You ever wonder why China seems to be the incubator for deadly viruses? Me too. In recent years it’s been the swine flu, then the bird flu and now the Coronavirus (Covid-19). I think it’s unfair that they name the latest virus after my favorite beer, but they didn’t ask me. In tribute to my beer of choice, from this point forward I will call the virus by its scientific name, Covid-19.
Before I get too far along, the focus of this article is not to scare the bejeebers out of you. The purpose of this article is to determine what impact this potential pandemic could have on commercial real estate in the United States. My guess is that my assessment of the impact may surprise you.
But before I can give you my opinion, I have to go through the scary stuff first. So here goes.
Is Covid-19 hype or not?
At first, I was wondering why everyone was so concerned about Covid-19. Last year in the U.S. we had 80,000 deaths attributed to the flu. I don’t recall anyone being more than mildly concerned about the deadly nature of last year’s flu outbreak. But then I decided to find out why everyone is so alarmed about Covid-19. Here are some of the most recent assertions about this virus.
- It’s not if the virus will spread to the U.S. It’s only a matter of when and how severe. So says Dr. Nancy Messonnier, director of the National Center for Immunization and Respiratory Diseases.
- It is estimated that once Covid-19 spreads to a population that 25 to 70% of the population will contract it.
- It is estimated to be 5 to 10 times more deadly than the flu which has a mortality rate of 0.1%
Let’s do the math.
The best-case scenario is that 25% of the US population (330 million) will get the virus and that it will be 5 times more deadly than the flu. Under that scenario:
- 330 million people x 25% x 0.5% = 400,000 deaths
The worst-case scenario is that 70% of the US population will get the virus and it will be 10 times more deadly. Under this scenario:
- 330 million people x 70% x 1.0% = 2,300,000 deaths
So if these assumptions are in the ballpark we can expect between 400,000 to 2.3 million deaths in the US resulting from Covid-19. This assumes that the spread of the virus to the US is inevitable, etc. That sounds apocalyptic. Doesn’t it? No wonder government officials are rightly concerned about this potential pandemic outbreak.
The Markets Finally React to Covid-19
And as the seriousness of the worldwide Covid-19 outbreak became apparent, the financial markets last week finally figured out that this pandemic could have serious consequences on the world economy. And as of last Friday’s market close:
- Last week the Dow Jones Industrial Average dropped 12% the biggest weekly losses since 2008.
- And the 10-year treasury closed on Friday at 1.156%, a new record low.
Let’s face it. No one at this point knows how Covid-19 virus will play out. Will it be as severe as these number suggest? Or is this all hype? No one knows. No one! At this point it is all speculation.
Black Swan Event
That said, it appears that the Covid-19 has become a black swan market event. A black swan event is a metaphor that describes an event that comes as a surprise and has a major effect on a market. By definition black swans have not occurred in the past, thus rendering useless risk management models based on historic data.
Most talking heads are in agreement that regardless of how severe this virus turns out to be, the damage to the world economy has already resulted in tipping it into recession. It’s too late to stuff the genie back in the bottle. The damage has been done.
What impact will Covid-19 have on US CRE?
Those of you who have read my blog over the years know that I am not some Pollyanna blogger, painting rosy pictures of kittens and lollipops when events say otherwise. I am cynical of the major real estate brokerage firms always trying to paint an optimistic view of the market to encourage investors to continue buying real estate. I admit, I am by nature a glass half empty type of person so my opinion about this crisis may surprise you. Let’s logically think through the impact of this black swan event on CRE.
Covid-19 has driven down interest rates to historic lows. If lenders do not put a floor on their interest rates, borrowers are going to benefit. They could benefit big time! If interest rates remain low for the foreseeable future I see many investors refinancing their properties resulting in either substantial cashback refinances or significantly improved cash-on-cash returns on their rental properties. Either way it’s a big win!
Increased Demand for CRE
I see stock market investors fleeing the equity markets and investing in real estate. Why wouldn’t they invest in CRE? After taking the drubbing they’ve taken last week it only seems logical that some of them would say enough is enough I’m going to pull my money out of the stock market and invest it some other less risky type of investment.
Further Cap Rate Compression
If there is increased demand for CRE and interest rates remain low, the logical result will be that capitalization rates will continue to compress even further than they are right now. This means that even if a real estate investor doesn’t refinance his rental properties, the value of his real estate will still go up as cap rate continue to compress. So bottom line is that those of us who have invested in commercial real estate will inadvertently benefit from this black swan event.
Now let’s look at the possible CRE losers
If the US economy goes into recession it seems quite logical that retail and office properties will be adversely impacted. Do you remember the impact the Great Recession had on these two property types? During the Great Recession office and retail properties in the Pacific Northwest saw significant increases in their vacancy rates. I would expect the same thing to occur this time around. So expect to see some pain and suffering for those investors investing in these two asset classes.
Those are my thoughts. I welcome yours. What do you think will be the impact of Covid-19 on the US real estate market?
Doug Marshall is the award winning author of Mastering the Art of Commercial Real Estate Investing. Check it out on Amazon!
Sources: CDC urgest Americans to prepare for coronavirus outbreak: ‘This might be bad’, Jackie Salo and Tamar Lapin, New York Post, February 25, 2020; The virus is coming, The Economist, February 27, 2020