Interest rates and commercial real estate values are tightly connected, according to NAIOP. Historically, interest rates are low when real estate prices are high, and vice versa.
Looking back at the Global Financial Crisis in 2008, we can see how interest rates influenced property sales during the last recovery. Sales volumes rose due to improving economic fundamentals and cap rate compression, created by a combination of low-interest rates and rising property prices.
Fast forward to today, with many real estate investors wondering if the commercial real estate market is now at the bottom of the same low pre-recovery trough of 12 years ago.
In this article, we’ll explore how the combination of ultra-low federal interest rates and the impact of the coronavirus could shape how CRE investors are exploring and acting on potential growth opportunities in the upcoming months.
What happened during the 2008 Great Financial Crisis?
The collapse of the global economy in 2008 wasn’t caused by COVID-19 but by the implosion of two of the largest investment banks in the world, Lehman Brothers and Bear Stearns.
This collapse triggered an economic chain reaction felt around the world, and affected the US commercial real estate market in several ways that are similar to what we see today:
- Investment activity in commercial real estate suddenly froze
- Construction and development stopped
- Banks pulled back and tightened up lending standards
- Tenant incomes declined, creating more demand for affordable space
- Vacancies increased and property values declined
- Federal Reserve lowered the effective funds rate from 5.25% in January 2007 to 0.15% in January 2009
In 2009, investment sales in the US were $66 billion across asset classes, including office, retail, and multifamily. This number represented an 88% decline from the peak sales volume of $570 billion in 2007. However, sales volumes dramatically increased over the following few years: 2010 saw a 120% increase year-over-year, with a 59% increase in 2011, 30% in 2012, and 19% in 2013.
COVID-19 and commercial real estate in 2020
The coronavirus pandemic of 2020 is causing similar damage to the CRE market that the collapse of the banking system did over a decade ago. Interest rates today are nearly at 0.05% (as of May 2020) and will likely rise if a V-shaped recovery takes hold.
Of course, how the economy recovers remains to be seen. In the meantime, there are several ways COVID-19 is affecting the nation’s CRE market:
- Foreign buyers could increase in the US if confidence in overseas markets wanes
- Lower production and economic activity will slow revenue and growth in commercial real estate
- Extended work-at-home policies by employers will exacerbate the decreased demand for office space
- CRE loan default rates could increase as under-capitalized owners struggle to meet loan covenants
Why COVID-19 could help some CRE sectors
Although it may seem counterintuitive, COVID-19 could increase the demand for potential acquisitions in the hotel and retail sectors later this year.
In their updated report, COVID-19: Global Real Estate Implications, JLL believes that as the hospitality industry recovers travel patterns and the types of lodging in demand will also change.
Destinations that can be reached by car and hotels in less dense markets may be the lodging types of choice, while non-professional ‘alternative’ options will likely fall out of favor due to guest concerns about health and well-being.
Forbes agrees with JLL’s view of the potentially positive impact the virus may have on the hotel industry while noting that acquisition opportunities in the retail sector may vary based on a U-shaped or V-shaped recovery.
The adoption of e-commerce by retailers is likely to be accelerated in either case. However, landlords leasing to chains or brands that become associated with the coronavirus may risk property values being affected, and those spaces may become more challenging to lease.
Impact of coronavirus on loans and capital markets
Earlier this year, Moody’s Analytics reviewed the credit risk impact on commercial real estate loan portfolios created by COVID-19.
The firm reported that credit losses on CRE loan portfolios held by US financial institutions could range from 1.3% to 5.4% or more depending on the speed of economic recovery and the continued effectiveness of stimulus by the Fed.
For example, Moody’s looked specifically at the value indexes of hotel and retail properties under a Severe Pandemic scenario where the economy recovers relatively quickly. Prices for hotel and retail assets would ‘bottom out’ in Q4 2020 and, over the 12 months, come close to regaining post-pandemic values.
For the time being, many lenders are putting transactions on hold while the CMBS origination market also pauses. However, unlike in 2008, interest rates today are about as low as they can go, and there’s plenty of ‘dry powder’ waiting to be deployed when the right deals come along.
More than $326 billion in global closed-end real estate funds currently sits on the sidelines, waiting to be invested in the market’s recovery. Investment capital flowing into the CRE market as investors seize opportunities over the next few quarters may help to limit real estate pricing declines when and if interest rates start to rise.