Where are we headed?

History is the story of who we are and where we come from. It may reveal where we are headed. History helps us understand current issues by asking deeper questions as to why things are the way they are. History allows us the opportunity to learn from others’ mistakes (and our own). Those who study such events describe life prior, during, and after. COVID-19 is an event that will undoubtedly be accepted as a point-in-time change.

There have been other global events over the past century that may provide some understanding as to what will follow. The Spanish flu pandemic of 1918–1920, the Great Depression, World War II and the Vietnam War are all events that brought about widespread societal, economic, and political changes. The Great Recession (2007-2011) was a global financial crisis, widespread and severe. Then the COVID-19 pandemic arrived nearly 100 years after the Spanish flu, disrupting almost all American lives.

Much of what we’re experiencing within the commercial property (CRE) markets is directly related to the year and a half we’ve had with COVID-19. But some of these trends were headed our way even before the COVID-19 pandemic took the world by storm.

Real Estate trends we can expect to see in the second half of 2021

The COVID-19 pandemic has simultaneously caused a severe and rapid economic contraction and significantly accelerated changes that were already impacting parts of the real estate markets. This double whammy poses some fundamental questions for how real estate will evolve as a sector of the economy and as an equity investment asset class.

To understand what is driving the real property markets, it’s important to understand the connection between the multiple commercial property markets.

There will be the asset class winners and laggards

Generally speaking, properties classified as industrial, data center, life science, multifamily, and single-family will remain the darlings for growth, investment, and increasing in value based upon strong demand. The impressive demand for these assets will likely cause transaction volumes to decrease over time as prices rise due to increased investor competition. The laggards who will be value-challenged are retail, hotel, and office.

The impact of COVID-19 upon the industrial property market has been and will remain a demand driver as companies continue to realign their logistics models. We expect the existing robust industrial property market to remain strong for at least the next 12 months – deep into 2022 or beyond. We see no signs of distress as there is currently little vacancy, rents continue to increase and there appears to be no shortage of capital for this property sector.

The growth and strength of this sector are driven by demand which in turn is a result of improved technology. The internet has become the channel of choice where almost anything can be ordered from one’s office or home. While the outcome is causing disruption within the retail industry, it has facilitated the shopping process for the consumer. Directly related, this shift in the delivery of goods also has accelerated the need for industrial space including warehouses, distribution centers, and the transition to smaller delivery spaces that facilitate “last mile” deliveries.

The sharp volume rises in e-commerce led by Amazon and others will continue to increase demand for “last mile” deliveries and will continue to drive the industrial property market. According to CBRE research, nationally every $1 billion in incremental e-commerce spend generates demand for an additional 1.25 million square feet of warehouse space. Given that 2020 Q2 e-commerce sales rose 44.5% from Q1, demand is expected to remain robust. In fact, the same research report estimated that there will be 250 million square feet of industrial space absorbed in 2021, well above the historical absorption of 211 million square feet annually.

Retail is experiencing unprecedented unknowns

Perhaps no other commercial real estate asset class has experienced more change than retail. The pandemic has drastically altered shopping behaviors and retailers are responding to these changes by right-sizing, reinventing their offerings and differentiating the shopping experience.

While it is certain that the retail shopping experience will continue to change, it’s difficult to generalize the outcome as retail includes a broad spectrum of both goods and services. What is clearly evident is there is much uncertainty causing many to wonder if retail is entering a post-pandemic “new normal” or is it possible for it to return to a pre-pandemic standard? 

For both COVID-19 and non-COVID-19 reasons, many retail businesses can no longer depend on their storefront to generate similar sales. This realignment is driving retailers to expand all available outlets including storefronts, websites, and social media. Supporting these new digital strategies will require industrial fulfillment and/or distribution centers performing multiple operations. The term “Omni-Channel” fulfillment involves not just the stock rooms, but inventory management of orders, deliveries, returns, and restocking.

Work from home continues

While many office workers remain at home, the vaccinations appear to be curbing the spread of COVID-19 allowing some workers to return to the office. Many companies are experimenting with employees working based on a modified revolving home-office “flex” schedule. This is causing many organizations to evaluate their current and future space needs as they realign their business models and cost cutting measures.

Recent reports indicate that many businesses have found that those working from home are less productive long-term than those who work in the office. The results may vary, but what is almost certain is that the workspace will be more transitory going forward.

The emerging unknown new threat with the COVID-19 variants is that they now may disrupt recently re-designed business protocols.

Interest rates will remain low throughout 2021.

The Federal Reserve appears committed to keeping rates low thus mitigating the financial impact related to COVID-19. The accommodative monetary policy should provide a favorable environment for commercial borrowers including real estate developers, and support the economic recovery. Many businesses are expecting the rates to remain at historically low levels through 2022 and possibly even into 2023.

Attraction to a suburban lifestyle expands.

Big cities are expensive, with rents far beyond the reach of many middle-income Americans. Work-from-home rules and public health mandated shutdowns have stimulated an exodus from a number of large cities.

Millennials who were leading the urban revival in many cities are now leading the exodus. They are getting married, having kids, and finding their downtown living quarters small and unsafe, particularly since the pandemic has stranded everyone at home. These families are seeking more space, affordability, more educational opportunities, access to nature, and community connection. Many mid-sized American cities are benefiting from this exodus.

Environmental, social, and corporate governance (“ESG”)

The pandemic has reinvigorated structural trends that existed before such as an increased focus on sustainability. Sustainability is popular and will be the topic of conversation in most, if not all corporate offices. Everything from solar and electric, to conservation and recycling is front and center. Investment in energy management and efficiency in the buildings, transportation, and manufacturing will experience both governmental incentives and/or penalties to encourage or force transformation.

Commodity volatility, Inventory challenges and supply disruptions

Increasing demand for construction materials, limited product inventory, and supply chain disruptions are driving up construction costs and resulting in longer lead times for obtaining materials. Commodity prices have skyrocketed as corporate and consumer demand returned and supply struggles to meet demand.

While demand for many products has increased during the pandemic, the supply side has not been able to ramp up as quickly. When the U.S. economy slowed down during the first quarter of 2020, capacity utilization dropped significantly. Many production and manufacturing operations slowed and/or stopped due to health concerns, and the supply chain felt the results.

Transportation issues began to emerge, and a scarcity of shipping containers contributed to longer lead times while other forms of transportation experienced delays including ocean freight, air freight, trucking, and rail services.

Soaring freight rates for 40-foot containers from Asia resulted in cost increases for numerous goods including construction materials. Many ports struggled to unload ships in a timely manner due to pandemic impacts on the port workforce further slowing down the delivery of goods.

While globalization and just-in-time delivery offer many benefits, we are experiencing one of the detriments. Therefore, we are expecting inflation to be higher than reported in the near term.

Real estate market dynamics

The increased material costs has resulted in a higher cost for new inventory in the market, which indirectly supports a higher value of existing assets. Higher costs result in higher rents provided there is ample demand and short supply. If demand subsides, then developers will have to absorb the cost of higher materials prices while dealing with supply chain uncertainty.

At the current rate of demand and supply imbalance, it appears there will be an opportunity to raise rents on existing space as new developments are delayed due to material shortages, though that could change quickly if demand were to stall.

Speculative development is at an all-time high. Developers have reasoned that once a need for space has been determined by a user that delivery and flexibility of the space is critical to the decision to lease existing space or build. From the occupier’s perspective, the risk is how confident one can be that functional speculative space can be secured in the right location to meet projected needs and timing. Warehousing and distribution requirements are often quite different than those of manufacturing, processing, and assemblage. The greater level of product specificity and timing required by the user will likely translate into a developer’s ability to absorb and or amortize a portion of the improvement cost because existing speculative assets may require significant retrofit to compete with a build-to-suit requirement.

Supply-demand imbalances will delay deliveries and likely keep costs high in the near term, providing both a cost and timing savings advantage for existing and currently under construction facilities over the build-to-suit strategy. Improvements in supply chains should be reflected in reducing the rising in prices and possibly a reduction in some materials by early 2022.

We'll experience what we did not expect.

Real estate exposure is likely to increase as it offers resilience in an unbalanced recovery. High valuations and low yields in most equity markets are likely to push more capital into real estate with a continued preference for industrial properties and what we don’t expect or yet know…perhaps driven by government incentives or penalties or, stated differently - government actions or inactions.

We don’t know the totality of the challenges and opportunities the commercial real estate industry faces going forward. Reviewing historical data provides little help in understanding the correlation of the factors contributing to hyper-growth in e-commerce, data centers, and warehousing while economies around the world were shut down. Understanding the unprecedented changes taking place may help both occupiers, developers, and investors gain a better understanding of what lies ahead.

Despite the unknowns, there are knowns which may provide clues of what to expect. Real estate has officially become an obsession on par with religion, politics, sex, and sports. There is no shortage of opinions regarding “what comes next” but due to the use, location, and recognition that no two properties are the same, it’s very unwise to generalize.

Industrial property performance dictates a specificity on the assets to be compared within a geographical location. This will help derive a better understanding of the disruptions that continue to take place and the possible outcomes. Using data, we can ask the question; “what-if” in our analysis to gain a sense of how the inclusion and exclusion of certain assets may affect performance. The use of a benchmark to measure expected performance relative to the broader market is intuitively done by those with common knowledge within a market, but often are based upon one’s motivations and a lack of understanding of the impact of outside forces that can leave room for significant error.

Understanding the differences among comparable asset performance will provide useful micro information, but it does not tell the full story of events taking place. Making predictions is challenging, let alone adding the complications of a global pandemic. So, at the very least… prepare for the future that you cannot predict.

Predicting the future… As the Danish proverb warns, “It is difficult to make predictions, especially about the future.”

Source: Ross Property Advisors 2Q 2021 quarterly newsletter; Scottsdale, AZ c/o Lance Ross, SIOR and Dan Paulus, MAI