CPE sat down this week with Calvin Schnure, senior economist for Nareit. Here’s what he had to say about the performance of REITs and commercial real estate overall amid the worsening coronavirus crisis and his outlook for the U.S. economy.
How have REITs fared amid the coronavirus-related stock market slide?
As of Monday’s close, REITs were down 9.4 percent (total returns including the dividend yield) whereas the S&P was 14.7 points at the close of Monday. So they had been faring better. And you know what the surprising thing was? There were several sectors that were positive for the year. If you look at the infrastructure (the cell towers) REITs, if you look at self storage and if you look at manufactured homes, they have 3 to 5 percent positive returns for the year. That’s just showing real estate has different exposures than the rest of the economy.
I have been surprised about apartments. As of last Friday, apartments were flat for the year, when the broad market then was down around 8 percent, but then Monday, they were down quite a bit. One of the points that I’ve been making when I am talking with the media is that the impact of the virus can be very different across sectors of the economy and sectors of real estate. One thing that could benefit REITs and a lot of commercial real estate firms—not just REITs–is the long-term nature of your leases. If I were looking at an apartment building, particularly the four-and five-star ones the REITs are running–all of the tenants who are in there on March 1 are probably going to be there on March 31. People are going to cancel a trip, a hotel. They may not go to the shopping mall. They may not go to work. They need a place to live.
The lodging industry was the front line when we first saw the virus. Regional malls have been quite affected as well. Especially, Monday was a very bad day for the regional malls because a lot of people are avoiding store shopping. And, for regional malls, it’s adding to a longer term trend toward e-commerce that has been affecting them. So this is accelerating something that’s already underway, which is the opposite of what you have for apartments, which is a very strong market. That’s how it is now. At market close, it might be a little different.
How had REITs been doing prior to the stock market slide?
Yesterday we published the Nareit T-Tracker®, an operating summary to the overall REIT industry, but with the coronavirus, that is history right now. They had record earnings in Q4. What I would have said two weeks ago was very different story: At the beginning of 2019, people were thinking that real estate was about to head into a downturn. No one would have expected record earnings. REITs had funds from operation of $16.8 billion in the fourth quarter, which was a record, and the annual was a record as well. And they had high occupancy rates and strong balance sheets. So it was a very solid performance.
Yesterday, I started off by saying that when this crisis hit REITs were in as strong a position as they could be with very strong balance sheets, high occupancy rates, and record earnings. But there’s just so much bad news right now that I’m uncomfortable giving too much of a reassuring message. We don’t know how severe the impact is going to be. In my gut, I feel that real estate could be less affected and, again, because the long-term nature of the leases, most of these property types are going to have most of the tenants at the end of the year as opposed to the restaurants, recreation, movie theaters that will suffer a real loss.
Is there anything you would suggest policymakers do?
Yes, public health is something they need to continue pushing on. Right now, we don’t have any actual evidence that there is (economic) damage or how big the damage could be. It seems pretty clear there’s going to be some damage. If the testing underway right now finds that there’s not a whole lot more virus than we had thought, then the government may not need to do a whole lot.
If it finds the virus is much more extensive than we had thought a week or two ago, then there’s probably a bigger economic impact. Then these traditional policy tools of a larger tax cut or some upfront stimulus payment may be appropriate. But it is too early to tell that.
A second remedy is not really the government’s decision, but many workers are grappling with the decision of ‘Can I work from home?’ and a lot of the businesses have rules that the limit from working from home. The government could encourage employers to be more flexible in allowing telecommuting. That might help.
But really, I go back to saying until we clear up the public health problem, the other policy measures are going to be after the fact.
How much do you think the U.S. will be affected by how the rest of the world is being affected?
I am still looking at the risks and I see a moderate loss of economic activity that is not long lasting and probably not a recession scenario, which means the stock market reaction right now is anticipating a much more severe scenario.
The rest of the world matters for probably three reasons. One is, for us, the public health issue, because there are still people traveling all across the world, coming from Europe or Asia are a potential source of contamination.
Second, the rest of the world matters for the supply chain because the first thing that we saw was the disruption in production for the tech industry and the automotive factories in China was causing delays and disruptions for U.S. manufacturing. The good news is we are seeing more reports that the situation has stabilized in China and some of their businesses are getting back to work. That’s one of the reasons I don’t go for the more extreme scenarios for the U.S. The Chinese economy has had a very bad month, but some people are saying they could be through the worst of it. So, if we haven’t had it as bad, we may not get into as serious or worse a situation and by April or May we see a path forward.
The third would be the global demand. And I put that third because it’s probably less than the other two. When we had the trade wars, many people were concerned about it. But that concern did not reflect that imports and exports are much smaller relative to the U.S. economy than they are for most other countries.
Coronavirus aside, do you see the U.S. economy as fairly healthy?
Yes, there has been a discussion about when is this cycle going to end. I do not use the term cycle except to point out that this is not a cycle. If a cycle, that is, a regular pattern of booms and downturns, were an adequate description, we’d have had a recession in 2018 or 2017. But we didn’t, and I’ve spent a lot of time over this period looking at what are the factors that have preceded every downturn of the past, and there are a couple of them. But three of them that stand out. In every downturn, we’ve had two or even all three of these.
One was overbuilding. Another was overheating. Another was over-indebtedness. Now, overbuilding in commercial real estate market we know what that is. In 2007/ 2008, it was the single-family housing market that had overbuilding. There was a little overbuilding in commercial real estate but not to the degree that single-family homes were. So, to get back into a defensive position, they had to cut a lot. Right now, construction is below its long-run average share of GDP. People talk about all the cranes everywhere, but the demand growth has kept pace with it. So, if there’s a shock to demand and construction is way above its long run average, you pull back a lot. Right now, construction is below its average, so the shock to demand is not a lot to be concerned about. That’s good for the economy.
So that’s commercial real estate but the rest of the economy—things like business investment, consumer purchases of autos, furniture, other durable items, those are also the cyclical parts that could exacerbate a downturn. Those are all below average. So that’s something that makes is the U.S. economy well positioned to deal with the shock. I’m not saying healthy, necessarily, I’d say well-positioned to deal with a shock.
The second was overheating. For the overall economy that’s usually inflation. You have inflation and the Fed raises interest rates. The Fed started raising rates in 2018 because there were some hints that inflation was moving higher. Well, we since saw that it’s reversed and it’s running below the Fed’s average.
In commercial real estate specular pricing, cap rates are really low. Interest rates are really low. The spread between cap rates and interest rates is middling. It’s not a speculative market. I’m not worried about, I’m not worried about prices being overdone.
The third is the indebtedness—over indebtedness—a traditional problem in commercial real estate. But debt growth has been slower than property price appreciation for the past decade, which means, in the aggregate, leverage is down. Now you’re going to find some people who go bankrupt, but there’s no broad, systemic issue.
So that says to me that, if the economy goes into recession, it’s because things are on pause while the public health issue is resolved. But it’s not something that has second-round and third-round effects because everyone has cut back to be in a defensive position.