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October 15, 2021 | 12:21
Commercial Real Estate Revival: Sector Matters
Economics
Economics
Economics
Fixed Income Strategy
Economics
Economics
Economics
Economics
Economics
Economics
Fixed Income Strategy
Economics
Economics
Economics
Commercial Real Estate Revival: Sector Matters |
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North American commercial real estate markets weathered the pandemic better than many expected as a result of cheap financing and substantial wage, loan and rent subsidies from governments. However, the market is deeply divided between the thriving industrial and multi-family sectors and the more-challenged retail and office segments. U.S. commercial property prices have rebounded 8% in September from pre-virus levels after an initial 11% dive during the shutdowns (Chart 1). By contrast, prices plunged 37% in the Great Recession and took nearly six years to retrace. Total returns on property investments hit a decade-high of 3.6% (not annualized) in Q2. Leading the way is the industrial segment’s 8.9% gain, the most since at least 1978, followed by multi-family with a 3.6% advance. Meantime, office and retail continued to lag with returns of less than 1.5%. In fact, retail turned positive only recently, compared with just a single quarterly loss for multi-family and offices and steady gains for industrial during the pandemic. The industrial sector has thrived on sturdy demand for goods and aggressive warehouse expansion to meet the growing needs of online sales logistics. U.S. real personal spending on goods rose 18% in Q2 from late 2019, while demand for services is down 3.4%. And more of those goods are sourced online. U.S. retail e-commerce (excluding food services) rose 47% in the similar period, more than double the run-rate before the pandemic. This is driving demand for last-mile distribution warehouses. In Canada, the shift to online spending has been significant as well, with e-commerce sales nearly doubling from pre-COVID levels at one point, before easing alongside broader storefront re-openings in recent months. Still, the associated price strength in warehouse space has been every bit as robust as in the U.S. market. In fact, capitalization rates in the sector have compressed meaningfully through the pandemic (Chart 3), and the Canada-wide average (based on CBRE survey data) now trades at a premium to the office and retail segments, a stark shift from recent years. |
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Despite a brief stumble as teleworkers initially fled big cities, multi-family has been underpinned by rising employment, government support programs, and soaring house prices that are now pushing prospective buyers into leasing. Rents are rising as vacancy rates fall, even in cities that earlier faced a shift to remote work. In the U.S., Zillow’s observed rent measure jumped 11.5% y/y in August, the most in the six-year history of the survey. While part of the increase reflects weakness a year ago, the two-year annualized rate is also elevated at 5.8%. In Canada, a lull in international migrants (particularly students and nonpermanent residents) applied some temporary upward pressure on vacancy rates and downward pressure on rents, but this is proving to be short lived. Keep in mind many urban markets in Canada were extremely tight before the pandemic, and all signs point to a return to high immigration levels north of 400,000 per year, which will support the sector. |
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Office sector returns are grinding out a modest recovery, benefitting from long-term leases that kept coffers full. However, the sector’s outlook remains foggy, with vacant sub-lease space soaring in major cities. The Delta wave pushed back return dates for office workers, raising the risk they might become too cozy at home, tilting hybrid plans even more toward remote. Though office workers are slowly drifting back, only 36% (on average in ten major U.S. cities) had returned by early October, according to an office security firm. Across Canada, the sector looks starkly different than the industrial and multi-family segments, with net absorptions still negative as of 2021Q3, and the national vacancy rate the highest since 1994. In the largest centres like Toronto (downtown), rents have softened so far, but hardly collapsed because of pre-pandemic strength. Others, like Calgary, saw a heavily oversupplied market even before the pandemic, and have seen a tough situation made worse. Apart from hotels, no sector has struggled more with the pandemic than retail. Total returns were negative for five straight quarters before turning modestly positive in Q2. Despite sound consumer spending, the sector will likely underperform until COVID-related anxiety eases further, allowing food services, entertainment, and travel to more fully recover. Retailers serving office workers may never fully rebound. Given the pivot toward online sales and telework, many physical retail stores could face long-term challenges. |
Based on the Fed’s latest survey of senior loan officers, commercial real estate prospects look bright. The net share of banks reporting an increase in demand for commercial property loans turned positive in Q2, while lending standards eased for the first time in several years in Q3. The latter is supported by improved credit quality, with loan delinquency rates dipping below 1% in Q2 to near all-time lows (Chart 4). Note that default rates spiked to almost 9% in the Great Recession, but hardly budged in the pandemic due to government support programs. U.S. banks’ commercial real estate loans have trended moderately higher this year. Meantime, investment demand remains strong amid broader asset price inflation and the hunt for inflation-protected yields. Cap rate performance has been mixed by sector, as discussed above, but commercial real estate overall has performed exceedingly well given the massive shock, yet still looks less frothy than the residential market. Relative to 10-year Government of Canada yields, the average Canadian cap rate (across all sectors) continues to trade at a premium consistent with pre-COVID norms, and reflective of a generally appropriately-priced market (Chart 5). Like most other asset classes today, the biggest risk would be an abrupt increase in interest rates that triggers a short-term repricing. With loan standards easing, it’s just a matter of time before nonresidential construction joins the economic recovery. Spending in the sector is down 19% in the U.S. and 17% in Canada since early 2020 (Chart 6). However, it steadied in the first half of the year in the U.S. and turned higher in Canada. Barring an economic shock, commercial construction is set for solid growth in 2022. The Bottom Line: The pandemic left widely differing marks on commercial real estate markets. It gave the industrial segment a virtual booster shot, while multi-family, after a brief sniffle, was mostly immune to the virus. Both sectors are now thriving, supporting the economy’s recovery. By contrast, retail was laid low, and offices are only now convalescing. Big question marks cloud their outlook, depending on how profoundly shopping and working habits have been altered by the pandemic. |
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