The wake of the COVID-19 pandemic will have an unprecedented impact on commercial real estate markets. Many secular trends that existed before the virus will quicken; others will shift. Getting ahead of these trends and capitalizing on these dynamics early in the recovery cycle offers significant return potential for those investors with the right strategy.
Dislocation Creates Opportunity
Our underwriting suggests a 10 percent decline in commercial property values, as occupancy and rental rates respond to a recession outlook. We also, however, forecast a wide dispersion of returns based on location and property types, with existential threats facing many retail and hospitality owners, and winners emerging in industrial, affordable rental housing and new modern office, as well as other nontraditional real estate sectors.
We are not believers in a V-shaped recovery. The economic damage and enduring behavioral changes from the COVID-19 shutdown will translate into permanent shifts in real estate demand patterns, which will dictate winning strategies in the new normal. Hence, we do not see this crisis as an opportunity to be value hunting in areas of the economy that face obsolescence. Instead, it is a time to access secular demand trends at extremely favorable prices.
The Growth of E-commerce
Over the last decade, according to data from the U.S. Census Bureau, the penetration of e-commerce into overall retail sales has doubled from approximately 10 percent to 20 percent. Based on our analysis of categories that have reached peak e-commerce activity, we believe this market share could reach as high as 50 percent over the coming years and will accelerate due to the COVID-19 pandemic. This rapid change will trigger several implications.
First, the retail sector will recalibrate drastically. Restaurants will come back, but delivery and takeout platforms will remain essential. Grocery consumption is going to experience a step-change shift to more distribution occurring via online platforms as well. Even experiential spaces—like movie theaters, casinos and fitness studios—are going to see some consumption shift to at-home solutions such as Netflix, DraftKings, and Peloton. With consumers visiting brick-and-mortar storefronts less often, the lowest quality malls and shopping centers in the U.S. are likely to shutter or be repurposed. The remaining retail square footage per capita in the United States will rationalize by about 25 percent, and, for reference, decline to a level on a par with Canada’s volume.
On the plus side, retailers will be focused on moving product and fulfilling orders online, highlighting the need for infrastructure improvements in the areas of logistics and fulfillment within the supply chain. To address these issues, we believe there will be greater focus on developing industry-leading supply chain capabilities to compete with fulfillers such as Amazon. We also see the potential diversification of manufacturing, warehousing and last mile distribution locations to create resiliency in the domestic supply chain. These factors will only further increase demand for investment in industrial real estate.
Growing Demand for Affordable Housing
Prior to the pandemic, increased construction costs and infrastructure constraints led to a housing shortage felt most acutely in the affordable housing subsector. This cycle has likely seen an overbuild of product skewed towards the higher end.
The upward trend towards the rental housing lifestyle will also continue. Homebuyers will likely be more reluctant or unable to make the necessary down payment required for home ownership in the face of an economic recession. The desire for dense urban living will not have the same appeal after witnessing the virus’ spread in major urban areas. A premium for space and less density may drive residents to the suburbs, where the need for affordability will accelerate the migration away from more expensive neighborhoods. For these reasons, we believe single-family rental and differentiated multifamily housing, with features such as direct-access garages and larger floor plans, will be even better positioned in the long term.
Modern Office Requirements Evolve
In the tight pre-COVID-19 labor market, office space was a recruiting and retention tool in the fierce competition for talent. That dynamic will remain, but it will shift in some respects. We will likely see tenant preference increase for well-located but drivable, low-rise and self-contained buildings that do not share space with other tenant communities. There will also be a heightened demand for healthy buildings with enhanced air and water quality. The appeal of coworking offices will be impaired for some time. Landlords should expect a reduction in tenant appetite for spaces specifically designed to maximize physical interactions.
These dynamics will translate to lower demand for office space overall. This scenario will distress owners and create the opportunity for well-capitalized investors to acquire prime-location office properties—newly unburdened of long-term leases to low quality tenants—at an attractive rate. Given the longer-term nature of office leases, we can expect these shifts to play out over the next 3-5 years as company policies and decisions are implemented.
The acceleration of these trends affords investors with conviction and experience in distressed markets the ability to acquire compelling real estate at a reset, attractive position, providing a competitive advantage upon which to execute value-added investment strategies. We believe these assets will be in a superior position to capture an outsized share of the demand recovery.
Scott Crowe is the chief investment strategist for CenterSquare Investment Management. The statements and conclusions made in this presentation are not guarantees and are merely the opinion of CenterSquare and its employees. Any statements and opinions expressed are as of the date of publication, are subject to change as economic and market conditions dictate, and do not necessarily represent the views of CenterSquare. This article presents the author’s present opinion reflecting current market conditions, which are subject to change without notice. It has been written for informational and educational purposes only and should not be considered as investment advice or as a recommendation of any particular security, strategy or investment product. The ODCE, short for NCREIF Fund Index-Open End Diversified Core Equity, is the first of the NCREIF Fund Database products and is an index of investment returns reporting on both a historical and current basis the results of 36 open-end commingled funds pursuing a core investment strategy, some of which have performance histories dating back to the 1970s. The future impact of COVID-19 is currently unknown.