Commercial Real Estate in a city

August 17, 2020

Top Considerations for Investing in Commercial Property in 2020

Commercial real estate investors typically play a long game, looking years ahead rather than making short-term decisions. Spring 2020, however, has been very different. Wholesale predictions about markets and property sectors were upended, requiring investors to make decisions in an entirely new context.

“We're in a completely different environment today than we were in 2019," said Mark J. Forbes, manager of real estate banking at City National Bank. "But at the same time, our clients who have built up their businesses over 20, 30 and even 40 years have been stress-tested before … obviously not by COVID-19, but they've managed through other types of crisis."

Experienced investors understand that every market has its risks and rewards, even in extraordinary times like these. Here's a look at this year's market hazards and benefits.

Revised economic forecasting

As businesses strive to reopen safely in some parts of the country, economists are revisiting their predictions about how real estate markets will perform in 2020 and 2021.

Mortgage Bankers Association economists Mike Fratantoni and Joel Kan anticipate recovery starting in late 2020 and improving in 2021. Their May 15, 2020 Economic Forecast predicted a GDP increase of 10.3 percent, 9.8 percent, 6.3 percent and 4.2 percent during the first-through-fourth quarters of 2021.

Transaction volume is predicted to rebound to $400 billion in 2021 and to $500 billion in 2022. The combined volume for 2020-2022 is expected to reach $1.175 trillion, a far better outlook than commercial real estate transactions during the 2008 financial crisis, when just $4.08 billion worth of transactions were recorded between 2008 and 2010.

Property sectors for investors to consider

While the distress of higher vacancy rates and unpaid rents was felt in most property sectors during the initial period of the coronavirus shutdown, the short and long-term impact of the pandemic has varied by region and by property sector.

Industrial: While a few deals may temporarily be on hold during the COVID-19 outbreak, Michael Kazemzadeh, regional manager of City National Bank's Real Estate Banking Group, said that investors still have a lot of confidence in the industrial sector. In particular, big box warehouses with 500,000 or more square feet continue to be developed and supported by healthy leasing demand.

“A typical timeline from developing vacant land to completion is 18 to 24 months and we expect that type of development to go forward," said Kazemzadeh.

Forbes reported that rent collection rates for big box warehouses — which handle logistics for companies like Amazon and Walmart — have been nearly 100 percent, even during the pandemic.

“There are some multi-tenant industrial properties where rent collections have been down 60 percent to 80 percent because some of those tenants are small businesses," he added. “While that's moderately negative in the near term, most of those businesses will resume."

Multifamily: Developer sentiment continues to be strong in the multifamily sector, said Kazemzadeh, particularly in California where apartments are more affordable than homes.

“Most landlords have been pleasantly surprised at the level of rent collected during the pandemic," said Kazemzadeh. “The general mentality for investors is that they want to work with tenants and be proactive about allowing them extra time to make their payments."

Investors in Class B and Class C apartments have felt more pressure than those who own Class A apartments, said Forbes, because tenants in the more expensive apartments are more likely to have kept their jobs and be working remotely.

“We'll likely see some erosion in occupancy rates, but I don't see a long-term rush to move to the suburbs," said Forbes. “The reality is that every major city has spent an inadequate amount of money on public transit, so people want to live closer to their jobs. They're not likely to find a job outside the cities and I don't necessarily anticipate a massive migration to remote work."

Offices: The long-term outlook for office space is a hot topic for discussion during the coronavirus crisis, with most people agreeing that it is just too soon to know what the future holds for workplaces, said Forbes.

“In the short-term, most office tenants are paying their rent even though their workers are at home," said Forbes. “The impact of nonpayment depends on the tenant mix. Law firms and accounting firms are likely to continue to pay, but some small businesses such as a travel agency can't pay."

While some analysts anticipate that more employees will continue to work from home and therefore companies will cut their office space when their leases renew, others expect demand for office space could rise.

“We're likely to go away from the idea that it's smart to cram everyone into small spaces," said Forbes. “Now we'll want lots of individual offices instead of an open floor plan and we'll want more space in between desks. Maybe some people want to work from home, but a lot of people with kids and spouses at home want to go back to the office."

Investors in buildings with a significant amount of square footage rented to co-working spaces are likely to take a big hit, said Forbes.

“But it's too early to say it's time to get out of office investing," said Forbes. “If 100 percent of the building is leased to one company, that could be bad because they might decide to take less space, but they may also go the other way and keep the whole building."

Retail: The retail sector has had to juggle short-term issues — such as limited rent collection from closed shops — along with long-term headwinds that were already creating headaches for some property owners before this spring.

“When we presented our economic forecast in January, I made a speech and said 'retail is going to be OK. in competing with e-commerce,' but now we see how retail is reopening largely online to stay afloat," said Kazemzadeh. “Clearly though, the demand for essentials like groceries and home products is high, but most of the side shops in those grocery-anchored sites are all closed."

On the opposite end of the spectrum, major mall tenants such as Neiman Marcus, J. Crew and JCPenney have declared bankruptcy. Malls will need to reinvent themselves, said Kazemzadeh.

“For investors, the biggest immediate challenge is rent collection, particularly if they own a building with a single tenant who doesn't pay," said Kazemzadeh. “There will be longer-term disruptions in retail too, because we're looking at a new world of unknowns such as how many people can be in a store or restaurant at one time."

The pandemic accelerated what has been known as the "Amazon effect" and could mean that more people continue to shop online for more products going forward, said Forbes.

“Retail is a higher-risk sector, especially now, but you'll see different outcomes depending on the product type, such as a mall versus a grocery-anchored site with other essential stores," said Forbes. “If you own property in these sectors though, maybe it's best not to sell right now. It's an investor-by-investor decision and this may not be your strongest investment right now, but you also don't want to sell at the bottom."

Housing for investors, students and seniors: From an investor standpoint, extremely low mortgage rates make housing a potential opportunity depending on the market and price point.

“We expect a moderate negative impact momentarily on the housing market," said Forbes. “The biggest drop-off in sales is likely to be in the luxury home market. Buyers may be looking for deals in the upper range of the market."

While Forbes expects student housing to experience short-term losses from unpaid rents dating to when students were sent home, he thinks it can be a good investment long-term.

“When schools find a way to reopen the students will return and start paying again," he said. “There could be even more demand for students and their parents who want to see them living somewhere other than a crowded dorm."

The outlook for senior housing is mixed, said Kazemzadeh.

“In areas where the demographics are strong, with well-positioned properties where appropriate measures have been taken to protect tenants' health, it might be OK," he said. “But there may be pressure on this space from new mandates and requirements that could limit the number of people who live there or increase costs. This is a licensed housing type with government oversight."

Self-storage: In the short term, some self-storage properties will face cash flow issues if customers are having credit problems and can't make their payments, said Forbes. However, Kazemzadeh said the long-term fundamentals for self-storage are good as long as these facilities are not overbuilt.

“These deals usually take from three to five years to stabilize," said Kazemzadeh. “Experienced investors know that self-storage is a long-term investment that needs to be supported by sound supply fundamentals and barriers to entry."

Land: While Forbes anticipates a slow-down in development of new projects in the near future, he expects only a moderately negative impact from the pandemic on landowners. One potential drawback to investing in land would be a zoning issue, he said.

“If you're zoned for a multifamily development near an employment center, that's great," said Forbes. “But it's not so great if the property is zoned for a hotel or retail use. Rezoning can take years in many states. It can take five to 20 years in California."

Opportunities in years ahead

Depending on your tolerance for risk, there could be some commercial real estate opportunities in 2020 and beyond.

“I think it's too early to look for bargains in many property sectors," said Forbes. “It takes time for the pressure and stress to build on property owners before they will start to offer buildings at rock bottom prices. Maybe in the fourth quarter of this year there will be some opportunities, but there could also be a back-up in the courts if lenders must foreclose."

Investors also need to take a careful look at when they may get a return on their investment.

“It's a leap of faith for investors to estimate how long it will take for an area or a property to recover even if it's a bargain to buy," said Forbes. “You may be able to get a great deal on a Holiday Inn on the outskirts of Detroit, but you need to think about when the occupancy rates will be high enough to make it attractive."

There are many unknowns in this current economy, and the trajectory of the recovery is highly dependent on the ability to reduce the spread of COVID-19, identify treatments and develop a vaccine. But the fundamentals that influence commercial real estate — including supply, demand and demographics — point to continued opportunities for careful investors with the help of experienced wealth planners.

In these turbulent times, City National encourages you to review your investment portfolio with your advisor. Contact our financial professionals today to ask questions and receive help with your wealth planning needs.

This article is for general information and education only. It is not to be construed as an offer, or solicitation of an offer, to buy or sell any financial instrument. It should not be relied upon as specific investment advice directed to the reader's specific investment objectives. Any financial instrument discussed in this article may not be suitable for the reader. Each reader must make his or her own investment decision, using an independent advisor if prudent, based on his or her own investment objective and financial situation. Prices and availability of financial instruments are subject to change without notice. Financial instruments denominated in a foreign currency are subject to exchange rate risk in addition to the risk of the investment.

City National Bank provides investment management services through its wholly owned subsidiary City National Rochdale, LLC, a registered investment advisor.

City National (and its clients or associated persons) may, at times, engage in transactions in a manner inconsistent with this article and, with respect to particular securities and financial instruments discussed, may buy from or sell to clients or others on a principal basis. Past performance is not necessarily an indication of future results. This article may not be reproduced, distributed or further published by any person without the written consent of City National. Please cite source when quoting.

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