Economist View: What Price Is Too High to Pay?

In a short time, the U.S. economy and the commercial real estate industry has been set up to fall very far, according to Dr. Peter Linneman.

The COVID-19 crisis is fluid and evolving quickly, with the World Health Organization officially declaring it a pandemic on March 11, 2020. The shutdowns are hitting the global economy hard, massively disrupting trade, tourism and supply chains. Expect to see 30 percent to 40 percent GDP drops from April through June. April and May will each see losses of tens of millions of jobs, if the shutdown continues.


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Nationally, there are about 15 million workers in the leisure and hospitality sector, or about 10 percent of total employment. With the shutdown, these jobs have completely disappeared. The leisure and hospitality sector alone can easily cause the unemployment rate to rapidly spike to 13 percent. The question will ultimately be⁠—as in any war⁠— what cost is society willing to pay to save perhaps 1 percent of the population? We know the question but not the answer. It is hard to believe, however, that it is worth destroying 30 percent to 50 percent of the economy.

Leasing losses

The hotel sector will be hit the hardest. If people, quite sensibly, do not travel or go to events, hotels will be in worse shape than low occupancy. They will be empty. In the retail sector, as people avoid stores, online sales will accelerate as long as supply chains do not break down. Grocery and drug stores will be the sole bright spot in brick sales over the next quarter. There will be few new retail leases executed in the coming quarters. Aside from large anchors, if the average retail lease term is seven years, or 84 months, then we can assume that 1/84, or 1.2 percent, of retail leases will be up for renewal every month. That is, 1.2 percent of retail leases are vulnerable each month. Think about mom and pop nail salons that have no customers. Will they want to renew? In such cases, landlords and tenants will have to work together to come to mutually agreeable renewal terms or part ways. Landlords have the “stickiness” of an existing tenant on their side, but tenants will know when to fold. We expect to see zero retail absorption in March as tenants stay in place, but there will be 1 percent to 2 percent negative absorption in May and April. And many tenants with leases will cease paying rent.

Using the same analysis but with five-year average leases, 1.4 percent of industrial leases will be up for renewal each month. Thus, we conservatively estimate that industrial landlords will experience negative net absorption of about 1 percent per month. The industrial sector will also feel some supply chain knock-on effects from declines in the retail sector. And again, many tenants will stop paying rent.

The office sector will effectively be in hibernation with no new leases over the next few months. With five- to seven-year leases, 1.2 percent to 1.7 percent of leases are up for renewal each month, one-third of which are likely vulnerable to non-renewal. But as with retail, the stickiness of an existing tenant can be strong, as most prefer not to move if they can wait out the storm. But many will hoard their cash and cease paying rent.

Even multifamily stumbles

Dr. Peter Linneman
Dr. Peter Linneman

Apartment demand will be muted, as recent college and high school graduates will struggle to find firms that are hiring. As a result, most will stay home with their parents and crash with friends. This will be particularly apparent from May to July. In addition, natural deaths will result in negative net absorption in the multifamily sector. At the same time, there won’t be an increase in home ownership by those in their 30s, given potential job instability. An estimated 5 percent to 15 percent will cease paying rent, and this back rent will never be collected.

For senior housing, we cover both independent living and assisted living. As with the other sectors, there will be no net new leasing for the next few months in senior housing. Again, this will be particularly exacerbated by natural deaths, apart from coronavirus-related deaths. We believe that the independent living sector will be especially negatively impacted in the short term. In many cases, people enter senior housing at the lowest level of required services—i.e., independent living⁠—and subsequently move to assisted living, followed by memory care or nursing facilities. Therefore, assisted living and memory care units have a natural feeder from IL units, but the decision to enter IL units will be temporarily cut off for as long as the COVID-19 threat remains uncontained.

Will the economy ultimately weather this very serious storm? Of course, but it will be a bumpy ride for all, including landlords. Once the virus is contained, significant catch-up growth will follow.

Dr. Peter Linneman is a principal and founder of Linneman Associates and professor emeritus at the Wharton School of Business, University of Pennsylvania. This article is an excerpt from The Linneman Letter, Spring 2020

Read the May 2020 issue of CPE.