The number of known cases of COVID-19 continues to growquickly in the U.S. Over 180,000 people have now tested positive, with over 3,500deaths recorded. The severity of the disease and the country’s response continuesto be debated on both side of the political aisle. However, the effect thevirus has had on the stock market over the last 32 days is not subject todebate.
Since the S&P 500 hit its peak on February 28, 2020, theindex has declined by nearly 30% in just over a month, despite a recent rallyof close to 10% upon news of the $2 trillion fiscal stimulus bill passing the Senatelate last week. Further, according to J.P. Morgan, equity markets are nowpricing a 10-plus-year recovery into their Earning Per Share (EPS), implied bycomparing current dividend futures to those at peak pricing just over a monthago.
The steep drop in U.S. corporate earnings is a direct resultof the loss in consumer spending. Social distancing has forced businesses toshut down, lay off workers, and request assistance from landlords and banks onrent or loan payments. President Trump has extended social distancing recommendationsthrough April 30, 2020. The economy has essentially stopped, but bills stillneed to be paid and the markets continue to trade.
Consumer spending accounts for roughly 70% of U.S. economicgrowth. With U.S. unemployment claims already reaching unprecedented levels(3.3 million), consumer spending has dramatically slowed. The crisis is poisedto hit low-wage workers the hardest. The jobs at the greatest risk of layoffs areservice jobs and in roles in industries like restaurants and hospitality.
Stimulus
On Friday March 27, 2020, in response to the COVID-19 outbreak, President Trump signed into law a bipartisan bill known as the CARES Act. The CARES Act is a $2.2 trillion fiscal stimulus package that will inject liquidity into the economy and provide relief to the disruption caused by the virus. To put the size of this stimulus package into perspective, the governmental response to the financial crisis in 2008 was an $800 billion package. The main provisions of the CARES Act bill break down as follows:
- $250 billion for enhanced unemployment insurance (UI) benefits.
- Will replace 80-90% of lost income, where UI previously replaced only 40% of lost income.
- Includes self-employed, contract, and gig workers.
- Up to $600/week. Program extended from 26 to 39 weeks.
- $300 billion for household payments to middle class Americans.
- Direct deposit stimulus of $1,200 per adult and $500 per child up to certain income limits.
- $500 billion in corporate loans.
- 2% annual interest, can defer principal and interest for 6 months.
- Available to companies with 500-10,000 employees.
- $58 billion in cargo loans and grants to airlines.
- $100 billion healthcare grant
- $340 billion in grants to state and local governments.
- $25 billion earmarked for public transit.
- $350 billion in small business grants.
- Loans forgiven if expenses are applied toward mortgage, rents, wages, other bills, interest on existing debt, etc.
- Only covers all-in expenses for a month for all small businesses.
- Grants up to $10 million.
- Available to businesses with fewer than 500 employees.
- $200 billion to other programs.
The CARES Act, combined with the $4-5 trillion monetary stimulus launched by the Fed on March 15, produced an overall government response calibrated to weather a 10% fall in U.S. GDP and shelter the overall economy from a worst-case scenario. That said, most economists anticipate a Q2 8-15% annualized economic shock in U.S. GDP as the pandemic death toll peaks in the middle of April.
Views differ on the effect of climate on the spread of the virus, but most anticipate the warmer, wetter summer months will slow the spread of the virus and expedite economic recovery. That prospect, coupled with the fact that, 47 COVID-19 vaccine programs are under way with human trials to begin this month, gives hope for recovery to start by Q4 2020.
Real Estate
So how does this affect real estate? In this writeup I will speak generally about all asset types, but I will place extra focus on the multifamily and last-mile industrial asset classes.
Today’s real estate market is fraught with uncertainty, just like every other market sector. For example, developers face near-term labor disruption and permitting issues, with town councils unable to convene to approve permits. Further, some states have designated construction as an ‘essential business’ while others have not, halting development altogether where construction is not exempt. In the long term, developers with projects underway can’t be sure of their exit cap rate assumptions and the economic landscape they will deliver their projects into.
Brokerage shops and lenders have fared well so far—any transaction or loan currently in process is still anticipated to close. Lenders have fared particularly well given today’s low interest rates and a substantial increase in refinance requests. On the other hand, property managers, engineers, and janitorial services have faced layoffs due to decline in asset-level activity, especially in the office, retail, lodging and industrial asset classes.
Real estate has a reputation as a stubborn, slow-moving industry, particularly in its response to economic shifts. The COVID-19 crisis is unlike the financial crisis of 2008 in that real estate will need to react within a chain of events, as opposed to being the catalyst of the crisis. For that reason, you would expect the effects of the virus on the real estate market to lag behind other sectors, at least until investors can assess the landscape.
On the contrary, over the past month landlords have already begun to field rent-relief requests from tenants, prior to the passage of fiscal stimulus package. The hope for this bill is that small businesses will be able to use grants from the government to pay their rent and continue paying their employees, while enterprises will be able to receive loans at low interest rates to do the same. The main issue with these grants and loans is that there is only enough money to pay for one month’s worth of expenses. Will that be enough? Or will another stimulus package be necessary?
In my opinion, this fiscal stimulus package will not provide sufficient relief for most companies, and real estate values will suffer as a result. I do not think the drop in value will be caused by commercial loan defaults. Vacancy rates will tick up, with immediate consequences for the property’s cashflow.
The debt market will become tight among banks, publicly traded mortgage REITs, and other non-bank lenders. However, the Fed’s monetary stimulus, especially their $625 billion weekly purchase of both treasuries and mortgage-backed securities, will allow federally backed lenders like Fannie Mae and Freddie Mac to be flexible on loan repayments, even to the point of restructuring loans.
Banks, while not the predominant lender in today’s real estate landscape, make up a large portion of the debt market. They enjoy as much financial strength as they have in 40 years. They will be able to maintain the flexibility to work with landlords in the short term. Agency lenders (Fannie, Freddie, Ginnie), backstopped by the government and the Fed, should be fine. Life insurance companies will also fare well—they have robust balance sheets and traditionally finance low LTV investments.
Debt funds, backed by private capital, are the main source of concern. According to Real Capital Analytics (RCA), debt funds made up a larger share of the commercial mortgage market than life insurance companies in the first half of 2019, capturing 10% of all lending activity in 2019 during that time. Debt funds are generally more generous with LTV ratios and lend on riskier, value-add deals, albeit in return for a higher interest rate. Lenders, especially debt funds, have some reason to be nervous, but ultimately the true value of a real estate asset springs from the companies and people who occupy it.
With people avoiding person-to-person contact to slow the spread of the virus, properties where people must interact face-to-face stand to lose the most value. For example, the lodging asset class (including hotels, inns, B&B’s or resorts), where people form dense clusters and interact face-to-face, have experienced the most negatively effects; meanwhile, data centers and cell towers have experienced the fewest negatively effects. Restaurants and retail space will also suffer, while property zones for industrial and logistics use will suffer less. The effect of the COVID-19 crisis on opportunities within the multifamily and last-mile industrial asset classes are detailed below:
Multifamily
COVID-19 has already put many Americans out of work. In Connecticut, as of March 25, 281,000 people, or 7.8% of the state’s population, were out of work. The fiscal stimulus benefit to individuals will help in the short term but will not do enough if the economy is not fully stabilized in short order. Eventually, as detailed above, landlords who do not have federally backed mortgages or subsidized renters will face atight spot vis a vis their lenders.
Last week, according to The Real Deal, the Mortgage Bankers Association estimated that mortgage companies could be on the hook for at least $75 billion on short notice, and possibly more than $100 billion if homeowners and landlords sought forbearance on a broad scale. However, all federally backed multifamily borrowers can request forbearance on their loan for up to 90 days, as long as the borrower is current on payments through February 1, 2020. In return, the landlord cannot evict a tenant during for non-payment of rent during the forbearance period.
Affordable housing assets or multifamily assets with significant section 8 tenancy are in better shape. Their tenants will presumably receive even more government assistance, as the stimulus set aside $1.25 billion for tenant-based rental assistance. If a renter is not subsidized, he or she will at least receive a $1,200 direct deposit by the middle of April. In response to COVID-19, New York State has already suspended evictions pursuant to non-payment of rent for 90 days and allowed tenants to use their security deposit to pay their rent. Look for more states to follow suit.
Again, these subsidies are only a quick fix. Some of the provisions stink of “kicking the can down the road.” If this pandemic continues and the economy does not rebound, the current fiscal stimulus is simply not enough to support individuals and small businesses, many of whom operate on a month-to-month basis. If tenancy within a multifamily asset is not predominantly subsidized, but rather full of low-income workers in industries like restaurants and hospitality, we could see a buying opportunity as real estate values fall in step with landlord revenues.
Last-mile industrial
Generally, class B or C industrial buildings (aka “last-mile industrial assets”) are located in highly urbanized and dense population centers, serving as a company’s final link in the delivery chain to their customer base. The tenants are often companies who need to deliver their goods to their customers in a short timeframe (24-72 hours). Unlike tenants in traditional industrial space, tenants at these locations are less focused on storage and more focused on the inflow and outflow of goods. Extreme clear-height and large total square footage matter less. Instead, location, property access and number of dock doors rank higher in terms of value proposition.
Since 2015, real estate investors have been drawn to the fundamentals of last-mile industrial assets because of the scarce supply close to city-centers and low vacancy rates. Today, the national overall vacancy rate in last-mile industrial property is 5%, which has led to significant rental increases in the asset class over the past few years.
Recently, post-outbreak, Amazon announced plans to hire 100,000 workers to improve operations at a time when millions in other industries stand to lose their jobs. As online shopping and food delivery continue to gain market share, especially in a pandemic environment where it is impossible to shop at a physical store, this asset class will continue to flourish.
That said, e-commerce tenancy only makes up a fraction of the overall tenancy of last-mile industrial assets. Other industries, from auto manufacturing to oil and gas, also traditionally occupy this space and will be directly affected by a downturn in the economy. This could create opportunities for some investors as values drop in a previously white-hot, competitive market segment.
Conclusion
In terms of the anticipated duration of the COVID-19, experts look to China to study how the virus has developed. So far, China’s economy is showing signs of revival, albeit very gradually. Broadly, economic activity is down more than 30% from last year’s levels. According to Barron’s, subway traffic in China rose 15% from the prior week, indicating more comfort with the infection risk and a return to daily routines. That said, subway usage is down 62% from this time last year. A “second wave” of the virus in China could devastate the global economy. Experts are keeping a close eye on Chinese schools their plans to re-open in the coming weeks. If the re-openings get delayed, it will be a clear sign that Beijing is worried about another outbreak.
In the U.S., Congress is already discussing another fiscal stimulus package, this one even bigger than the CARES Act. The general consensus is that the current relief package ($2.2 trillion fiscal, $4-5 trillion monetary) was sufficient to withstand a few months, but more is needed given the scale of the economic shutdown. President Trump, along with hedge fund investor Bill Ackman, has recently called for the next bill to focus on national infrastructure improvements, an initiative President Trump has been pushing since his election in 2016.
The fundamentals of real estate come down to companies and people. Real estate will hold steady for the next few months, but unless lost job income is replaced by further government subsidies, or unless people are allowed to return to work en masse, residential real estate and multifamily assets (especially non federally-backed) and the correlated lending markets will be hit first. This will then send larger shockwaves into the commercial markets. Look for opportunities in the distressed multifamily space in the short-term, and last-mile industrial in the medium-term if the crisis continues.
Over the past few months, I have come to respect the people who have admitted to “not knowing, what they don’t know.” These are unprecedented times. Even scientists are relying on educated guesses. No one has a crystal ball, me included.