The unprecedented nature of the COVID-19 pandemic and the subsequent drastic effects on commercial tenants resulted in a sharp rise in force majeure litigation with financially troubled renters looking to escape their contractual obligations. Despite the California judiciary’s somewhat lenient interpretation of what events qualify in order to invoke the defense of force majeure for purposes of excusing non-performance, some local governments have passed legislation mandating that commercial tenants attempt to cooperate with their landlords in an attempt to work around rental payment difficulties. For example, the Beverly Hills City Council enacted Section 2 of Ordinance No. 20-O-2815, which requires commercial tenants to meet and confer with their landlords within 45 days of notice to discuss payment strategy for repayment, and, if the tenant refuses to do so, the landlord would then be entitled to all unpaid rent due on October 1, 2020. These type of mandated mediation measures will be a key aspect of the overall CRE recovery phase, and could help facilitate a smoother transition to normality as business operations and the resultant income start to return to pre-pandemic levels.
Historical CRE Recovery Data
The personnel and corporate effects of COVID-19 continues to present a dynamic challenge around the world. The exponential rate at which the virus continues to spread, and the mitigation measures different jurisdictions are implementing to stem the tide are having a subsequently serious and never-before-seen impact on the manner in which business is conducted. Although the full effect of these occurrences cannot yet be fully measured, a quick look to the past can offer a valuable insight as we prepare for the post-COVID-19 recovery phase.
Over the last 100 years, external factors including epidemics followed by an economic freefall have had an instant effect on asset prices in the CRE space, but a much more muted impact on transaction activity. Still, the CRE sector recovery in each of these instances varied—although event-oriented negative trends exhibited a faster recovery, longer lasting events, for example, the 2008 economic crisis, led to a more elongated recovery. Generally speaking, the CRE market has historically been six months behind the overall economy in terms of recovering from systemic external factors. However, the tremendous scope, depth and reach of COVID-19 has produced CRE impacts much faster than in the past.
Whereas the CRE industry was struggling during the onset of the 2008 market crash, it was in a very healthy state prior to the outbreak of the coronavirus. Balance sheets, capital availability, and liquidity all pointed to continued growth and businesses could control their debt maturities to longer positions. Ever since the middle of March, however, when COVID-19 was officially declared a pandemic, financial markets have taken a collective nosedive on a global scale. The S&P 500 and Russel 2000 dropped by 13 and 29 percent year to date respectively over the course of less than a month. Likewise, the US 10-year treasury yields fell by 127 basis points to 0.6 over the same timeframe. Rather than the usual six-month lag behind the overall economy, the CRE sector exhibited immediate effects because trade activities and occupiers’ operations were effectively shuttered altogether.
CRE Subsector Impact Analysis
The fluid nature of the coronavirus economy has produced a strong influence on landlords, real estate professions, builders and proptechs. Here’s a quick breakdown by CRE subsector to take a close look at the impact the virus has had.
Regarding real estate investment trusts (REITs), the subsector has shown a varying impact across property categories based on the virus’ effect on the profit margin of tenant business operations. To exhibit, in mid-April, the data center REITs index had jumped 34% year on year, whereas retail and hotel REIT indices had gone into a freefall of 48 percent and 53 percent respectively. From a broad perspective, the immediate vacancy risk is mitigated because the majority of them operate on long-term lease agreements.
Real estate developers’ project itineraries and balance sheets are impacted as a consequence of sluggish activity and the closure of certain categories of construction, to include new residential developments. An April survey indicated that over half of US construction firms that responded had stopped or delayed projects and over two-thirds ran into delays caused by material shortages.
The effect on proptechs is variable based on the product category and associated services they offer. Coworking, coliving and holiday rental properties have experienced a negative result—potentially due to the fact that customers are not likely to return to a short-term lease model in the post-COVID 19 market. On the other hand, proptechs that offer digital solutions catered towards property and building management services might experience more positive results, as CRE businesses could use technology to manage operations and interact with tenants while maintaining social distancing.