The U.S. federal government has passed an unprecedented $5.3 trillion of stimulus as part of the effort to recover from the COVID-19 pandemic, and trillions more of infrastructure spending appears to be on the way. The expected boost to the economy should create a smooth highway for commercial real estate, but will there be a toll at the end?
The “go-big” spending packages are expected to help produce a rapid recovery, with GDP forecast to grow by 6.5 percent in 2021 and 4.0 percent in 2022, according to the Organization for Economic Cooperation and Development. If those projections come to pass, it would mark the strongest recovery since the economy grew by 4.6 percent in 1983 and 7.2 percent in 1984 following a recession in 1982.
“It’s going to be a big jolt for the markets,” said Andrew Nelson of Nelson Economists, the former chief economist for Colliers International. “There are big upside implications for the country and property markets.”
The gain for commercial real estate doesn’t come without potential pain. Rapid growth from stimulus-fueled consumer spending creates concerns about an exploding federal deficit, a rapid increase in inflation, and rising Treasury rates. Such conditions could produce an increase in the cost of capital, and potential for lower returns and distressed debt in commercial real estate.
“My sense is that if we see growth in inflation, it won’t be incremental,” said Donald Sheets, a managing director at Broadsheet Capital Partners. “It will be like a fire that spreads quickly.”
In the short term, though, the economic consensus is that the relief spending is preferable than the cost of inaction. More than 70 percent of economists surveyed by the National Association for Business Economics this month believe current monetary policy is “about right,” and only a quarter of respondents views current Fed policy as “too stimulative.”
Infrastructure Bill Ahead
Economic policy took a sharp progressive turn in the wake of the pandemic and the Democratic sweep in the 2020 elections. President Joe Biden this month signed the $1.9 trillion American Rescue Plan, which provides $1,400 checks to about 85 percent of American households; expands the child tax credit for 66 million children and cuts child poverty in half; increases unemployment aid by $300 per week; reduces health-care premiums; and provides $350 billion for state and local aid. Provisions that benefit commercial real estate most directly include $21.6 billion of renter aid and billions of dollars of grants to restaurants and small businesses that lease commercial properties.
Although the plan was just passed and will take months to implement, the administration’s plans to remake the economy are just getting started. Democrats are expected to soon introduce a $3 trillion infrastructure package that will encompass spending on roads, airports, bridges, water supply, schools, housing, clean energy, social justice, and changes to the tax code.
Daleep Singh, deputy national economic director of the National Economic Council, described the scheme as part of an “aggressive two-step strategy to rescue and then recover” for the economy.
Speaking last week to the annual NABE policy conference, Singh said the coming legislative proposal will address “investments in modern and clean infrastructure; mobilization of domestic manufacturing and innovation; building caregiving infrastructure; and advancing different programs for racial justice.”
Structural inequalities, Singh said, are not just a matter of equity and fairness but “represent a limitation on our country’s capacity to produce, to compete, to innovate, and to lead by example in the global economy.”
Commercial real estate stands to benefit from the relief bills. For one thing, consumer spending is forecast to jump from the combination of direct stimulus and tax cuts. Americans saved nearly $2 trillion more than they otherwise would have during the pandemic, according to Oxford Economics. Pent-up demand for goods and services is expected to surge when people get vaccinated and feel confident about going out in public.
The increase in spending could be a boost for several property segments. Industrial benefits from the continued growth of online shopping and demand for logistics space. Retail centers benefit as shops re-open and increase sales, which should enable more tenants to pay rent. The lodging industry, which saw revenue per available room drop by more than half in 2020, anticipates pent-up demand for travel from people who have been stuck in their homes for more than a year. Renter aid and enhanced unemployment will help multifamily, assisting residents with paying rent and making up for rent arrears.
“Stronger economic growth is good for commercial real estate,” said Sara Rutledge, a veteran industry researcher who is founder and principal economist for SRR Consulting. “More spending as people get relief checks, support for state and local government, and reopening schools all help with the economic recovery and increase the demand for space.”
The biggest question for the industry is how long the low-interest-fueled honeymoon will last. The Federal Reserve has pledged to keep policy rates at zero for an extended period while unemployment remains elevated. As of February, the economy remained down 9.5 million jobs from its peak and is not expected to get back to pre-pandemic levels until late 2022 or 2023. Concerns about robust growth, inflation and the growing deficit, however, prompted the 10-year Treasury rate to climb above 1.6 percent as of late March after remaining below 1.0 percent for the last three quarters of 2020.
Commercial real estate values remained stable during the pandemic-driven recession, in part, because low interest rates produced a historically low cost of debt, with mortgage debt available to most borrowers with coupons of 2.5 percent to 4 percent. Property values remained stable during the 2020 recession in most asset types as investor demand remained strong because, partially, the cheap cost of debt produced a high premium between mortgage rates and acquisition yields.
Going forward, some worry that Treasury rates will rapidly increase and make debt more expensive to access. That would erode property values and present a dilemma for properties with maturing low-rate mortgages. With property owners facing increasing expenses such as taxes and capital expenditures to make buildings energy efficient and safer, increased mortgage rates could be a straw-that-breaks-the-camel’s-back issue.
“Market participants focused on the effect of rising interest rates as being solely a cost of funds issue are not fully appreciating the corollary effect that rising rates also have on discount rates of future cash flows,” Sheets said. He added:
“Debt-service coverage metrics tighten with a rising rate environment, which translates directly into higher probability of both payment and maturity defaults. Participants that don’t factor in the rising cost of debt into their weighted average cost of capital calculations—in other words, their discount rates—will overvalue assets by a meaningful magnitude. The bottom line, so to speak, is that interest rate momentum is not just a factor in the profit and loss side of the equation, but the balance sheet side of the equation, too.”
Others think that inflation persistently above the Federal Reserve’s 2 percent target is unlikely. “Since 2008, actual inflation has been well below the target set by the Fed,” Rutledge said. “It’s hard to see sustained inflation levels above 2 percent.”
Another worry for the industry is the likely increase in taxes to pay for the likely $8 trillion-plus of total pandemic-related stimulus and infrastructure. Changes believed to be on the table are higher property and transaction taxes, higher corporate tax rates and the elimination of long-held tax breaks such as 1031 exchanges.
The federal deficit topped 100 percent of GDP last year for the first time since World War II. According to Phillip Swagel, director of the Congressional Budget Office, even before the latest $1.9 trillion rescue plan, the deficit was projected to top 200 percent of U.S. GDP by 2051. Swagel, speaking at the NABE conference, said the deficit could grow worse than current projections due to additional spending and slower-than-expected labor force growth.
During a NABE panel, Jason Furman, professor at Harvard University’s John F. Kennedy School of Government and senior fellow at the Peterson Institute for International Economics, said that rising debt-service payments and health-care costs account for much of the growth in deficit projections.
Rather than viewing the deficit through the framework of the deficit’s share of GDP, Furman said, it makes more sense to consider the cost of interest payments. He suggested that higher levels of public debt are sustainable if rates remain low and that maintaining debt-service payments of 2 percent of GDP is achievable.
Despite the potential downsides, the new policy landscape provides opportunities in commercial real estate. In the short term, economic growth should provide a boost to demand in most segments and limit the downside. Distress has mostly been held at bay by mortgage providers’ willingness to negotiate with borrowers rather than foreclose, while the demand is strong for property types with upside, including: multifamily, industrial, and niche segments such as self-storage and student housing.
The coming infrastructure debate parallels closely with a renewed focus in the sector to environmental, social and governance issues. “What comes next has the potential for more lasting impact,” said Nancy Vanden Houten, lead economist at Oxford Economics.
Change in governing policy, Sheets said, could present an opportunity to market players with foresight: “Proactive investors and lenders able to recognize and adapt their businesses to embrace climate change and infrastructure rationalization can disproportionately take early market share in what will be multi-generational spending programs. The smarter ones among us will transition the issue away from a political one and, instead one that equates the sheer magnitude and momentum as something that can be quite profitable.”