Commercial Real Estate Midyear Update: Why Developers Must Adapt to COVID-Related Changes
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For commercial real estate owners and developers, 2021 is serving as a reset button. While performance at the property level was relatively stable throughout the pandemic, business shutdowns and the resulting recession ground transaction volume to a near halt, largely because capital became more disciplined.
Unlike during the 2008-2009 financial crisis, capital did not evaporate, but it certainly pulled back. Throughout 2020, lenders became highly selective, focusing on existing clients and a few preferred asset classes, such as industrial, apartments and medical offices—property types that proved the most resilient throughout the year. With the slowdown in transaction volume for most of 2020, valuation uncertainty constrained capital availability.
By the start of 2021, however, it seemed as if that all changed. With debt capital availability increasing at a rapid pace, deal activity picked up significantly—both on property sales as well as new construction. This allowed developers who delayed project starts in 2020 due to the pandemic to proceed. Similarly, investment activity accelerated with ready buyers and sellers.
All of this is taking place in a benign interest rate environment in 2021, but that may not be sustainable, and real estate values tend to correlate to the fixed income markets. For investors looking across asset classes, real estate looks like a pretty good place to be. Our view is that the rest of 2021 will continue to be robust, with unprecedented levels of capital liquidity leading to a record pace of transactions. Headwinds to watch for in 2022 include rising construction costs, interest rate volatility and evolving trends in tenant demand in property types such as commercial offices.
Property Type Performance
Industrial developers and owners are having a very strong 2021 after relative stability in 2020 despite the pandemic. This asset class continues to benefit from demand trends that far outpace supply nationally. Some of the factors contributing to the increasing demand include an increase in e-commerce sales and supply chain pressures leading to changes in inventory management. Given that we anticipate strong ongoing demand for industrial space, we believe this sector is poised for a long-term run with stable to improving values, rent growth and continued development.
Among other asset classes, medical offices suffered a bit of stress with some of the early lockdowns, but they were able to recover almost immediately. Apartments have done well. Some exceptions notwithstanding, tenants stayed put and paid their rent during the pandemic.
The headwinds we're seeing right now are specific to property types that may have been permanently disrupted by the pandemic, such as multitenant commercial office assets. Even as people return to work, there will be some permanent disruptions to how they use office space.
Hotels, student housing and senior housing had some unique headwinds directly related to the pandemic, but with the vaccination program enabling much of the country to reopen, current trends are working in their favor. A full hotel recovery will continue to be constrained until business travel resumes.
There are also some geographic challenges. The larger gateway markets—New York, San Francisco, Chicago, Boston—are the main ones that suffered population and job losses during the pandemic. These are also markets that rely heavily on public transportation, which will constrain some of the immediate recovery. However, as employers begin to bring employees back to offices these markets are improving. We continue to support the view that the large, urban markets will attract residents, businesses and investment.
Inflation, Tax Concerns and Labor
Inflation is a concern to real estate owners and developers due to its direct impact on both construction costs and interest rates. That means margins will tighten on new development but can be offset by rental rate increases.
Another concern is that the Biden administration has its sights set on tax reform, particularly around repealing the 1031 exchange for gains greater than $500,000. Gains above that figure would incur a 39.6% capital gains tax. That could have an impact on transaction volume.
Finding sufficient labor has been a challenge for some sectors more than others, such as hotels and senior housing. In the hotel space, for example, it's hampering reopening plans because owners can't find enough people to work the front desk, drive airport shuttles and the like.
Preparing for Success
Prior to the pandemic, the commercial real estate industry enjoyed a 10-year recovery, and many owners were preparing for a slowdown with high levels of liquidity and manageable leverage. The stimulus available in 2020 helped the more impacted sectors such as hotels and senior housing, but improving trends point to a recovery.
As we move into the back half of 2021, developers and owners may want to reevaluate their portfolios, including whether they should sell some of their properties while market valuations in certain asset classes are favorable. In preparation for 2022, we're seeing developers implement strategies around commodity prices by hedging or pre-purchasing materials. Inflationary pressures will likely continue into 2022, and developers are going to have to figure out a way to manage their construction costs. If they can't, they're going to find it may not make sense to build new projects, which would constrain the ongoing growth.
Another caveat: with banks eager to lend and interest rates low, capital availability is heightened for real estate. Historically, excess capital can lead to irrational exuberance. Continued focus on leverage levels, liquidity and rational market projections will benefit real estate owners.
Finally, developers will need to determine what trends came out of the pandemic that are likely to be permanent shifts and how they may impact future developments. Across many asset classes, there are some meaningful, likely permanent changes coming regarding what space people want and how they'll use it. The best developers are thinking about that and incorporating it into their designs or the types of properties they're building.
Kim Liautaud
Head, Real Estate and Infrastructure, U.S.
312-461-3090
Kim joined the BMO Commercial Bank’s CRE team in June 2012 as relationship lender on the private institutional lending team. Most recently she held the r…(..)
View Full Profile >For commercial real estate owners and developers, 2021 is serving as a reset button. While performance at the property level was relatively stable throughout the pandemic, business shutdowns and the resulting recession ground transaction volume to a near halt, largely because capital became more disciplined.
Unlike during the 2008-2009 financial crisis, capital did not evaporate, but it certainly pulled back. Throughout 2020, lenders became highly selective, focusing on existing clients and a few preferred asset classes, such as industrial, apartments and medical offices—property types that proved the most resilient throughout the year. With the slowdown in transaction volume for most of 2020, valuation uncertainty constrained capital availability.
By the start of 2021, however, it seemed as if that all changed. With debt capital availability increasing at a rapid pace, deal activity picked up significantly—both on property sales as well as new construction. This allowed developers who delayed project starts in 2020 due to the pandemic to proceed. Similarly, investment activity accelerated with ready buyers and sellers.
All of this is taking place in a benign interest rate environment in 2021, but that may not be sustainable, and real estate values tend to correlate to the fixed income markets. For investors looking across asset classes, real estate looks like a pretty good place to be. Our view is that the rest of 2021 will continue to be robust, with unprecedented levels of capital liquidity leading to a record pace of transactions. Headwinds to watch for in 2022 include rising construction costs, interest rate volatility and evolving trends in tenant demand in property types such as commercial offices.
Property Type Performance
Industrial developers and owners are having a very strong 2021 after relative stability in 2020 despite the pandemic. This asset class continues to benefit from demand trends that far outpace supply nationally. Some of the factors contributing to the increasing demand include an increase in e-commerce sales and supply chain pressures leading to changes in inventory management. Given that we anticipate strong ongoing demand for industrial space, we believe this sector is poised for a long-term run with stable to improving values, rent growth and continued development.
Among other asset classes, medical offices suffered a bit of stress with some of the early lockdowns, but they were able to recover almost immediately. Apartments have done well. Some exceptions notwithstanding, tenants stayed put and paid their rent during the pandemic.
The headwinds we're seeing right now are specific to property types that may have been permanently disrupted by the pandemic, such as multitenant commercial office assets. Even as people return to work, there will be some permanent disruptions to how they use office space.
Hotels, student housing and senior housing had some unique headwinds directly related to the pandemic, but with the vaccination program enabling much of the country to reopen, current trends are working in their favor. A full hotel recovery will continue to be constrained until business travel resumes.
There are also some geographic challenges. The larger gateway markets—New York, San Francisco, Chicago, Boston—are the main ones that suffered population and job losses during the pandemic. These are also markets that rely heavily on public transportation, which will constrain some of the immediate recovery. However, as employers begin to bring employees back to offices these markets are improving. We continue to support the view that the large, urban markets will attract residents, businesses and investment.
Inflation, Tax Concerns and Labor
Inflation is a concern to real estate owners and developers due to its direct impact on both construction costs and interest rates. That means margins will tighten on new development but can be offset by rental rate increases.
Another concern is that the Biden administration has its sights set on tax reform, particularly around repealing the 1031 exchange for gains greater than $500,000. Gains above that figure would incur a 39.6% capital gains tax. That could have an impact on transaction volume.
Finding sufficient labor has been a challenge for some sectors more than others, such as hotels and senior housing. In the hotel space, for example, it's hampering reopening plans because owners can't find enough people to work the front desk, drive airport shuttles and the like.
Preparing for Success
Prior to the pandemic, the commercial real estate industry enjoyed a 10-year recovery, and many owners were preparing for a slowdown with high levels of liquidity and manageable leverage. The stimulus available in 2020 helped the more impacted sectors such as hotels and senior housing, but improving trends point to a recovery.
As we move into the back half of 2021, developers and owners may want to reevaluate their portfolios, including whether they should sell some of their properties while market valuations in certain asset classes are favorable. In preparation for 2022, we're seeing developers implement strategies around commodity prices by hedging or pre-purchasing materials. Inflationary pressures will likely continue into 2022, and developers are going to have to figure out a way to manage their construction costs. If they can't, they're going to find it may not make sense to build new projects, which would constrain the ongoing growth.
Another caveat: with banks eager to lend and interest rates low, capital availability is heightened for real estate. Historically, excess capital can lead to irrational exuberance. Continued focus on leverage levels, liquidity and rational market projections will benefit real estate owners.
Finally, developers will need to determine what trends came out of the pandemic that are likely to be permanent shifts and how they may impact future developments. Across many asset classes, there are some meaningful, likely permanent changes coming regarding what space people want and how they'll use it. The best developers are thinking about that and incorporating it into their designs or the types of properties they're building.
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