By Jim Costello on March 9th, 2020
I spent a good part of last week at the Pension Real Estate Association (PREA) spring conference in Los Angeles. Talking with participants at the meeting and listening to the observations of Mohamed El-Erian, it is clear to me that a period of economic weakness, perhaps even a recession, is ahead. Still, even with an economic downturn triggered by COVID-19, commercial real estate investments might weather this panic without major damage.
Attending the PREA conference felt like a last hurrah before unpleasant times ahead because so many key industry conferences have been cancelled or postponed. (MIPIM in France and NCREIF in the U.S., for instance, were both to have taken place this week.) If investment managers, capital sources, and service providers cannot get together to talk informally and determine where the ranges of opportunity can be found, deal activity can stall with uncertainty and indecision.
Back in Los Angeles, former PIMCO chief El-Erian outlined four stages of what a downturn would look like. These stages can be summarized as: sudden economic shocks (the period we are in now); financial contagion; bottoming out; and, a new normal. While his comments were centered on corporations, there are lots of parallels with the commercial property market.
Take the “financial contagion” stage. El-Erian’s comments were more focused on firms with high-risk/high-yield debt, but his notion was that if some of these firms go belly up from cash flow challenges, it could ricochet back to reduced debt availability for other firms. He was talking about corporations broadly, not commercial real estate investors, but it seems to me that, CRE may not get to this stage everywhere in the world.
Sure, investors in CRE will feel pain if the real side of the economy falters. Some tenants will be late with rent checks, some may even go out of business. Property income is going to be challenged. However, there have been fewer investors in CRE in this economic expansion using such risky debt.
In previous recessions where there were combinations of demand and supply side shocks to the economy, CRE performed OK … at times. Take the contrast between the U.S. and the U.K. commercial property markets in the 1970s in response to the economic shocks of the oil embargoes. In the U.S., commercial property prices continued up in 1973 – albeit at a slower pace – even as they faltered in the U.K. because a currency shock impaired lending. So long as this COVID crisis only hits income and global lenders react as U.S. lenders did in the 1970s, the commercial property sector can muddle along.
The third stage outlined is bottoming out or, buying the drop. Once weakness is seen in prices, some investors will think about coming back to the market. The bigger the fall, the more investors who will look at conditions and consider jumping back in to scoop up investments at a relative bargain.
For commercial real estate, the price declines needed to inspire buyers to come back to the market need not be as extreme as the 22% drop in the RCA CPPI seen from ’07 to ’10 during the Global Financial Crisis. Consider the office market in Manhattan in 2017. The top of the bidder pool disappeared as Chinese investors stepped away from the market and office sales plummeted as buyers and sellers wondered where the bottom would be found. A 20 bps change in cap rates, though, was enough to inspire buyers to come off the sidelines.
To be clear, it is so early in this crisis that there is scant evidence yet of a slowdown in commercial property sales in the U.S. (The next U.S. transaction data report from Real Capital Analytics will be released March 25.)
The conclusion of El-Erian’s presentation involved advice on how we should all think about structuring investments in the future. One key message was to not extrapolate the experiences of the last 24 months into the coming 12 months. There has clearly been a change in the global economy, and we will see changes in all investment classes, even commercial real estate. That said, by building more agility, resilience and optionality into portfolios, investors can weather this storm. I should add though, we will all get through this if we watch our health and wash our damn hands.
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