Is Coronavirus CRE’s Black Swan?

Protracted supply chain disruption and contracted consumer spending could trigger a U.S. recession, cautions Jay Maddox of Avison Young.
Jay Maddox. Image courtesy of Avison Young

Most commercial real estate fund managers and lenders entered 2020 with optimistic funding goals and a generally very positive outlook. Now that markets are reeling from the sudden impact of the coronavirus epidemic, with many economists forecasting a recession, the question arises as to how CRE lenders and investors will react. Will coronavirus be CRE’s “black swan”?

In the past, the government has used monetary and fiscal tools very effectively to address financial crises. But, this time things are different. No amount of interest rate cuts or government stimulus will get fearful people back in the malls, stadiums, restaurants and movie theaters when and if the virus spreads. And obviously, the longer the disruption continues, the greater the impact on the economy.

How Likely is a Recession?

Even if the domestic impact of coronavirus is mild, we can expect significant economic disruption. The sudden steep decline in China’s economy in terms of idled production, travel restrictions and general panic affecting consumption has already triggered a recession there, as well as massive disruption to the U.S. supply chain across many industries. It will be months before economic growth and the supply chain returns to normal in China. And, we are already seeing major disruption among our other key trading partners such as South Korea and Japan, which is a recipe for global recession.

The twin dangers of a protracted supply chain disruption and a contraction in consumer spending could trigger a recession in the U.S. as well. Unemployment may not rise significantly because the U.S. is predominately a service economy, with manufacturing only representing about 20 percent of GDP. The big unknown is the impact on consumer spending, which has been the backbone of the U.S. and global economy. Until the recent concerns about a pandemic, there didn’t seem to be any headwinds, but obviously that can change rapidly. 

How will different sectors of CRE be affected?

Over the near term, commercial real estate could be considered a safe haven from financial market volatility, but not all sectors will benefit. Multifamily should continue to fare well and seems to be fully recession-proof in many markets. Hospitality, retail and tourism businesses will likely suffer, but it’s difficult to tell which sectors would be most affected. Finally, office and industrial may be little affected unless there is a sustained decline in consumer demand, manufacturing and/or international trade.

What is the likely impact on CRE Lending?

Until this unforeseen event, capital flows for CRE were robust. Most market participants had forecasted continued growth in 2020 due to generally strong underlying supply and demand fundamentals. Competition among lenders and investors had driven risk spreads down to the bone, and many were considering strategies to improve returns by taking on increased risk in terms of higher leverage, going into secondary and tertiary markets, or increasing emphasis on construction lending.

Most likely, mortgage rates won’t decline in lock step with recent declines in U.S. Treasury yields which have reached historic lows. With increased risk and volatility in the capital markets we are already seeing credit risk spreads widen significantly on new CMBS issues coming to market. Banks, insurance companies, debt funds, REITs and private lenders will also adjust their pricing, and many will build rate floors into their loan applications.

Another major consideration is the impact on construction projects. Construction costs have been rising much faster than general inflation, greatly impacting the feasibility of many projects. Developers sourcing steel, components, or equipment from China, South Korea and Japan will now face significant construction delays and higher costs unless they can utilize other sources. These factors could contribute to a general slowdown in new construction.

Over the short term, there may be little impact on CRE lender and investor strategies. So, at least for the moment, this doesn’t appear to be a black swan event. But, stay tuned. If the crisis lingers and/or widens one can expect reduced capital flows, higher risk premiums, and more conservative deal underwriting especially with regard to valuations and rent growth assumptions.