Six months ago the Urban Land Institute, a real estate industry body, made a prophetic warning when it noted the wild optimism of US commercial property players. Almost 80 per cent of them told a survey that their 2020 prospects looked “excellent”.
ULI economists also highlighted some disturbing parallels with 2006: ultra-loose monetary policy was pushing commercial real estate prices ever higher, as investors gobbled up assets in the hunt for yield. “At this point, the abundance of capital is a blessing and a curse,” the ULI team lamented, warning that a “Niagara [falls] of capital . . . could lead to a bad end.”
Quite so. The CRE sector has now tipped into crisis amid the Covid-19 downturn. Last week, for example, a ULI meeting projected that CRE prices would fall 7 per cent in 2020 in North America, with just $275bn worth of transactions — half the 2019 level.
If that forecast proves correct, the fall would still be smaller than in the 2008 financial crash. The ULI team also expects a rebound in 2022. However, this 7 per cent average drop in prices conceals searing pain in some CRE sectors, especially retail and hospitality.
“Assets that have greater human density seem to have been the hardest hit: healthcare facilities, regional malls, lodging and student housing have sold off considerably,” notes McKinsey in a recent report. “As of April 3, by one estimate, the unlevered enterprise value of real estate assets had fallen 25 per cent or more in most sectors and as much as 37 per cent for lodging.” Ouch.
Indeed, conditions in such sectors are so bad that Tom Barrack, founder of the $50bn Colony Capital investment group — which runs real estate investment trusts with heavy exposure to hard-hit assets such as hotels — warned in March that the market for CRE mortgage loans was on “the brink of collapse”.
And this month, Colony officials revealed that $3.2bn of debt linked to its hospitality assets is in non-recourse default. This means the company is holding restructuring talks with lenders who could seize these assets (but not take action against the Colony parent itself). Moelis & Co, the investment bank, is exploring options for the assets.
This is startling — and symbolic, given that Mr Barrack is a close friend of President Donald Trump. Yet while Colony might exemplify the current pain of CRE, it points to an unexpected potential silver lining for the wider economy.
Under investor pressure, Mr Barrack is due to step down early as chief executive of Colony, and be replaced by Marc Ganzi, head of a Colony division that invests in assets such as data centers.
Two years ago, these digital assets were a paltry 2 per cent of Colony’s portfolio. However, even before Covid-19, Colony was “rotating” into digital, as Ganzi told investors this month, and he now expects that digital investments will represent almost 60 per cent of the portfolio by the end of 2020 — and 90 per cent in 2021. Yes, really.
Other real estate groups are also scrambling to remake themselves as digital players and are being rewarded by investors for doing so.
“On April 15, the Data Center Reits index was up 34 per cent year on year, while retail and hotel Reit indices were down 48 per cent and 53 per cent, respectively,” notes a report from Deloitte. Meanwhile, last week’s ULI meeting predicted that industrial properties this year and next will deliver positive returns of 2 and 7 per cent, primarily because of this digital play — even as retail properties are expected to deliver losses of 12.5 and 2.5 per cent.
A cynic might say this just highlights the propensity of property groups to find new investment stories to peddle. An optimist might retort that it demonstrates the potency of the sector’s entrepreneurial spirit, as Covid-19 accelerates structural trends already under way in the economy. Both interpretations may be true.
Either way, the key point is that Covid-19 has blown off the froth from some previously overheated sectors, such as CRE, and accelerated trends in a way that may help the US economy over the long term.
That will not comfort investors who dashed into old-style CRE in recent years: many of them now face big losses on Reits or the junior tranches of collateralised debt obligations. It may also be that the new “Niagara” of liquidity supplied by central banks amid the pandemic could create fresh bubbles in CRE, and elsewhere.
Meanwhile, though, a world with more CRE investment in digital infrastructure — rather than overpriced hotels or golf courses — is surely better for US productivity growth. It is tragic it took a crisis for this to happen.