New Normal for Real Estate?
We’ve heard a lot about the “new normal” while adjusting to Covid and lockdowns. Will this mean a New Normal for Real Estate?
It’s hard to gauge exactly yet, how bad Covid has been or will be for the economy. If you had secluded yourself on a desert island on January 1st and came back today and looked at your 401K balance or the stock indices, you’d think it might have been an uneventful year, after all the markets are positive on the year, and in fact have hit new all-time highs. However, if you asked around you’d soon find out very quickly that it has been one of the most tumultuous years ever for small businesses.
Small Businesses
A lot of small business have been decimated and will not recover, and while the massive unemployment figures from the peak of the pandemic have improved substantially, they are still high. There is a worry that some jobs simply won’t come back due to permanent business closures, or businesses that have learnt how to adapt to new circumstances with less employees.
The Stock Market appears detached from the economy, but it is always forward looking whereas financial results & economic data are backward looking. Nonetheless, the Stock Market seems to be forward looking well beyond it’s normal range. The Government stimulus, near zero interest rates, and the Fed willingness to buy up almost any bond security in the market has a lot to do with that. When you have the Government as a guaranteed buyer of bonds in the market, it drives down their returns and forces investors needing yield into other securities or assets they may otherwise avoid. Hence the buoyant stock market.
The Government is effectively printing cash and pumping it into the market. This printing of money should cause inflation. Yet traditional inflation measures seem to have been kept in check. The money printing is directly inflating security asset prices, and not impacting the prices of the traditional consumer commodities or “basket of goods” used to measure inflation rates.
The recovery has been described using multiple letters of the alphabet, from an L, to a V, or a W, depending on what perspective you take, or what agenda you might be pushing. I like the description of a K shape recovery best. It suggests that certain sectors of the economy are booming despite Covid, and in fact may have benefited from it, while other sectors or businesses are hurting badly and declining. This is one reason why the stock market looks ok, as it contains the top performing companies in the country, and they represent the upward arm of the letter K. If we had an index made up of just small private businesses it would tell a different story, and represent the down leg of the letter K.
Bank Health
A major area of concern with such a downturn, after our primary concern for the impacted businesses themselves and their employees, is how the ripple effect will impact the wider economy. This pandemic has affected every corner of the economy, but it’s true impact is yet to be measured. Banks always take a big hit when there is a recession or a major part of the market deteriorates.
Due to the financial crisis 10 years ago, the ensuing financial regulations that followed forced banks to be better reserved for the next crisis. It appears that most major banks will be well able to weather expected impairments to their loan books. All the big banks made huge provisions for loan losses in the 2nd Quarter, however they are now in the 3rd Quarter reducing these provisions substantially. This is heartening, as these banks should be talking with their borrowers, and should know firsthand the true state of their businesses and the likelihood that their loans will be paid back. But these big banks mostly deal with well capitalized large businesses that are doing ok.
At the other end of the spectrum are the small local banks, whose customers are the typical small business owners that have been most effected by Covid. These banks don’t catch the attention or headlines as they report their earnings and loan loss provisions. In any event, it is yet to be determined how badly they may get effected. So far, many businesses have been supported by PPP loans, Economic Injury Disaster Loans, or the Main Street Lending Program. These programs have been a lifeline to many, or a just drop in the bucket for others such as the hospitality industry where these loan programs do little to help a shuttered business. Now that these programs have been accessed and the money spent, we will have to wait and see if businesses will return to their pre-Covid level.
Many local landlords are also being impacted with loss of rent collection. With a prolonged loss of rent many landlords will be unable to service their loans. At a very early stage the FDIC issued guidance to lenders to work with their borrowers that were in distress. The lenders were encouraged to put the most distressed cases on deferment whereby debt payments would be deferred for a period of time. Most banks have been accommodative with distressed borrowers, by either offering full deferment or putting loans on interest-only.
This is why it is very hard to judge just yet, how badly the banks will be impacted because we have both the stimulus effect of Government loan support, and the lender deferment of loans, all contributing to a short-term band-aid. Once the funds from these Government programs have been fully spent, and the deferments from banks are expired, if we remain in a prolonged situation of pandemic restrictions, we could see some major pain at the banks.
Having said all that, it is unlikely we will have a banking crisis like 10 years ago, as mentioned already the banks are much better capitalized. What we may see at the small bank level is an acceleration of consolidation where smaller banks get acquired by larger better capitalized competitors.
Lending Today
Most banks are still eager to get new business and make new loans. However, most banks are taking a more conservative view with their underwriting, either changing their lending criteria by reducing LTVs, increasing debt service coverage ratios, or requiring greater reserves; and some are only lending to existing customers. This makes sense given our current environment, but it is also telling that they have concerns about what may transpire with their local economy, their current borrowers, and their loan book in the months ahead.
Interest Rates
Rates are at historic lows, for both home mortgages and for commercial mortgages. Home loans are only available to consumers for their personal property and are priced differently to commercial mortgages. Home loan rates are set by a very competitive bond market where most loans are sold in large tranches. Part of the Fed buying up bonds has pushed home interest rates down. Commercial Mortgages & Construction Loans on the other hand are typically held by the bank that issues you the loan, on their balance sheet for the duration of the loan.
Commercial Mortgages are usually of 5, 7 or 10 years in duration, with the principal paid on an Amortization schedule of 20 or 25 years, compared to 30 years for home loans. Commercial mortgages will price off a benchmark index tied to the loan term. The most typical loan term is for 5-Years, and a common benchmark for that would be either the 5-Yr Treasury Rate (0.41% yesterday) or the Federal Home Loan Bank of Boston Advance Rate (0.87% yesterday). The bank adds a spread to the benchmark of anywhere from 2%-3%, therefore you can expect commercial mortgage rates of somewhere in the 3%-4% range today. In this low interest rate environment banks usually put a floor on how low they will go.
Interest Rate History
FHLBB 5-Year Advance
0.87% - Yesterday
1.99% - 1-Year Ago
3.44% - 2-Years Ago
6.71% - 20-Years Ago
5-Year Treasury
0.41% - Yesterday
1.59% - 1-Year Ago
3.02% - 2-Years Ago
5.73% - 20-Years Ago
So while rates are incredibly low, the underwriting standards to secure a new loan have become a little more stringent. Securing a new loan today will possibly mean having to approach a lot more lenders than usual, particularly for construction which carries more risk. On the other hand, for investment property, if you have a property with tenants in place, and it cash-flows well, there is plenty of bank capital available to lend,
Asset Class Prospects
I list various real estate asset classes below and give my opinion on their future prospects.
Residential – Homes
There is evidence of a flight to the suburbs. With people stuck working from home, some are finding they want more space, or they don’t want to be in a densely populated urban area. I have seen this first hand with the suburban communities getting an influx of interest and a spike in pricing. Personally I don’t see this as a long-term trend, and as life returns to normal the draw of the city will also return. I am also seeing evidence of some urban communities with many unsold units. This will cause a pricing correction in the short-term but there is little chance that it will cause a collapse in values.
Residential – Rentals
Something unusual for Boston urban areas is apartment vacancy. Most city landlords have not seen much vacancy at all in the past 10 years, yet today some city neighborhoods have 10%-15% vacancy in multifamily apartments. Much of this can be attributed to college students not yet back on campus, and hospitality workers that have been laid off. These vacant unit will be filled very quickly once colleges return, it’s just a matter of how long that will take and how landlords and their lenders work through this period together.
Retail
Retail is persona non grata right now. It’s definitely taken a beating and is the one to watch. Retail was already in a fight with online platforms, especially Amazon, but with this prolonged shut-down the biggest danger they face is the changing human behavior people adopt. Online retail sales is still a relatively small percentage of total retail sales, but it is growing rapidly. People form new habits after a couple of months, and the trend to online shopping may have leaped ahead by 5+ years.
Hospitality
Bars, restaurants, and cafes operate on the thinnest of margins as it is. With the extended lockdown, and the insufficiency of a PPP loan to help when you have zero revenue, the prospect for many is bleak. This industry has a very high failure rate, and we will see it rise further. The best chance for survival here is if the operator owns their building and has a bank helping them through, or if they have an understanding landlord offering a rent-free period. Some in this industry have adapted quickly and taken to delivery services, or availed of the many 3rd party delivery services such as GrubHub, UberEats, or DoorDash. Although these are an expensive high commission service, they have provided a lifeline to many. This sector is hurting badly, but unlike retail this sector should bounce back, maybe with new owners, but most people are yearning to get out and socialize properly again.
Hotels
Hotels are in a similar boat to bars & restaurants, and it will be the strongest and best capitalized that will survive. It will also be a consolidating time where the weaker owners & operators may get acquired by larger groups. The large groups have greater access to capital markets willing to finance their survival. Once the pandemic is over, the hotel industry should return to normal relatively quickly. Some predict the travel industry could take a decade to recover, but I seriously doubt that, I know I’m looking forward to getting away soon. Similar sentiments were shared after 9/11, but it didn’t take long for normal travel to return.
Industrial
Industrial had already been on a boom prior to Covid, and this has now increased further due to Covid. Industrial property is in hot demand for distribution centers, think logistics, such as FedEx and UPS for all that new online shopping, and of course Amazon distribution.
Office
Like housing, urban office space is in less demand while suburban office is in greater demand. As office leases tend to be in 5-Year terms, it will take longer, until leases expire, to see what long-term decisions businesses make regarding their office space needs. A positive for landlords, given the medium to long term nature of the leases, businesses may resume back in their space and not contemplate downsizing or relocating for a few years until lease expiration is approaching. By that time businesses may not be inclined to move.
I have heard many first-hand stories of businesses approaching lease expiration where the business will not renew and will resort to remote working from home, while utilizing limited shared office space or a conference room in the city for client meetings. Some are also finding clients are fine with not coming into the city for meetings, and prefer meeting in the suburbs or via zoom, which saves time & money. Office is therefore a very tough one to call. While a lot of people like the flexibility of working from home, some also like the escape and change of environment that an office brings. Businesses like the reduced cost of rent with remote working, but they also miss on the collaborative time for supervision, training, and brainstorming.
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