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Black Swan Reset and the Fate of Commercial Real Estate

4/30/20

By Elliot M. Shirwo, Founder and Principal
BridgeCore Capital Inc



We are in the grips of a global black swan event.

The COVID-19 pandemic is having a near-catastrophic impact on most sectors of the world economy. For commercial real estate, the soon-to-emerge “new normal” will force new fundamentals that will determine the stability, dynamics, and fate of our industry for years to come.

COVID-19 has forced all of us to rethink how we live, work, play… and how we borrow and invest.

For those of us in commercial real estate – whether investors, borrowers or service providers – how we do what we do every day will likely change forever. The transition is more than just an adjustment, it represents a change in the way we think and in the dynamics of how we work.

As the lockdowns start to get lifted and we begin to emerge from our cocoons, we’ll start to get a sense of the “new” commercial real estate landscape. No doubt, the transition will prompt business and property owners to reassess their positions, which will then trigger a slew of activity, including everything from building sales and new and renegotiated tenant agreements, to subleases and sale-leasebacks.

With this new reassessment and scrutiny will come opportunity.

Retail

For commercial real estate, the retail sector has taken the greatest hit, as all non-essential businesses have been forced to close, bringing their sales to a complete halt or relegating them to online only.

Since most retailers rely heavily on day-to-day income to survive, the changing time horizon on the current lockdown has not given many retailers—especially service-based and small businesses—any option except to furlough or lay off workers, or permanently close. Imagine the ripple effect of these small businesses never reopening.

The closures will impact the fate of the business owners and their employees, as well as that of the ubiquitous empty spaces that will result in landlords going without rent payments. In turn, banks could potentially lose out on debt service revenue and repayment of principal.

Hospitality

The hospitality sector, which has taken a devastating blow from severe travel restrictions, may be slow to recover because of lingering consumer fear, even after the economy reopens. This could contribute to longer-term financial and operating fallout.

Economic dislocation will give larger hospitality flags and investor groups opportunities to pursue aggressive property acquisition strategies. Potentially most at risk are smaller, independent hotels and/or highly-leveraged assets that are more likely to experience sustained distress.

Hospitality will ultimately recover, but the landscape and the experience will be very different for travelers, hotels, airlines and attractions, as a new reality accounting for guest and employee safety, facility and room sanitation, and use of space, will have to be considered.

Office

As a result of the closure of non-essential businesses, the unemployment rate is expected to reach a staggering 14%. This level of unemployment, along with the ability of businesses to adapt, and adopt new ways to work remotely, will inevitably affect the office market whether tenants downsize their office environments or eliminate them altogether.

Due to these unforeseen economic and market conditions, tenants and landlords alike will also experience a shift in the functionality and utilization of office space. Best practices are already being formulated to include increased sanitation, reconfiguration of workspaces to maintain social distancing, touchless technologies to minimize surface exposure, and new protocols for remote work schedules.

Suffice it to say that there will be a new normal when the economy reopens. The question is, how prepared are landlords and tenants to address the business and legal decisions that come with it?

Industrial

Most commercial real estate industry professionals agree that one of the industry’s growth categories and potential shining-lights is industrial.

Even before the pandemic, e-commerce had already made last-mile considerations a necessary part of supply chain management. Led by retail giant Amazon, but by no means limited to the native e-tailer, the hunt was on for properties that were or could be converted to industrial use.

The coming online of emptying big boxes triggered by the retail evolution was creating new opportunities for operators and distributors to house and distribute their e-sold wares to and from densely populated areas. These typically urban and suburban locations offer access to large swaths of consumer bases from ready-made shells for local last-mile solutions. Industrial space outside of repurposed big boxes is where we manufacture and store goods, food, and equipment for the sale and distribution to any and all American consumers who would like to purchase them.

Pre-pandemic logistical and last-mile concerns were in many ways driven by consumerism and the increasing “wanting” of goods. Coronavirus has taught us the importance of last-mile distribution strategies to fulfill the need of essential goods, namely, food, medical supplies and basic consumer products such as toilet paper and cleaning supplies.

Multifamily

The multifamily category was traditionally a resilient real estate asset class and one of the more stable categories for longer-term holds. This will remain especially true in the new environment, especially for projects that include affordable housing, which benefits from high demand outstripping supply, and a spectrum of local, state and federal incentives.

That said, the coronavirus pandemic has caused many states to issue executive orders pertaining to multifamily residences. On March 16, for example, California Governor Gavin Newsom issued Executive Order N-28-20 which gave local governments the ability to halt residential and commercial evictions and requested banks and other financial institutions to do the same.

This order and related protections were further expanded on March 27 with Executive Order N-37-20, which prohibited the enforcement of eviction orders for residential tenants affected by COVID-19 through May 31, 2020.

What will the impact of these orders and similar ones across the country be on rent collections, landlords and the financial institutions that hold the mortgages? The answer to that question is still unknown.
The National Multifamily Housing Council’s latest numbers show that as of April 12, 2020, approximately 84 percent of the 11.5 million professionally managed apartment households had made full or partial rent payments. That’s not a substantial drop compared with the 2019 numbers when 90 percent of renters made full or partial payments during the same April 1-12 period.

May 2020, however, could prove to be more challenging, as more workers get laid off or furloughed, and more businesses close.

The domino effect is clear. If owners collect less rent, they may not be able to make their debt service payments, pay for utilities or make necessary or urgent repairs. Some of the larger conglomerates will be able to weather the storm, but highly leveraged developments and many individual owner/investors will not make it through to the other side without help.

While the moratorium on foreclosures and payments temporarily relieves the short-term stress for renters and borrowers, when the ban is lifted, there is certain to be displacement.

Capital

As evidenced by the daisy chain of the economic impact on all stakeholders in the capital stack, institutional and private capital alike will undoubtedly experience a cataclysmic shock to the system that could potentially dislocate and fractionalize the market.

Many banks have already pressed the pause button on making loans altogether, while others are greatly reducing volume with stricter criteria, or are encountering severe bottlenecks with third-party reporting, travel for site inspections and repairs, among many other things.

Agency lenders are noting that they remain open for business, but they are implementing new guidance across the transaction process in everything from changes to their inspection procedures to guidelines that increase debt service reserve requirements for new loans.

The liquidity crunch in the capital markets has produced an opportunity for private lenders to fill the gap until a post-COVID 19 normalcy returns. Loans that would typically go to agency lenders are now going to private lenders for capital resolution. In many of these cases, there is an urgent need to secure financing, especially if the transaction involves a purchase agreement already in place, a 1031 exchange, or maturity.

Guided by best practices that have been implemented from lessons learned following the Great Recession, disciplined private lenders will have the opportunity to optimize a strategy of capital preservation by investing in institutional quality mortgages that meet five basic criteria:

1. Income-producing
2. Low loan-to-value, sub-65% of as-is value
3. Ample equity coverage
4. High income-to-debt ratios
5. High-quality asset in a great location

With greater flexibility and agility, private lenders will be in a unique position to support the markets and move transaction pipelines forward through the current environment.

The way forward

The coronavirus global pandemic has undeniably dealt the world, our country, and our industry a severe blow.

While no one really knows how long the pause button will remain in the “on” position, many agree that a systematic process for COVID-19 testing, containment and treatment will be necessary to reopen the economy.

Once we’re open for business, which will not happen overnight, we’ll begin to see how the fundamental dynamics of the commercial real estate market—from capital liquidity and valuations, to vacant spaces and space us —will adjust to accommodate a new reality.

As with any black swan event, the unexpected nature is disorienting and enveloped in the haze of uncertainty. However, we know that this moment will pass, and that our country and industry will emerge stronger on the other end.

For more information about Elliot Shirwo or BridgeCore Capital Inc, please visit www.bridgecorecapital.com







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