Waiting to See
COVID-19 was the black swan event nobody could have predicted, so prepare for 2021 by understanding what you don’t know.
While 2021 may feel like an extension of last year so far, the new year will be as different from 2020 as last year was to 2019. A famous quote from one of baseball's greats, Yogi Berra, sums up 2020 perfectly: “It ain't over until it's over.” This adage can be applied to the pandemic, Federal Reserve quantitative easing, unemployment, and even the record rise in the stock market. The jury is still out on whether any or all of these will conclude in 2021. So, perhaps the outlook for 2021 could best be captured by another of Berra's quips: “The future ain't what it used to be.”
For economists, 2020 punctuated that forecasting is a subjective and humbling activity. At the onset of 2020 I shared “pitcher influences” — issues that would likely determine whether our economy and the CRE industry would be a year seen as a glass half full or half empty. These influences included tariffs and trade wars, LIBOR transition, ESG, the November election, workforce availability, and the fiscal health of federal, state, and local governments. But COVID-19, a black swan event unlike any in the past century, swooped in to define 2020.
Why did our economy not only survive but perform so much better compared to the Great Recession? Was it because the Federal Reserve slashed interest rates to zero almost immediately and ramped up quantitative easing (while using the Fed's balance sheet to buy assets with newly printed money)? Was it because we had technology that enabled much of our workforce to work remotely? Was it a myriad of other factors? Regardless, what resulted was a housing boom, record highs in the stock market, acceptance of remote work, and the evolution of e-commerce and supply chain technology that was destined to take much longer to evolve without a disruptive event like a pandemic.
Finding Your Route in 2021
Before setting out with a new CRE strategy for 2021, you first need to assess where you have been and your starting position. On my first cross-country trip from Colorado to Georgia in 1981, I relied on AAA Auto Club's TripTik, an easy-to-handle, flip-chart-style map book with valuable information regarding type of roadways by segment, exits with services, road construction, and more. While we use apps for everyday travel today, consider this capital markets update an economic TripTik to help guide you through the sometimes-complicated maze of economic data.
Just as you check the dashboard gauges on your automobile before any trip, basic macroeconomic measures should be in focus at the beginning of a new year and refreshed monthly. These metrics include, at a minimum, GDP (translated local to the state and MSA level), jobs figures, and transportation measures. However, don't take the heavily trafficked government data path, like the U.S. Bureau of Labor Statistics monthly employment situation report. Instead, focus on forward-looking figures. For employment, monitoring private payrolls and job cuts — from sources such as ADP and Challenger, Gray & Christmas -provide a more accurate picture. ADP's National Employment Report foretells what is happening with private employers, whereas the Challenger, Gray & Christmas's monthly job cuts report provides insight as to where the size of the workforce of private employers is headed — and the subsequent demand for CRE space.
2020 was an employment rollercoaster ride with private job growth starting out in 1Q below trend, averaging +150,000 new jobs per month. It collapsed in the second quarter with the onset of the COVID-19 pandemic and a record 19.4 million private job layoffs in April. Employment appeared to rebound over the summer as states reopened and eased lockdown orders with 9.5 million rehires from May through September. That trend slowed materially in 4Q2020, as COVID-19 cases spiked to their highest levels and lockdown restrictions returned. The November elections and rollout of the COVID-19 vaccine have not reversed the trend for employment as hoped thus far. Challenger, Gray & Christmas reported a record 2.3 million job cuts in 2020 — up 289 percent over the 593,000 cuts in 2019. That annual total is the highest on record, a 17.8 percent increase from the previous record of 1,956,876 in 2001.
The outlook on jobs for 2021 is a bifurcated one. The first half of the year is likely to be bleak, with aggregate job growth struggling to average 100,000 per month in 1Q2021. Why does 1H2021 employment look so dire? First, only a $900 billion fiscal bandage was applied to the economy in December, which is not sufficient to support the unemployed and small businesses until full vaccination in 2H2021. Second, the logistics of the vaccination have not transpired as hoped. According to the CDC and Beckers Hospital Review, South Dakota, North Dakota, Connecticut, New Hampshire, and Iowa are the five states with the best vaccination efforts, having administered more than 55 percent of provided doses. But Georgia, Arkansas, Alabama, and Arizona are struggling to attain 20 percent administration of provided doses. Varied vaccination results by state will impact the employment outlook and economic performance by state in 2021, much like the varied lockdown restrictions did in 2020. You can correlate the vaccination rollout stats by state directly to the employment outlook.
Still, 2H2021 could see robust job growth as the vaccination effort becomes more effective and widespread. That success could then mean the Fed reverses course on its quantitative easing policy. Getting to 2H2021 is going to be a lot like driving on fumes along the highway, hoping to make it to the next exit with fueling services. Plan to drive on fumes until 2H2021 and engage in cashflow preservation strategies to stretch your reserves.
In addition to GDP and employment, monitor transportation metrics such as airline passenger counts by the Transportation Security Administration and rail traffic by the American Association of Railroads. As goes the business traveler and intermodal rail traffic, so goes the travel and leisure industry and supply chain — an area that impacts consumers, retailers, manufacturers, and logistics infrastructure alike. The airlines will struggle with less than 50 percent passenger loads, and route consolidation will continue.
Loss of airline service in secondary and tertiary MSAs could be a leading factor in cities filing Chapter 9 bankruptcy. A record 74 counties and cities filed Chapter 9 bankruptcy in the wake of the Great Recession, and a higher figure is expected from the pandemic. Additionally, many of the leading 138 college towns are under fiscal strain having experienced revenue declines of 40 percent or more from lost sales taxes as students continue to engage in remote learning. Nuveen is a reliable resource for tracking the fiscal health of state and local government and the history of Chapter 9 bankruptcies by city and county. The process and ability to file Chapter 9 bankruptcy varies by state.
Capital Markets Perspectives for 2021
After employment and transportation measures, take the pulse of CRE capital activity. Last year saw approximately $478 billion in activity, falling short of the record $500 billion in 2019, according to Statista. This year will likely see transaction volume in the range of $400 billion to $450 billion as the Federal Reserve continues to support mortgage-backed securities with more than $2 trillion of single and multifamily mortgages on its balance sheet (up from $500 billion in 2019). The wild card to monitor is how much of the 2017 Tax Act the Democratic-controlled Congress will reverse, particularly 1031 exchanges and the capital gains treatment for CRE.
Trepp data on the volume of loans being transferred to special servicers and delinquency by property type are good proxies for the ripple effect of COVID-19 on the health of CRE debt. A note of caution here is that although loan delinquency appeared to stabilize by the end of 2020, Trepp warned that the data is understating the true rate because loans in a forbearance program are excluded from the calculation. For example, multifamily loans secured by an FHFA Freddie Mac/Fannie Mae mortgage with loan forbearance due to eviction moratoriums and/or rent forbearance are not considered delinquent. As rent forbearance and eviction moratoriums wind down in 2021, loan delinquency rates are expected to rise.
Industrial property has the lowest delinquency rate at just above 1 percent; lodging has the highest at a record 19.66 percent, followed by retail at 14.2 percent. Note that multifamily delinquency is on the rise and now above 3 percent, despite the beneficial treatment from eviction moratoriums and loan forbearance.
For bank debt, look to FDIC reports on bank failures. But don't take the results from the year-end 2020 Federal Reserve's Bank Stress Tests at face value. Layer in the rise in the Texas Ratio, a metric that looks at what percent of a bank's capital is tied up in problem loans. This decades-old ratio is back on the rise. A healthy bank would have a ratio of less than 5 percent. The double whammy of COVID and a destructive season of natural disasters have left some banks with Texas ratios reaching 30 percent.
The Texas Ratio is determined by comparing the total value of at-risk loans to the total value of funds the bank has on hand to cover these loans. At-risk loans are any loans that are more than 90 days past due and are not backed by the government. The amount of funds on hand consists of the loan loss allowance that the bank has set aside plus any equity capital. If you want to check out the Texas Ratio for banks in your state, DepositAccounts.com is a good resource, as is BankRegData.com.
Industrial Continues to Shine
Whether one looks at GreenStreet Advisors or Real Capital Analytics CPPI (Commercial Property Price Index), industrial was tops for property price appreciation in 2020. Through 3Q2020, multifamily and industrial tied with a one-month CPPI of 0.8 percent in October, but industrial surpassed multifamily with an 8.5 percent year-over-year price increase. (Multifamily registered a 7.2 percent YOY increase.) Retail CRE experienced the largest price decline at 5.2 percent. (Hotel is not tracked by RCA in its CPPI.)
The booming industrial sector of CRE is part of a long-term trend in the economy that has accelerated by five years thanks to COVID-19. Consumers are moving from a shop-and-take-home model to one where they order online and have it delivered. It seems, regardless of what happens in the economy in the next six months, industrial is only looking at how high its ceiling will be. The retail-to-industrial conversion of vacant or closed former big-box stores is another trend that continues to impact both of these sectors.
Considering the expected growth in industrial, CRE professionals will be instrumental in facilitating enough square footage to meet demand. In this respect, struggles in other market sectors could be a benefit. While hospitality and retail have faced difficulties, capital wants to migrate into stable, promising sectors. A new course I helped develop for CCIM Institute's Ward Center for Real Estate Studies,
Last-Mile Logistics: The Final and Most Expensive Link in the Supply Chain, takes a deep dive into this topic.
Retelling Retail CRE
Until one recognizes that retail is in a constant state of remaking itself, it is overly simplistic to accept characterizations of this property type as one facing an apocalypse. Although an estimated 12,000 retail stores closed in 2020, new retail concepts emerged and approximately 3,000 stores opened, according to Coresight Research.
Dollar General is one example. The company is introducing its new PopShelf concept, which is an upscale discount store. The locations for the rollout of these stores are in places like Nashville, Tenn.; Huntsville, Ala.; and other Southern and inland markets.
Retailers looking to solve for last-mile delivery and the reverse logistics challenge of returns represent unique opportunities in retail. ShipMatrix estimates more than 3 billion packages were shipped between Thanksgiving and Christmas in the U.S. in 2020, about 800 million more than 2019. For the 2019 holiday season, UPS reported returns peaked on Jan. 2, 2020, dubbed “National Returns Day,” with a record 1.9 million returns taking place — a 26 percent increase from the previous year's peak. This continued boom in e-commerce is a real opportunity for CRE professionals, who can be valuable assets to clients looking to enhance last-mile capabilities, from site selection to finding possible adaptive reuse locations.
And finally, the mall becoming the new office is another trend to follow in retail CRE this year. The most recent example is Epic Games with its recent purchase of the 980,000-sf Cary Towne Center in North Carolina. Epic, the company behind the popular Fortnite video game, plans to convert the mall and move its headquarters to the location by 2024. Driven by retail declines, Epic is just the latest company to tap into the opportunity presented by a vacant or troubled mall asset. These adaptive reuse initiatives are part of a larger trend driven by declining mall traffic, growing e-commerce activity, and shifts in CRE in the U.S., especially in the retail sector.
Office Faces Headwinds
The strain on office CRE from major economic or market disruptions typically lags behind other property types because the space is leased on a long-term basis, which allows for a delay as market rents and occupancy adjusts. What typically happens in the interim is tenants attempt to sublet excess office space as they downsize. Monitoring sublet space is a key bellwether to the health of office CRE. At the end of 3Q2020, CoStar reported that the amount of available sublet space on the market rose considerably during 2020, beginning midyear and further accelerating in 3Q2020 to a total of 156 million sf. Prior to the second and third quarters of 2020, the supply of U.S. sublet space had been generally stable, varying between roughly 100 million sf and 110 million sf over the past decade. The 156 million sf of available sublet space at the onset of 4Q2020 was a record high and represented an increase of 40 million sf from the end of 2019.
Tech hubs such as San Francisco and Austin, Texas, have seen the amount of sublet space on the market double since the end of last year. The downsizing of office space has broadened to retail companies like REI (which sold its new Washington HQ in 4Q without ever moving in); financial services companies such as Wells Fargo and Citigroup (both of which have learned how 50 percent or more of their workforce can ditch the office and work remote permanently); and most recently, manufacturing companies like Boeing (which is reevaluating all its office needs as it consolidates 737 Max manufacturing to Charleston, S.C.). This trend is not reversing in 2021. The opportunity may lie in finding more hub-and-spoke office structures that require smaller chunks of office space in suburban and secondary markets where employees desire to work from on a remote basis.
Because of these market forces, suburban offices in business parks — properties that people thought were basically worthless a few years ago — could see a spike in demand. Characteristics that were undesirable — like single-story designs, multiple entrances, and lack of density — are now strengths.
Three Areas of Opportunity
As mentioned before, COVID-19 did quite a job in humbling those of us in the forecasting business. Economists never could have guessed where we ended up on Dec. 31 back in January 2020. But looking ahead to 2021 and beyond, CRE professionals will have opportunities to excel, even as the industry continues to change in response to a constantly evolving situation like COVID-19.
Here are three promising avenues in CRE:
Single-family housing as a CRE asset. Apartments and townhomes are the affordable alternative to the rising costs for single-family homes in MSAs with job growth and inventory shortages, such as Phoenix, Salt Lake City, Denver, Dallas, and Nashville, Tenn. But in response, a growing market in for-rent, single-family housing is emerging in the South and Midwest. California and some major urban areas with challenging construction costs are also ripe for opportunities in this new sector that sits adjacent to multifamily.
During the housing crisis, Wall Street won big by buying up homes during the foreclosure crisis and renting them out. Investors are headed back to the suburbs in hopes of scoring again. With the pandemic driving demand for larger living spaces, institutional investors are pouring money into single-family rentals. In addition to buying houses on the open market, they're bankrolling subdivisions — inventing a new kind of suburban living that's easier to afford, but where the financial benefits of homeownership go to Wall Street firms.
CRE professionals fill role as capital advisers. In times of change and distress, CRE investors turn to industry professionals, CCIMs in particular, as experts. Think of yourself as a CRE capital adviser. Know about the banks, know about the concentrations, know how to diversify, know that credit unions are lending for certain CRE loans, know where the delinquencies are. Just because interest rates are low, loans may not be easy to secure because of these delinquencies.
Underwriting ratios are getting tougher. Debt service is going up, while loan values are decreasing. Lenders want more equity in the deals, so they are functionally redlining markets. If you're in a leisure and tourism market like New Orleans or Las Vegas, good luck getting a loan. When looking at the “other L&T” industry — logistics and transportation — you've got a bright future.
CRE professionals can be vital in helping clients navigate these obstacles and making the most of their investments.
Building relationships in the business. Virtual meetings have been crucial in maintaining the ability to collaborate and work remotely in response to the pandemic. But CRE is a business built on relationships that are hard to forge from our home offices. Despite COVID-19's continued impact on in-person interaction, events are starting up again.
Look for safe, feasible ways to meet people and reinforce existing relationships. If you can drive to a venue instead of jumping on an airplane, businesses are amenable to this type of regional travel. Hosts are also becoming more creative in venues, with meetings held outdoors at nontraditional locations like local parks. Events can also be partially in-person, with a few dozen on-site participants and plenty more joining virtually.
The CRE industry may need to rethink how and where meetings are held, which could be a huge opportunity for secondary markets to host smaller, drivable events at smaller venues in 2021 and 2022. Anticipate that it may be 2022 before we consider going back to established megamarkets for conferences, such as Las Vegas, Orlando, or New York. COVID-19 may prove to be like 9/11 psychologically speaking, where we change fundamental behaviors to respond to such a psychologically scarring event.
With some signs for optimism and some warning signs on the horizon, 2021 will be a year spent responding to the unprecedented challenges presented to us in 2020 with unprecedented innovation, creativity, and level of CRE expertise. While we couldn't have foreseen those events, we are now in a position to respond effectively and do our part in moving the industry forward.
For more on this topic, check out the member-exclusive webinar playback of 2021 Commercial Real Estate Outlook featuring CCIM Institute Chief Economist K.C. Conway located in the Members Only section of ccim.com.