Will Commercial Real Estate Rebound?

The pandemic and resulting stay-at-home orders from governments and private employers has upended the commercial real estate market on a number of fronts.  And we are now looking square into the Pandemic Recession which has just begun.

For now, it’s merely a matter of unpaid rents and empty spaces, which means short-term losses for building owners. But if working at home has lasting appeal—and the sometimes-resistant culture of American business changes—or if shopping from home stays at its currently heightened level of prevalence, commercial real estate could lose longer-term value.

Office real estate might fare better in the long run than retail, if businesses decide to remain after all. Many of them have continued to earn profits even as employees work from home, and many have multi-year leases that provide landlords with a fiscal cushion. In some cases, tenants have actually asked for more space to be able to welcome back their employees but in socially distanced fashion.

Still, the combination of short-term reductions in business revenues and longer-term rethinking how much space is needed may lead to lower rental rates, and landlords might receive pressure to structure leases differently; for example, office users could request “go dark” clauses like those of retail anchors tenants. Shared office rental spaces might suffer and consolidation could ensue in that piece of the office market.

Retail property owners facing a longer-term decline in brick-and-mortar stores had had some success prior to COVID in shifting to tenants like restaurants, gyms, and spas that provide experiences shoppers can’t get online. But those tenants have seen a drop-off in business too, and, for example, if consumers purchase exercise equipment for the home during the pandemic, they might not be returning to those gyms.

Evidence of the problem that the commercial real estate sector is facing is best seen in the employment figures.  Employment in the real estate industry has dropped 3% since February with no end in sight.

The decline in retail stores, at least in brick-and-mortar form, could lead to a corresponding surge in demand for warehouse and industrial space as online retailers gain market share. E-commerce already had been boosting demand prior to COVID for warehouse and logistics space, leading to all-time-highs in industrial rents and asset values. New records could continue to be set.

While location, location, location will remain the most important factor, the qualities inherent in the most desirable locations is likely to change as a result of pandemic. For example, proximity to mass transit might or might not continue to enhance a property’s value, and municipalities might or might not continue to encourage dense, multi-family living near transit stops. Suburban areas and properties like data and logistics centers, which will be needed no matter how and where employees are situated, could become safer bets.

Across sectors, tenant bankruptcy proceedings likely will be part of the mix, and delays in those proceedings because of the inability to hold in-person court will prolong the agony. Landlords might end up considering rent abatement in exchange for extending leases or otherwise altering terms to balance out the abatement, yet provide business tenants with some short-term headroom to defray overhead.

Time will tell which of these changes to the commercial real estate marketplace stick, which we may look back on as temporary relics of the pandemic era.  But the fact remains, that both landlords and tenants are facing difficult choices.  It’s hard to pay rent when your store is closed or when customers are staying home.  And if tenants cannot pay rent, then landlords rental income drops and jeopardizes the financial integrity of their investment.   We face an uncertain future with the looming post-pandemic recession and both landords and tenants need to reassess their long term strategies.