Is real estate the frog in the pot?

Today’s real estate market brings to mind the metaphor of the frog in a pot with a gradually increasing flame that goes unnoticed until it is too late. Whether the pot in this post-Covid real estate world ultimately does come to a boil is uncertain; what is clear is that the resolution is likely to take quite some time. As a pandemic that sent shock waves affecting property sectors in myriad ways continues to subside, it’s leaving behind a whole new set of challenges for property markets and creating Covid winners and losers. Let’s review:  

Covid winners

• Industrial warehouses, data centers and cell towers E-commerce was rapidly carving out a niche within the country’s system of distributing goods when Covid hit, accelerating this shift as consumers and workers stuck at home shopped the internet for ways to make life more comfortable and accommodating. Indeed, lockdowns, shutdowns and work-from-home (WFH) mandates were like steroid injections for warehouse space, driving demand for more and more, especially in the “last-mile” nearest the customer base. Similarly, a wave of cloud computing and mobile communication that was driving data center & cell tower demand before the pandemic exploded under Covid.
• Outdoor suburban shopping centers Open-air centers, particularly those anchored by grocers, sailed through the Covid experience, offering “community” without all the risks. Their usefulness as mini distribution centers closest to the customer creates added utility (and demand).
• Housing and self-storage Home values soared on demand stimulated by WFH, generationally low financing rates, a rapid rebound in employment and supply-chain/labor-shortage-induced restrictions on builders’ ability to build enough homes. Rental homes also benefited, aided by 1) the same forces driving single-family home growth, 2) technological innovations that have made managing a portfolio of single-family homes a viable economic proposition for institutional owners and 3), a boom in single-family home prices that undermined affordability and elevated the rental option. These same forces lifted multi-family apartments, too, as well as demand for self-storage. Owners and renters alike needed some place to put all their stuff as bedrooms became offices and new furniture replaced old.

Covid losers

• Office buildings This is especially true in major cities, with hybrid arrangements or even fully remote positions increasingly common and clearly popular among employees. Employers are not uniform in their acceptance, citing the merits of in-person collaboration, but utilization nationally based on actual key card data is still running about half pre-Covid levels. Should unemployment suffer a meaningful increase, employers may regain enough leverage to require more frequent in-person work. But the longer this low return-to-work environment lingers, the more likely it becomes the norm. Over time, employers undoubtedly will embrace the benefit of smaller commercial footprints (and lower rent expenses that go with it).
• Indoor malls Being forced to shut their doors as the risk of indoor interactions was considered too high, traditional mall tenants began to recognize the merits of lower-cost, suburban-focused, outdoor centers. A-class properties are somewhat immune from the competition, but lower quality locations continue to suffer.
• Urban retail (See “Office buildings,” above) Lower office utilization means less foot traffic and therefore reduced property value in many urban cores. Indeed, there is a growing push among many cities to repurpose old skyscrapers into residential high-rises and build new high-density housing in available plots, too. Perhaps that could work eventually, but the build-out times will take years and the costs of turning high-rent offices into housing may prove prohibitive.

Post Covid

Today’s environment—a Fed removing stimulus by rapidly raising rates (turning up the flame) to fight inflation, reduced credit availability (a Q1 Fed survey, taken before the current banking crisis, shows banks’ willingness to lend already had fallen to levels that historically have preceded recessions) and altered demand patterns favoring some sectors over others—is rippling through property markets. For example, with mortgage rates topping 7% before their pullback on the recent Treasury rally/banking turmoil, home demand has cooled and prices have rolled over. Average prices relative to annual income, a measure of affordability, are still near all-time highs and inventories are low (who wants to sell and give up an ultra-low mortgage rate?)

Office markets are showing signs of stress, as well, as higher rates are hitting at the same time tenants are reevaluating their need for space, creating costly refinancing headaches. Office leases tend to have a long duration (10- to 15-year leases are common), so as financing rates have increased without a corresponding increase in rental income, property values are deteriorating. This is forcing owners with maturing financing agreements to inject additional equity into the equation to meet the lender’s loan-to-value credit requirements. There already have been noteworthy transactions where owners walk away, handing the property over to creditors after recognizing the reduction in value had wiped out their equity.

This type of credit-driven event is unlikely to be limited to just office space. Any highly levered property with duration-mismatched liabilities and assets is almost certain to confront problems in this rising-rate environment. Silicon Valley Bank is a good comparison. As short-term liabilities (deposits) began to flee, it was forced it to sell long-term assets (Treasuries) whose value had plunged as interest rates increased. Unfortunately, its difficulties only worsened as depositors left en masse. Creditors and property owners will increasingly confront similar—albeit not as catastrophic—scenarios as financing arrangements are renegotiated, with the stress only worsening if the Fed continues raising rates.

The good news is owners in aggregate are very well-positioned for this post-Covid environment. Employment remains strong, banks are well capitalized, balance sheets are solid with debt maturities extended, and in general markets are not over-supplied. So, even should the Fed’s inflation-fighting efforts begin to weigh heavily on economic and employment growth, it’s not a foregone conclusion that the real estate market will reach a point of severe distress. Essentially our frog floats in a much bigger pot than usual—think lobster pot, not saucepan—and there is some chance the flame can begin to be reduced before it reaches that boiling point. But until the post-Covid dust settles and Fed hawks roost, certain segments of the real estate industry are facing uncertainty … and more pain.