I can’t comfort you when it comes to the health concerns of the COVID pandemic since I am not a health expert but I can give you an update on what’s going on with commercial real estate during this pandemic and where I think things are headed with the office, industrial, and retail markets.
Office
Starting with the office market, leasing activity is slowing down, particularly with Class A office space. Class A office space is defined as property that is well located, typically newer, being a high-rise or having a large footprint, upscale amenities and usually a parking garage. In times of crisis or disruption, typically tenants move “down” in quality of space to save money with lower rents. In some cases, a tenant can save 10 to 20% by doing this. A key indicator of a slowing of activity is that landlords are starting to offer more abated rent than they have since early 2019. Landlords are having to do this to keep existing tenants and to attract new ones. Although they haven’t lowered their rents yet, I see them coming down in the next six to eighteen months. And keep in mind how corporate office leases work. Corporate leases are typically 5 to 7 year lease terms occupying significant portions of a building. So, while many companies continue to have their employees “shelter in place” working from home, executives are activity thinking about how to social distance their employees when they return to the office. They are also thinking about how much office space they really need. If they decide to downsize, they likely can’t do that right away if they still have term on their lease unless they get lucky and are able to sublease. This likely downsizing of corporate space will take place in a staggered way over the next 2 to 3 years as their lease renewals come up. What does this all mean? I believe we will see more vacancy in Class A and some upper Class B buildings that will drive rental rates down some but not substantially, maybe a few percentage points.
From an office ownership standpoint, property values are holding steady today but as office vacancy increases and rental rates soften, I think we will see a softening of property values. Another factor affecting the value of properties is already showing itself as lenders start tightening their belts on new loans since many are expecting to see about a 20% business/real estate loan default rate post pandemic. The lenders want to hold onto cash reserves to weather the temporary uptick in anticipated defaults. I see this phenomenon as temporary and think for Class B and lesser quality office buildings their values should stabilize in 6 to 12 months. Class A values could come down slowly some as vacancy and rental rates decline over the next few years.
Industrial
The leasing of industrial, manufacturing, and distribution space has been surprisingly resilient thru Covid. Leasing activity did slow down in the first quarter of 2020 but in early June started to pick up steam. I am seeing competitive situations with multiple users looking for 10,000 ft. to 30,000 ft of dock loaded, high bay space. One thing folks are realizing during this pandemic is they can’t manufacture or distribute products effectively from home. Because of the increased demand for warehouse space and the fact that of the 6.6M sq.ft. feet of space coming online in the next 6 months, 75% is preleased to companies like Amazon, who is taking 4M ft in Pflugerville. I expect to see rental rates creep up with less concessions being offered by landlords. The recent announcement that Tesla is adding a 4 to 5M sq.ft. manufacturing plant in east Austin will only continue to upset the supply and demand balance because companies that do business with Telsa will want to expand and/or relocate to Austin. There’s simply not enough current, or to-be-built, inventory coming to handle the increase in demand.
From an industrial ownership standpoint, because leasing demand is high, I believe property values will hold steady and increase moving forward.
Retail
The retail leasing market is relatively stagnant because of the shut downs of retail shops, bars and restaurants. This segment of the market is in a state of shock as many longstanding retailers such as GNC, Pier 1 Imports, Men’s Wearhouse, Game Stop, Kays, Zales, Jared, Steinmart, Bed Bath and Beyond, and Victoria Secret to name a few either are closing multiple locations or shuttering their entire brick and mortar properties permanently in the coming months. The increase in vacancies will no doubt cause landlords to get aggressive to attract new retailers to their properties by reducing their rental rates, increasing rent abatements, and conceding on add-ons like percentage rent. With this unfortunate change of fortune for some, it creates an opportunity for new retailers, that pre-covid, were fighting for the few prime retail locations that existsed throughout the US. The same holds true for restaurant space, as reports of popular chains such as Olive Garden and Chili’s will be closing locations. The “wait and see” moment for this specialized segment of the market Is who will step up to take over the vacant restaurant spaces as they start to come available.
From the standpoint of owning retail centers, this segment of the market will get hit harder than the others, value wise, since it likely will be harder for landlords to backfill their vacant spaces. This will translate to lower property values. For landlords looking to sell their retail centers, they will likely have to sell at a discount to get investors attention
If you would like more market intel on any of these market segments, email me at oddo@toweratx.com
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