracy or completeness of these materials or accept liability for loss from their use. USAA Real Estate and its affiliates may make investment decisions that are inconsistent with the recommendations or views expressed herein.

The opinions and recommendations herein do not take into account the individual circumstances or objectives of any investor and are not intended as recommendations of particular investments or strategies to particular investors. No determination has been made regarding the suitability of any investments or strategies for particular investors.

Research team staff may make or participate in investment decisions that vary from these recommendations and views and may receive compensation based on the overall performance of the USAA Real Estate or its affiliates or certain investment funds or products. USAA Real Estate and/or its affiliates or clients may be buying, selling, or holding significant positions in investments referred to in this report.