The risk mitigation measures intended to stem the spread of the coronavirus led to an unexpected and almost complete shuttering of business operations on a nationwide scale. This subsequently led to a number of businesses finding themselves unable to come up with the requisite funds to pay their leases for months on end, creating unique cash flow issues for landlords in all industries. Additionally, since the end of March, countless employees have lost their positions, resulting in unprecedented unemployment rates not seen since the Great Depression almost a century ago.
The dramatic decline in business performance is expected to have far reaching effects on the commercial real estate sector as well as REITs. Accordingly, the demand for rental units has dropped off considerably over the first quarter of 2020, despite the fact that the crisis only reached pandemic status in the closing weeks of that timeframe. Conditions are expected to worsen in the coming months, until such time normal economic activity can resume.
The collective impact of mandatory social distancing and closure of business operations differs significantly based on the specific real estate and REIT marketplace, and, for certain sectors, the effects are quite concerning. On the other hand, some sectors experienced relatively little disruption due to the crisis. REIT stock market performance since the start of the COVID-19 crisis provides insight into both the scope of the inherent risk associated with these assets as well as the different impacts based on property category. The REIT sector overall began the period in a very healthy state compared to previous market fluctuations in terms of operational rates, balance sheet strength, and availability of liquidity prior to the start onset of negative market factors attributable to the virus. This strong initial starting base offers some degree of support for the mid- to long-term forecast for REIT investments.
The beginning of the pandemic most clearly impacted the travel, lodging, restaurant, and entertainment sectors as mandated quarantines ceased most business operations in these spaces, leading to widespread business shutdowns and employee layoffs. Another market that felt the effects of the coronavirus early on was the retail space, as buyers were wary of shopping in public areas unless it was for essential goods such as groceries and medicine. Online marketplaces and delivery providers saw an uptick in business, whereas less pressing purchases were delayed or canceled altogether. Several non-essential medical procedures were rescheduled, causing specialized medical personnel to experience a notable lag in business.
The Inherent Resiliency of REITs
All of these factors contributed to the decrease in demand for commercial space in the office, retail, residential, and industrial markets in both privately-owned and REIT-owned properties alike over the course of the first quarter. The decrease, however, when compared to the first quarter of the previous year, were largely negligible. Vacancy rates held relatively stable and rent growth experienced promising growth on both a sequential and annual basis for all categories of properties.
On the whole, the REIT industry entered into the COVID-19 outbreak with favorable balance sheet indicators and adequate sources of liquidity—having raised over $440 billion in equity capital over the course of the preceding decade. REITs utilized this capital to fund acquisitions of more rental spaces, and they became more reliant on equity capable as opposed to debt. Accordingly, leverage ratios measured at the close of 2019 were close to the lowest they have been in over 20 years. REITs also extended their debt maturities, scaling up from a weighted median of under 60 months in 2008 to almost seven years by 2019. Extended debt maturities and restructured maturity models have lessened the requirement to refinance debts in the coming months. This robust financial profile at the onset of the crisis boosted the REIT market’s ability to weather the lean period caused by the pandemic.
Pitfalls to Avoid for REIT Investors
REIT investors have an understandable cause for concern amidst the recent economic turmoil. Although the idea of selling a REIT might feel compelling given the current circumstances, this approach could wind up costing investors dearly in the long run. Those with holdings in the REIT sector should try to avoid making the following mistakes in order to preserve their assets and profit from a long-term perspective.
When the market dips dramatically, such as it did in during this year’s first quarter, investors should first question whether they are looking to sell solely because the REIT sector has dropped off, or, alternatively, because they believe it will continue to fall based on fundamental characteristics that will lead to a net loss regardless of how long the assets are retained for. This step will help counter any knee-jerk panic sells that investors may come to regret. Keep in mind that REITs operate in several sectors including residential, data centers, and healthcare. The market dynamics of each respective space are very different, so it is impossible to treat all holdings the same.
Investors looking to buy REITs in the economic downturn often make the error of focusing only on the type of property they already have in their portfolios. Alternatively, the favorable pricing available now is a great opportunity to acquire high-performing stocks that were once too cost-prohibitive when the market was booming. Doing so could give investors the distinct advantage of diversification and enhance the long-term performance of their portfolios.
Many investors assume that market conditions will self-correct relatively quickly and it will be business as usual in the coming months. Many industries, however, are anticipating continued unemployment and interrupted business operations for the foreseeable future even when the coronavirus is eventually contained. This forecast will make it challenging for even the most favorably positioned companies to bounce back quickly and investors should plan accordingly.