Covid-19 Vaccine Hints of a Return to Normal, but for CRE Markets, Uncertainty Lingers
On Tuesday, March 23rd, Citigroup became the first major U.S. bank to declare the future of work will be hybrid. Newly appointed CEO Jane Fraser told staffers that most of them will be expected to be physically present in its offices only 3 days a week in the post-pandemic world.
The company joins a growing contingent of businesses that have announced plans to either shift to a permanent work-from-home model or hybrid arrangements. In January, CBRE reported 60 percent of office occupiers indicated they are “aggressively pursuing” efforts to reduce office space throughout 2021 and 70 percent have paused expansion plans due to uncertainty regarding their space requirements.
While many workers celebrate benefits including the flexibility and reduced commute and employers see value in the agility and reduced overhead that remote work offers, the shift of WFH policies from a temporary solution to COVID-19 lockdowns in major metropolitan areas to a more permanent feature of the “new normal” in a post-pandemic world has major implications for commercial real estate markets.
According to a recent report from Fitch Ratings entitled CRE Post-Pandemic: WFH Secular Shift Will Pressure U.S. Office Properties, remote work “is viable for most office-using employers and employees, which could have negative cash flow and rating implications for office properties.” The growing embrace of flexible-work arrangements is expected to increasingly weaken office sector fundamentals as practical business decisions result in higher vacancy rates and the sensitivity of rental rates to shifts in demand. The downward pressure on rents as landlords seek to rebuild reduced occupancy levels incurred in 2020 is being further compounded by the excess supply stemming from the growing trend of companies seeking to offload their excess space by subletting it to new tenants, Fitch said.
The impact of the pandemic on CRE loan performance thus far has been uneven across property types, with greater effects on office and retail property markets and smaller or little impact on multifamily and industrial properties. However, projections from CBRE suggest that property values for apartments, offices and retail real estate have yet to find their bottom. In the office space, for example, a KPMG survey found that just 31% of businesses expected their operations to return to normal this year, while 45% expected a return to normality in 2022. Meanwhile. CBRE expects the CRE sector to reach its nadir later this year but estimates that the rebound to pre-Covid levels could take until 2022 or beyond.
As struggling property owners reach the end of their forbearance grace periods and other pandemic relief programs expire, those who have fallen behind on debt are going to have to put more money into their buildings, sell at distressed prices or risk defaulting on their loans. Furthermore, roughly $430 billion in commercial and multifamily real estate debt matures in 2021. According to the Federal Reserve’s recent Financial Stability Report, which singled out commercial real estate as particularly showing signs of weakness, the risk of mounting loan losses and the stress they could impose on the banking system is a very real concern for the post-pandemic economy and financial markets.
This confluence of events, combined with the understanding that the fundamentals of real estate have been dramatically altered since the onset of the pandemic, will force lenders and borrowers to come to terms with what buildings are worth in a world reshaped by COVID-19 triggered lockdowns. From widespread adoption of e-commerce by consumers and small businesses alike to the normalization of remote work and businesses’ reevaluation of the necessity of travel, warehouse and logistics facilities and data centers, the pandemic has upended the economics of commercial real estate markets.
While the last property market downturn was caused by excess and exuberance in the residential mortgage-backed securities market, the distress in the commercial real estate market reflects a fundamental shift in how society lives, behaves and functions. However, as it was when U.S. and global housing markets collapsed in 2008, the fallout from the pandemic economic crisis will likely reverberate across throughout the entirety of the CRE industry, with implications for borrowers and lenders of CRE loans, CMBS issuers and investors, and the U.S. economy at-large.