The Lingering Impact of Coronavirus on Urban Commercial Real Estate

In reporting about the impact of the coronavirus outbreak by industry, it’s common to read about the devastating effects on industries like Travel and Tourism, Airlines, and Restaurants. And although the specific predictions of when these industries will “bounce back” vary, the general perception is that, over time, they will indeed regain their strength as consumer behavior returns to (or approximates) the pre-coronavirus normal. 

For one industry not mentioned quite as frequently as otherscommercial real estate (CRE)the short-term pain has been similarly sharp as for the industries above, but the longer-term prospects may be murkier. Some of the dynamics driving the downturn in CRE since coronavirus began spreading around the world may be deeper and tougher to displace over time. 

Indeed, the public health crisis has accelerated two massive societal trends underway before coronavirus that are now moving much faster: how do consumers want to shop and where do people want to live?

The shift in these two, intertwined forces may be changing the CRE sector forever.

Economic impact was sudden and severe

The commercial real estate sector entered 2020 with significant tailwinds. Year-over-year, transactions had increased four percent, prices had increased 36 percent, and private equity real estate investors were amassing increasing amounts of capital to invest. In a Deloitte survey of 750 global CRE executives, 76 percent of respondents were optimistic about the year ahead. 

All of this changed, though, with the outbreak of the coronavirus and the quarantines and lockdowns put in place around the world. The impact on the CRE sector was swift and severe, particularly for retail real estate. 

Tenants (retailers, restaurants, and others) were unable to make their rent payments, creating a liquidity challenge for landlords under pressure to make their own mortgage payments. 

This tension has manifested in some high-profile litigation, including Simon Property’s lawsuit against Gap for failure to pay $65.9 million in rent owed during the coronavirus crisis. Simon Property is also seeking to terminate it’s $3.6 billion deal to acquire Taubman Centers, owner of two dozen luxury malls. Simon Property said that Taubman’s indoor malls “are the last types of retail real estate properties that most consumers will want to visit on a long-term basis after Covid-19.”

This domino effect of tenants missing rent and building owners missing mortgage payments has been common over the last several months. “The numbers are truly eye-popping,” said Lisa Pendergast, executive director of the CRE Finance Council, an industry group focused on the $4.6 trillion commercial real estate finance market. 

During the global financial crisis it “was kind of a rolling disaster that was slower to materialize,” she said, speaking of the distress that eventually hit commercial properties a decade ago. “Here, it was overnight.”

Additionally, there’s vast leasable square footage going empty. Leasing volume is a key metric tracking the health of the sector crashed by an unprecedented 53.4 percent in Q2. Even those facilities that are able to stay open in some capacity face higher sanitation costs to meet public health guidelines.

Across the sector, CRE professionals are confronting the question, “How long will these impacts last?” It’s a complicated question to answer given some of the broad shifts in consumer buying behavior and even residential preferences happening around the sector.  

“Customers will continue to shop differently”

One reason predicting the rebound in CRE is challenging is that the shuttering of millions of square feet of brick-and-mortar retail locations due to coronavirus supercharged a movement already underway to shopping online. There’s reason to believe that shift may be permanent for many shoppers.

This year, according to eMarketer, although total US retail spending will decline 10.5 percent to $4.894 trillion, ecommerce sales will actually increase by 18 percent to $709.78 billion. The impact of the coronavirus falls squarely on brick-and-mortar retail stores, where sales are forecast to see a historically significant decline of 14 percent to $4.184 trillion.

The decline in sales is leading to a massive wave of bankruptciesand vacant spaceacross the retail sector. “More companies have gone bankrupt than any of us have ever expected, and I do believe that will accelerate as we move through 2020, unfortunately,” said Deborah Weinswig, founder of Coresight Research, an advisory and research firm that specializes in retail and technology. “And then those who haven’t gone bankrupt are using this as an opportunity to clean up their real estate.”

“Customers are and will continue to shop differently than they did prior to the pandemic,” said Amber Seikaly, vice president of Neiman Marcus, when announcing the closure of their flagship location at the Hudson Yards mall. 

Department stores account for 30 percent of all mall square footage in the United States, so the store closures and bankruptcies announced by large department stores like JCPenney, Sears, and Neiman Marcus will have a devastating impact on those malls.  

It’s estimated that by the end of 2021, more than half of all mall-based department stores will close. The loss of the department store “draw” is likely to then drive smaller retailers to depart in their wake. 

This will leave many malls around the country as “empty boxes” in need of redevelopment or repurposing.

Changed calculus for city living

Just as the CRE sector is battered by the march of shoppers out of brick-and-mortar stores and to ecommerce, the industry may also be facing the march of residents out of densely-populated urban centers (where commercial rents are generally quite high) to the suburbs or ex-urbs. 

New prevalence of work-from-home policies and a new awareness of the public health risks of densely-populated cities may be combining to create significant headwinds for CRE in coming years.

Generally, the costs of living in a city, especially the largest ones, are significantly higher. The tradeoff for some city dwellers often centers around the convenience to their office (thereby avoiding the need for a long commute) and ease of access to all of the amenities cities generally offer, including theaters, restaurants, museums, and the like.

People had already started migrating from large cities, including NYC, LA, and Chicago, to smaller ones before the pandemic. What becomes of the value proposition of living in the city at a time when many companies are putting liberal work-from-home policies in place or when cultural and social benefits of living in the city are dramatically curtailed?

Perhaps out of necessity borne of the coronavirus crisis, companies are increasingly comfortable with their employees working from home. Companies like Twitter, Facebook, and Nationwide have made the decision to allow their employees to work-from-home permanently. In fact, Morgan Stanley analysts said they expect the trend of working from home to triple by 2024, a shift they see pushing office rents lower in New York City and San Francisco and affecting higher vacancies over roughly the next five years. 

Even if the impetus for creating new remote work policies was originally the coronavirus, real estate economics for many companies may be the reason the policies stick.

Research from Reach Advisors found that high real estate and labor costs were driving companies to shift to more remote work moving forward. “The biggest shift away from density will likely be in markets such as the Bay Area and New York City,” said the company’s president, James Chung. By shifting to remote work “they can dramatically widen their labor pool and evade the labor-wage trap that they are in.”

If proximity to work is no longer a value driver for many city residents, then what of the cultural, social, and other benefits outside of work? “People were attracted to cities not only for economic opportunity but also for the urban lifestyle,” says Geoffrey Garrett of Wharton. 

There’s reason to believe that for many people, the perceived health risks of crowded spaces (stores, subway trains, cafes, etc) will linger even after the coronavirus outbreak recedes. After months of enforcing social distance protections, walking through a crowded mall on Black Friday or riding a packed bus will take some time to get used to. 

Continued caution by patrons will maintain the pressure on retailers and restaurants to make their rent payments.

Closing thoughts

Over the last several months, the coronavirus has accelerated two broad trends that were already posing a double-whammy of challenges to the commercial real estate sector: shoppers moving online and residents leaving large cities for smaller ones. Although the direct impact of the public health crisis on CRE, from closed buildings to higher sanitation costs, will likely recede, the consequences of these two broad trends are likely to linger.

Even if these trends continue, there’s reason to believe the sector can adapt. The evolution may be as straightforward as lower prices for commercial real estate. Supply and demand may eventually balance out to whatever normal is post-coronavirus.

For commercial office space, developers should be identifying ways now to build out new spaces with density restrictions in mind. More flexibility in space design may cater to the lessors of the future. 

Even the shift to ecommerce sales may offer an opportunity as demand for warehousing and other industrial space for ecommerce businesses to store or fulfill inventory increases. Some of the “empty box” mall spaces may very well become the ecommerce fulfillment centers of the future.

How else has the coronavirus pandemic shifted consumer behavior? Check out the most recent insights on back-to-school plans for college students.

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