Economists Evaluate the Commercial Real Estate Recovery

Fueled by government stimulus and the continued vaccine rollout, along with the easing of pandemic-related restrictions, the U.S. economy is expected to rebound in 2021.

Commercial real estate should also begin to recover from the impact of COVID-19. However, that recovery will vary significantly by sector and geography, according to REIT magazine’s recent conversations with a group of five prominent economists. 

In addition to assessing the outlook for financing conditions, interest rates, and cap rates, the panel also considers the impact on the wider economy of pandemic-related population shifts.

What are your thoughts on the state of the broader U.S. economy as we look toward the other side of the pandemic?

Constance Hunter: The overall economic outlook is very dependent on the trajectory of the pandemic. Globally, the progress on vaccinations must improve in order for the economy to fully recover. With that said, substantial fiscal and monetary assistance, combined with a strong vaccination program, will help the U.S. recover faster than the rest of the world. That recovery is likely to include a jolt to digital transformation and productivity that could impact GDP growth for years to come.

Mariya Letdin: There’s light at the end of tunnel. There has been some pent-up demand and pent-up funds that are just waiting to get unleashed. President Biden announced the vaccination outlook for all adults this spring, and I think we’re going to take off like a rocket.

Eva Steiner: My outlook in the near term is positive. The pandemic conditions are slowly improving. The number of cases is starting to decline. The vaccine rollout is picking up, and I’m confident that we’ll soon be on a better path. 

At the same time, we have all of this pent-up consumer demand for goods and services from the lockdown, which is going to start pushing for outlets. And of course, this is supported by the tremendous economic stimulus that the government has made available, which has very positive effects on U.S. growth forecasts for this year.

Susan Wachter: The economy is poised for a sharp recovery. Pent-up demand and savings, together with new fiscal support, should support an historically high rate of growth, exceeding 5% annually for the second half of 2021 and 2022, bringing employment back to pre-COVID levels by the end of 2022. Although, of course, this will be heavily tied to the success of vaccine distribution and economic stimulus.

How would you describe fundamentals for commercial real estate?

Barbara Denham: They’re mixed. The warehouse sector should remain pretty strong as e-commerce gains will continue, but obviously, the flip side is that retail will continue to suffer, especially older malls in slow-growing or poorly located markets. The return of restaurants in the fourth quarter should be a boost to the retail sector, but mainly in denser markets. 

The office sector will also struggle as many companies reconsider their necessary space requirements. A number of small companies may not renew, but opt for a flexible, WeWork-type space. Most renewals will be for the same or somewhat smaller sizes. Still, I think other than taking longer to recover, it will recover. The pandemic was not the end of the office sector as we know it, as some have said. 

The apartment sector suffered significantly in many metro areas in 2020, but it should see positive occupancy growth in most markets and a return to rent growth some time in 2021.

Steiner: In the short run, there’s a bifurcation where some property types have healthy fundamentals and others that rely heavily on in-person interaction are struggling. In the long run, the pandemic is an anomaly, and properties whose values currently may seem depressed are likely to regain their potential once the restrictions can be safely lifted. There’s also an opportunity to intelligently adapt designs of properties to new user requirements that come out of the pandemic.

Wachter: Fundamentals for housing, life sciences/R&D and industrial, specifically distribution, are strong. In the case of housing, consumer preference is the main determinant. High-density multifamily in gateway cities like New York City and San Francisco is still very weak, while low-density multifamily and single-family rental housing in attractive, secondary cities with positive net migration have been incredibly strong. 

Fundamentals for hospitality, retail, and traditional office are still weak. Hospitality fundamentals are highly tied to leisure travel, which is poised to come back first, while business travel is expected to lag. Traditional, big-box retail continues to falter, but leasing activity in boutique and neighborhood retail environments has begun to rebound. For traditional office, there’s still a great deal of hesitation. What the use of office space looks like in the future remains very unclear.

Letdin: Suburban/outside central business district (CBD) multifamily and industrial are the “golden children.” Grocery-anchored and essential services retail are doing fine. Hospitality depends on location. For destinations like Florida, hotel rates are off the charts, while in major cities that went under shutdown, hospitality is in pain. 

The big question mark is office. The good news in the finance sector is that we learned lessons during the financial crisis, and since then, lending standards have been conservative. Office owners are not levered as high as they were during the last recession. Owners have long-term leases so they can hang in there. 

What is the state of financing conditions for commercial real estate as we approach mid-2021?

Hunter: According to the Fed’s Senior Loan Officer survey, financing conditions are less tight than they were at the beginning of the pandemic, yet still tighter than pre-pandemic levels. Meanwhile, demand for loans is only just returning to pre-pandemic levels. 

As the economy recovers, we expect lending standards to ease and demand to rise. Additionally, although yields have backed up from the lows, we remain approximately 30 basis points below pre-pandemic levels. 

Denham: I’d say that banks are in a better state than they were after the housing bust, but they will be very discerning with respect to property type and location.

Wachter: Financing conditions depend very much on the sector and have never been better for COVID “winners,” including, most obviously, multifamily—especially single-family rental. Properties in distress including retail, hotels, and CBD office sectors are facing workout negotiations in a forgiving macro-environment for now. 

Recently completed appraisals for collateral for stressed properties have been far more resilient than one might expect. It helps that coming into the crisis, banks underwrote real estate carefully. Going forward, much will depend on the macro-environment and, particularly, on whether low rates persist through the recovery cycle necessary to reposition out-of-favor real estate to new uses.

Steiner: Lenders have been patient with delinquent borrowers. In 2020, we had a moratorium on foreclosures and evictions, but my expectation was that in the new year lenders might start putting more pressure on delinquent borrowers, and that doesn’t seem to have happened yet. It seems to me that there’s still a lot of investment capital looking to be deployed in real estate. 

Also, lenders may consider the impact of the pandemic on the demand for space to be temporary, and that puts a floor under prices and gives lenders reasons to be optimistic about long-term collateral values.

Do you see interest rates staying steady for the near term?

Letdin: They’re very low. They went up 50 basis points in the last couple of months, but I don’t think there will be massive hikes because that would destroy the recovery. Nobody wants to do that. I think we may have seen the bottom already. Rates may go a little bit higher, but the big message will be rates are low because we want to stimulate the economy.

Wachter: Given the Fed’s stated support, short-term interest rates are likely to stay relatively steady. Ten-year rates have increased, and prices will continue to be under pressure with a strong recovery likely. Going forward, there’s likely to be heightened uncertainty about the interest rate outlook as already demonstrated by a large, recent trading surge in interest rate hedge swaps, although the Fed can utilize its considerable balance sheet to steady rates for the near term.

Denham: The Fed will be more accommodating in the next few years than it was in past recoveries. Oxford Economics sees the fed funds rates staying reasonably low before rising in the second quarter of 2023.

Steiner: Based on the latest Federal Reserve communications, they’ve signaled that they’re going to stick to their goal of achieving maximum employment and will hold off any increases in interest rates until realized inflation has persistently reached their set average targets.

Looking specifically at the implications from COVID-19, what are you seeing regarding cap rates? 

Hunter: I look at the 10-year adjusted cap rates. In that regard, you’re looking at cap rates moving up, given what it costs to finance. Like in every recession, hotel cap rates are rising faster and have a little more volatility than say apartment cap rates, which have risen the least and tend to be steadier. 

Office cap rates depend on geography. Cities with a high percentage of people who can work from home tend to mirror the characteristics of those employees—higher educated and higher paid. This translates into higher real estate costs. As a result, these cities have seen much lower rates of inbound migration and some outbound migration. This has put pressure on apartment rents along with office and retail rents. 

Denham: It’s mixed. There’s still a lot of money chasing deals. A number of investors are seeking opportunities, assuming that they can find bargain-basement prices, but this is not necessarily the case. Banks are in better shape so there will be fewer fire sales than there may have been in the last recession. Cap rates have not increased as significantly as many would have predicted.

Letdin: I think it’s too early to tell. For outside CBD multifamily, cap rates were already really low. Industrial has probably had some compression and is now around a 5.5% or 6% cap. Other asset types are just not trading. Folks don’t want to trade hotels, retail, or office today, so it’s hard to get an update on cap rates. 

Will the pandemic result in population shifts to certain geographic regions, and what larger impact could that have on the economy? 

Steiner: With the remote work model more widely accepted, we’ve seen a trend of moving from high-density locations to lower-density locations. That de-densification could make central locations relatively less expensive. That could be a risk, in the sense that people with big-city salaries are buying up properties in more rural, smaller areas where the average salary is lower, which could have implications for affordability and inequality.

On the other hand, as demand for space in dense city locations changes, there are opportunities to rebuild how our cities are organized. What used to be a dedicated office district could become more mixed use, meaning less need for a lengthy commute that could help improve the environmental quality of city life. Additionally, the experience of lockdown and crammed urban homes could help push for more open and green space in and around city apartments.

Denham: With the major moves in 2020, there should be a bit of an adjustment in 2021. Some, but not all, who moved away from expensive cities in the Northeast and West Coast will return. Others may seek rent-adjusted options in these cities; namely, those who felt that the pricier cities had been unaffordable in the past may look to get a “good deal,” especially young, single people. Still, the population changes will not shift back fully for a few years. 

Hunter: As people get fully vaccinated and we start to see a return of city activities such as theater, restaurants, and social gatherings, people who wanted to live in marquee cities but previously couldn’t afford it, may make that move. While there’s going to be greater flexibility by firms in regard to employees working remotely, human beings want to be around other human beings. I’m not ready to call the death of the central business district yet.

Wachter: I see a new wave of “distributed urbanism” replacing the recent trend of urban concentration. The largest, most dense cities will lose population and second- and third-tier cities, if they are amenity rich, will see outsize gains. As the new “Zoom towns” build up amenities in new local urban centers, they will become more attractive in a self-reinforcing cycle. The new prominence of Zoom towns is not going away, and COVID’s acceleration of population shifts to more affordable, low-tax, high-amenity locations is unlikely to reverse.

What is the major economic barometer you will be watching most closely this year? 

Hunter: I look at the labor force participation rate and the unemployment rate, which really work in tandem.

Letdin: I look at the appetite of lenders. The Senior Loan Officer Opinion Survey shows how much liquidity and “gasoline” there is in the system, and I look at employment. I also pay attention to the volume of subleased office space because it correlates highly to employment.

Denham: For the real estate market, we look at jobs, jobs, and jobs. This indicator is more tied to real estate than GDP, even though GDP will be stronger than job growth in 2021. It will be stronger in this recovery, however, because office-based jobs will recover long before the office market will, as firms will reevaluate their office space needs.