Commercial Real Estate and COVID-19: Three scenarios

By Michael Moran  |  Apr 16, 2020

 Executive Summary: Commercial Real Estate (CRE), and its office subcomponent in particular, face a daunting landscape ravaged by the COVID-19 outbreak. Like all US economic sectors, CRE has taken a hit from the government-ordained lockdowns across the planet that resulted in empty offices, an abrupt halt and revenue drop for businesses of all kind, with consequent defaults on lease payments and demands for rent holidays. Some will struggle to remain solvent during this period, and smaller operators may be subject to capital calls if the lockdown period extends into the summer as valuations decline. But in all of our scenarios, the greater challenges will occur after the lockdown ends and a start-stop process or getting back to business begins. Corporations and others who rent dense commercial office space will emerge financially weaker, seeking efficiencies and armed with empirical data on how their workforce performs remotely – outside expensive leased office space. What’s more, tenants and staff will rightly demand to know what steps have been taken to secure their health and well-being now that issues like personal space, infection risk and the importance of good ventilation have been highlighted by the lethal coronavirus. With valuations bound to drop from their pre-pandemic peak, those building owners, Facilities Managers and those who manage large real estate investment porfolios who take steps to address these issues now will be in better shape to survive the shakeout to come.

Introduction

In these difficult times, Commercial Real Estate owners, and those who own commercial office space in particular, are pursuing what we have dubbed the “Rosie” scenario. Rosie in this case is “Rosie the Riveter” – in real life, Rosalind P. Walter, who died at 95 earlier this year and symbolized the enormous changes and sacrifices that American society embraced during the last great national emergency: World War II.

Women like Rosie took jobs in munitions plants, in shipyards and on assembly lines as the men were sent off to fight in Europe and the Pacific. These women powering the country’s most important contribution to the defeat of global fascism: unrivaled industrial production. The war over, Rosie and most of her cohort downed tools and went back to being homemakers. It was, for its time, precisely what today’s CRE owners, brokers, asset and facilities managers hope for when the COVID-19 lockdowns end: a return to “normalcy” after a crisis. Or put more simply, business as usual.

Such thinking runs counter to best practice in terms of risk assessment and mitigation. If we view the world  from a scenario analysis point of view, it’s irrelevant whether the issue is US national strategy, demand in a particular economic sector or who’s going to win the American League East. The fact is, the tried-and-true process is the same: Scenario A is the Most Likely Scenario; Scenario B a Viable Alternative, and Scenario C is generally an Outlier – something less likely but definitely worth planning for (for instance – and take notice national policymakers – a global pandemic).

Judging from reports and commentary from major commercial real estate companies, the Rosie scenario of a “V” shaped snap back to profitabilituy seems to be Scenario A in the collective mind of building owners, facilities managers and investors. If that’s true, Commercial Real Estate as a sector – and particularly its office subsegment – is in for a nasty surprise. (Multifamily Residential real estate is very different story, largely because of the lack of affordable housing options for tenants of these large, dense apartment complexes).

The idea that, when the most virulent phase of the coronavirus outbreak ends, there will be a morning when the world’s corporate office culture just snaps back to its Q4 2019 high margin former self is recklessly optimistic. For commercial office space right now, that strikes us more like Scenario C, and even if it does happen, the many global, regional and local players who have commercial real estate such a vital part of the global economy should not hope that “back to business” is the way things will play out. The successful in any field learn from mistakes and the resilient got there by learning to take punches, not by getting lucky and pretending they’ll never face another. COVID-19 is treating us all to a master class in our arrogance and mistakes as a species, as a nation and as a profession. We can either learn and evolve, or evolution, literally, will mark us down for extinction.

Scenario A: Rosie It Ain’t

There will be no return to normalcy for commercial real estate of any category, at least of all there commercial office space, which has defined “normal” over the past decade as a building binge that drove 682 million square feet of new office space in the largest US metros.[i] Unlike Rosie and other wartime factory workers, office workers and the corporate portfolio managers who pay the rent will not be able to unlearn the lessons of this catastrophe. Health and safety issues will weigh on brands (liability) as well as workers and their families (the risk of intimacy, proximity). Being sued for not taking the proper steps to protect your workforce, some of whom may die as a result, is now a risk not only for dangerous manufacturing plants but for the quiet, corporate culture hives of our downtown business districts.

From a worker’s perspective, there is a genuine (if preventable) risk of losing your life, or the life of a spouse, parent or partner, for the sake of a company whose facilities management team failed to use the quarantine period to upgrade cleaning, HVAC, waste management and the related data systems. This is not a risk everyone will want to take. And it is not a risk corporations should be asking them to take. And let’s face it, who’s going to blame a person who hesitates when their managers or our current political leadership says, “Hey, it’s safe to go back into the water.”

As for corporate tenants, they will now ponder what amounts most comprehensive test case ever imagined for remote working. Productivity metrics may suggest that not much, if anything, was lost when the staff vacated that expensive downtown high rise. Indeed, some experts believe remote worker spend more time, on average, working at their job than the class nine-to-fiver. Either way, the ROI for continuing to fund vast corporate real estate portfolios will face new scrutiny in a period of economic distress when bean counting is at a premium.

So What, Just Fold Up the Tent?

Our Scenario A, by the way, is not the Worst-Case Scenario (see Scenario B, chart at right). The first step in tackling any challenge is defining it. The second is accepting it. The fact is, Commercial Real Estate is facing not merely a downturn, not merely a rise in vacancies and defaults due to the government-ordained shutdown of most economic activity. We are dealing with a game-changing social event that will challenge even the post farsighted in the industry and will weed out those who will not or cannot adjust. Commercial Real Estate portfolios are many things, but nimble isn’t one of them.

But there is some good news. First, this is a classic opportunity to get stronger from that which does not kill us. At a global and national level, that means not getting caught ever again with our pants down when something like this happens. Michael T. Osterholm, a renowned epidemiologist and author of the chillingly prescient book, Deadliest Enemy: Our War Against Killer Germs, gets its right when he points out that the US would never treat any other lethal threat with such negligence.

RISKS SCENARIO A SCENARIO B SCENARIO C
Main Narrative
Crisis spawns major reassessment by large corporate tenants as well as investors. Values plummet as downturn  leads to spike in delinquencies + new fear of density/infection risk weighs heavily on office market future occupancy projections.
Efforts to reopen economic activity in  Q2 2020 lead to immediate resurgence in COVID-19 cases. Corporates and other large tenants begin to default on lease payments as government aid runs short.
COVID-19 outbreaks abate in late Q2 2020 and government assistance helps avert major defaults. Rent collections recover and delinquencies under control. Nervous tenants stream back to commercial spaces and values, which dipped by 20% in early Q2, slowly recover.
Regulatory
EU and US weigh new regulations on office density, contingency planning and sick leave policies for large office spaces.
Congress acts to suspend bankruptcy proceedings, liens and other traditional legal remedies as crisis deepens. In US, patchwork of state lockdown constrains new leasings, construction and move outs.
Programs aimed at helping landlords and tenants through the crisis sunset after Q2, with no provision made for making them a permanent capability for future incidents.
Reputational
Sporadic outbreaks and risk of Second Wave of COVID-19 create dilemma for corporate HR and brand managers.
Increasingly vocal CRE operators, asset managers and investors in early Q2 2020 join those pushing for a full reopening of the economy, exposing them to backlash when virus reemerges.
CRE marketing efforts help convince tenants and corporate staff that COVID-19 was a ‘Black Swan’ event that that return to high density office spaces poses no further risk.
Valuation
After an initial decline of up to 25%, values recover slightly in Q4 2020 only to falter again as lease renewals decline in 2021.
Commercial office values, which hold up through Q2 2020, plummet and the sector enters a depression after second wave outbreak in Q3. Corporates making plans for alternative “low density” options.
Valuations recover gradually in Q3 and Q4 in step with largest US and global economy. By Q2 2021, rent per square foot in major metros have recovered completely.
Legal
Risk of legal action by tenants and staff rises significantly based on corporate work-at-home, sick leave and other policy decisions, and whether such decisions were based on data.
Torrents of lawsuits between tenants, landlords, facilities managers and contractors clog the already overwhelmed courts. This adds to lawsuits from tenants groups, unions, class action groups and individuals. Delays of 2 to 3 years are projected for adjudication. Regulatory ban on liens and other remedies hampers settlements.
Legal action proceeds on behalf of some tenants, workers and class action groups (transit unions, grocery store workers, etc..) whose employers allegedly forced them to take unreasonable risks during the COVID-19 crisis.
ESG
Investors and potential tenants demanding more granular and updated data on building/portfolio performance on such issues as infection risk (predictive cleaning), occupancy, air quality, staff/tenant engagement and ventilation.
In spite of market and regulatory demands, CRE operators and investors are in survival mode, with technological innovation and ESG concerns relegated to “luxuries we can’t afford.” This further undermines faith in CRE.
Source: Michael Moran, Transformative.io
The COVID-19 crisis results in a reorientation of resources toward internal capacities to control infection risk, examine carbon footprint (energy use), water and air quality, building wellness, and provide transparent tenant-landlord communication on problems.

“If we have a crisis in the Mediterranean, we’re prepared to send in a US Sixth Fleet battlegroup,” he writes. “We don’t start to requisition funds at that point to build an aircraft carrier .. and everything else we would need.” We need to know, as a planet, as a nation – and further down the food chain in our commercial real estate portfolios – what to have stockpiled for a crisis before it happens. That’s doable, and tentative signs of it happening are already evident.

A second piece of good news is that the COVID-19 crisis coincides with the emergence of several market and technological trends which had already argued for a more serious focus on building wellness, preventative intelligence and a data-driven assessment of the real value of spending on real estate.

The first of these is the ESG movement – Environment | Social | Governance – probably best known to the CRE sector from the actions of Blackrock CEO Larry Fink. Driven partly by climate change activism, partly by regulatory pressure and partly by millennial investors less inclined to just grow the money they are inheriting in a values-neutral way, ESG demands accountability from corporate executives and asset managers across a portfolio. This takes data – ESG data – which traditionally has been expensive (and sometimes embarrassing) to collect.

Microshare has years of experience bringing transformative and actionable data to bear on offices, buildings and large facilities of all vintages. From Predictive Cleaning to reduce infection risk to Feedback Stations that give tenants and staff anonymized input and a sense their voice matters, Microshare does IoT Sensing-as-a-Service at scale for many of the world’s largest facilities management, commercial real estate operators and corporate real estate portfolios.
From hospitals that needed a quick-to-deploy way to alert staff of the presence of a new COVID-19 patient, to wearable sensors to help trace staff interactions amid the pandemic, our data scientists and sales engineers are on the front lines of the technological struggle to make the world a healthier, more resilient place.
Waste Management solutions, Water and Air Quality solutions, Energy Use, Asset Zoning to track vital mobile equipment, Occupany Monitoring for rooms, labs, hospital wards and more – Microshare’s easy-to-install, inexpensive deployments turn inert brick-and-mortar buildings into living, breathing assets with a 24/7 flow of vital performance data.
What’s more, the same IoT data that drives down costs deliver precisely the data required now by the European Union’s new ESG (Environment | Social | Governance) rules and which investors and market sentiment in the United States increasingly expects. And delivered in auditable historic formats, instrumented with alerts for actionable change, and living completely separate from senstive corporate computer networks, thus posing no risk of cyber compromise.

The second happy coincidence is the explosion in data collection capacity and tumbling of cost occurring in the realm of the Internet of Things (IoT), where inexpensive, long-battery life sensors can now be installed in buildings dating from the Black Death and still produce actionable insights and ESG data. All of it, if done properly, can run on a system that never touches the sensitive corporate network and thus poses no cyber risk.

Not Your Father’s Crisis

We need to face the fact that this is not a crisis with much precedent in our history. Yes, there are lessons to draw from the Spanish influenza outbreak during the First World War, and from the vanquishing of polio, smallpox and other ailments during the 20th century. But the direct lessons from previous pandemics are too old to graft onto the risk matrix today.

Similarly, we can enjoy anecdotes about the changes wrought by the 2008-2009 financial crisis (higher cap requirements for banks, tougher mortgage requirement from Fannie and Freddie, for instance) or the 9/11 attacks (the proliferation of Jersey barriers in our public spaces, and the conga line of inconvenience we all submit to now at airport security).

But this time truly is different. None of those previous crises – none of the wars of our history, nor even the Great Depression – posed a theoretically mortal risk to every citizen, nor did they shutter, almost completely, US economic activity.

For those who own or operate office buildings, the self-isolation period  is not a moment to learn Italian or take up the clarinet again. Use this time to do everything possible to distinguish your portfolio of office spaces from those whose idea of mothballing pretty much stopped at locking the front doors. There are technological solutions, many of which you have never heard of, that will allow you in good conscience to stand at the front door the day your tenants and staff return for the first time, look them in the eye, and say: “We have done everything possible to make this the safest, cleanest, infection resistant facility on the planet.” These people, their families and loved ones and, I might add, attorneys, will expect no less.

Michael Moran is Chief Risk & Sustainability Officer at Microshare Inc. and a former partner at the global risk consultancy Control Risks. He also serves at Managing Partners at the Denver-based multifamily investment firm Preferred Climate Resilient Properties Group (PCRP Group).

[i] Yardi Metrix, via Commercial Café https://www.commercialcafe.com/blog/top-u-s-cities-add-682-million-square-feet-of-office-space-in-10-years/