Long-term historical analyses have shown that investments in real estate, when compared with the stock market, have experienced lower volatility while earning equal to higher risk-adjusted returns. Commercial real estate can protect investors from the daily volatility you see in the stock market.
CBRE, one of the largest full service commercial real estate firms in the world, have published the following figures:
Direct real estate
However, real estate as an investment is not immune from economic slowdowns. Real estate investors, like those investors in the stock market, has seen losses over the years. Commercial real estate experts were already talking about weaker fundamentals over the next several years after ten years of stellar performance. That was before COVID-19, commonly referred to as the coronavirus, increased the probability of a recession in 2020.
Some well-known investors, like Carl Icahn, are saying it’s time for the commercial real estate market to incur some significant losses. He is shorting the commercial mortgage bond market and believes that assets that back mortgages of certain commercial real estate, like corporate offices and shopping malls, are going to get killed as defaults go up. Icahn says the commercial real estate is his biggest short right now.
That is not good.
Is commercial real estate going to experience significant losses in 2020?
A Prolonged Recession Caused by the Coronavirus: Defaults on Real Estate Loans Go Up
If the economic shock from COVID-19 is turns into a recession (defined as two or more quarters of negative economic growth) then commercial real estate will be impacted in several ways:
- more tenants that lease commercial property will default on their leases;
- targeted rent increases to fuel investor returns will slow down or stop;
- lenders and buyers of real estate may slow down their activities leading to liquidity issues for projects and investors.
All of these things reduce the value of real estate.
Bottom line, the performance of real estate as an investment will suffer this year with some types of real estate investments performing more poorly than others. Certain types of real estate are more sensitive to the “social distancing” taking place to mitigate the spread of the coronavirus. Retail properties, first and foremost, were properties already being negatively impacted because consumers are making more of their purchases online. Retail properties could begin to go into default and become distressed properties with consumers staying home and slowing their retail spending. Office properties are better insulated with long-term leases but a prolonged recession with more people working from home could become an issue for these investments. We might see additional headwinds with office properties if the work-from-home environment persists after the virus goes away. Real estate development projects, or ground-up projects, will have trouble on several different fronts and some development projects could be halted, or at least returns significantly impacted, if a prolonged economic downturn takes place.
For other real estate investments involving properties with strong underlying cash flows, like multi-family apartment buildings, investor returns may soften but a loss in your investment is unlikely as long as the property does not have unacceptable debt levels. A prolonged recession means tenants for apartments may begin to miss rent payments more often, or look to reduce their housing costs by renting a cheaper place, and targeted rent increases may not materialize. However, these investments can weather the storm if the properties have manageable debt levels and cash flow that can cover expenses, including mortgage costs.
Real estate debt secured by high-risk real estate projects or that have a minimal equity buffer, could see losses. Real estate secured by quality real estate and with a sufficient equity buffer should not see loss in principal. Cash returns from real estate debt could go down as yields in other assets go down and investors continue to hunt for yield and drive down interest rates on real estate debt.
The Central Banks Reaction to the Coronavirus Slowdown: Potential upside to Real Estate
When interest rates move down, real estate usually stands to benefit. The coronavirus has already led to two significant interest rate moves. Prior to this Sunday, the Federal had completed a 50 basis point cut to the fed funds rate and the 10-year Treasury yield has reached all-time lows. On Sunday the Federal Reserve took the fed funds rate to near zero. This is the lowest the fed funds rate has been since 2008 and the Federal Reserve has never taken the fed fund rates into negatives territory. It will take some time but lower rates may ultimately mean that real estate can lock in lower interest rates for their debt and benefit from lower debt payments. Smart property sponsors will take advantage of this opportunity.
Also, the Federal Reserve’s strategy of pumping liquidity into the markets has driven all asset prices up over the last ten years. Real estate assets may continue to be a beneficiary from this strategy (if the strategy continues to work). On Sunday, the Federal Reserve announced a new $700 billion quantitative easing program.
I also believe quality real estate equity investments will benefit from this low interest rate environment because investors are hungry for yield. With the 10 year Treasury rate below 1% and high quality real estate assets still yielding more than 5% – over the next several years, after a cure for the virus is in place, investors may be willing to pay more for high quality real estate to receive a higher yield than what other asset classes are offering. Cap rates for commercial real estate are at 4-5 in the United States for many properties and part of this has been driven by the already existing lower interest environment. If yields continue to go down in asset classes like government bonds you may see cap rates go down further for real estate which means prices go up and investors benefit.
What Does this Mean For You?
The risk for all asset classes has gone up significantly but real estate is less affected by short-term economic shocks. Real estate could benefit from the monetary and fiscal policies the U.S. government uses to prop up the economy and real estate could be a net beneficiary if the slow-down to the economy is short-lived. However, if the coronavirus slowdown becomes a prolonged issue and the U.S. consumer does not return to his/her buying ways later in the year then real estate will begin to see reduced returns and some investor losses. Real estate development and properties in more sensitive sectors like retail should see the biggest losses.
My recommendation is to tread lightly and, when the time is right, invest in lower-risk real estate debt and real estate equity investments that hold properties with positive cash flow and lower debt levels.
Will I Invest in Real Estate in 2020?
I believe the U.S. economy will bounce back at some point in 2020 and certain asset classes will continue to benefit from the monetary and fiscal policy actions that governments are currently putting in place to fight the economic impact from the coronavirus. I think real estate will continue to be one of the better assets to hold in 2020 but new investments should be considered carefully.
I will continue to hold my real estate debt investments because they are loans supported by low loan-to-value ratios and they are typically secured by properties like apartment buildings or other residential investments. One fund that I invest in has been around for twenty-seven years and never lost any investor principal because of its conservative practices.
I hold two real estate funds in my main portfolio and I will continue to hold them for now. I am actually not that impressed with their returns over the last few years but they are conservative funds that will likely maintain most of their value during this time of uncertainty. These funds invest in cash-flowing core properties.
Regarding additional investments, I had begun to invest in real estate projects through the real estate crowdfunding platforms but I am going to keep these investments to a minimum until we get more clarity on how the economy is doing over the next few months. Regardless, we are in the later stages of an economic cycle and I am only going to invest in cash flowing properties that are using lower levels of debt. I am going to use the following criteria to select my real estate investments through CrowdStreet for at least the next twelve months:
- Investment Type: Equity Only (I have significant real estate debt already)
- Property Type: Multifamily, Office, Industrial, Storage (no more than 4 investments for one property type); will consider Hospitality property for up to 2 investments
- Business Plan: Core, Core-Plus, Value-Add (no more than 5 investments of any business plan); no Opportunistic or Development investments due to higher risk
- Location: Anywhere but focus on Secondary Markets in East and Midwest
- Sponsor Type: Tenured or Enterprise Only (meaning project sponsors have worked through prior recessions and late stage economies)
- Sponsor Diversification: No more than 2 investments per sponsor
- Debt-to-Value Ratios: Cannot exceed 75%
I am participating on a call this week regarding the commercial real estate market and the impact we are seeing on this asset class. I will update this article after the call based on what I hear and give you my latest thoughts.