Trends that Will Impact the Future of Commercial Real Estate Investing
The risk profiles of property types and locations are shifting. Work with your advisors to identify and prepare for these changes.
Scott Lorenz, Senior Commercial Real Estate Advisor
As many real estate owners feel the pain of missed or reduced rent payments, their tenants are considering what adjustments they will need to make to post-pandemic operations. In some instances, adjustments are already being made, such as in retail and hospitality, where businesses have quickly adapted to takeout-only models and enhanced cleaning protocols. Likewise, office tenants have already begun planning both temporary and permanent changes to the design, use, and size of their spaces.
All of these adjustments will invariably impact the desirability of certain property types and locations, which will affect the demand for space, and ultimately, properties’ valuations and the risk/reward expectations underlying them. Below are six trends that we believe commercial real estate investors will need to navigate in the months and years ahead.
1. Retail and office rental rates may decline.
The forced closure of physical premises will cause far-reaching repercussions in the commercial real estate world for years to come. By closing, countless businesses have realized that their physical occupancy of office or retail space is no longer viable. Those businesses that survive this period will strongly reconsider whether to occupy as much space as they do now.
Most rental rates are predicated on demand for space. If demand falls, either because businesses fail or reduce space, rental rates will likely decline – all else held equal. The most severe cases will be in retail, including restaurants, which relies on sales volume. If retailers and restaurants are unable to serve their pre-pandemic number of patrons, rents as a percentage of revenues could become burdensome, putting pressure on landlords for alternate rent structures. Retail and restaurant minimum rents may decrease, and the use of percentage rent tied to sales may increase.
In the office sector, some tenants are currently asking for more space, on a temporary basis, to implement better physical distancing practices. But in the long term, office tenants may implement more work-from-home opportunities for employees and create an alternating schedule so that the entire staff is not in the office concurrently. Also, communal or shared office space, a trend that showed potential and growth prior to the pandemic, may no longer be desired by smaller tenants, and there will likely be consolidation in the sector. Decreased demand by major tenants will quickly correlate into lower rents at these properties.
2. Non-monetary lease terms may shift unfavorably for landlords.
With uncertainty surrounding the pandemic’s impact, now may be a great time to lengthen lease commitments and lock in current rental rates, if possible. Already, new lease agreements are incorporating future pandemic response provisions, and some tenants may require more flexibility and protection in new lease amendments. Will office users request “go-dark” clauses like anchor tenants in retail? Will apartment landlords move toward insurance-style security deposit products instead of cash? Will insurance carriers modify coverage to protect landlords or tenants in the event another pandemic occurs? These types of considerations – and many more – highlight the benefit of locking in lower-risk terms now while they are still available.
3. Delays in bankruptcy proceedings could exacerbate revenue challenges.
In the wake of the pandemic there will be numerous bankruptcies. Landlords will need strong bankruptcy strategies to support their interests as creditors. Key to any strategy is the landlord’s ability to understand the tenant’s financial condition. Does the tenant have a significant investment in the build-out of its space? Is the landlord able to negotiate reasonable rent deferral terms to work with the tenant over an extended period of time? The landlord may also consider abating rent and adding new terms at the end of the lease to avoid a tenant bankruptcy. All landlords should consult skilled bankruptcy counsel and understand the process and timing of working through a bankruptcy filing. If a tenant is likely to file bankruptcy, “the sooner it files, the sooner it is out” is a phrase sometimes used by landlords.
Some space may effectively be taken off the market during the bankruptcy period while the tenant retains possession and prior to a final court determination. If bankruptcy filings spike, there may be delays in the court’s ability to review each case and provide a decision, thereby causing further challenges for the owner in generating revenue on these spaces.
4. A decline in brick and mortar retail stores may accelerate demand for industrial space.
Retail businesses will quickly implement operational changes to allow for physical distancing and to meet health department requirements. Will municipalities partner with businesses to adopt reasonable new health and safety guidelines for retailers and restaurants? And will those guidelines allow each business to generate sales that support pre-pandemic rental rates? Answers to these questions will impact individual tenants’ long-term design and space needs.
For the industrial sector, demand for storage space from online retailers may continue to increase after the COVID-19 pandemic. The e-commerce industry has created strong demand in major metropolitan areas for warehouse and logistic space, fueling record rental rates and asset values for industrial properties, while at the same time reducing demand for some retail sectors. Is this the final straw for the brick and mortar retail store?
5. Location will continue to reign but preferences will change.
How will the location of an asset be positively or negatively impacted by tenant preferences after the pandemic? Will certain location attributes, such as hard corners or proximity to mass transit, enhance or detract from a property’s desirability? Will city and county-planning agencies in urban areas continue to try to densify multi-family living areas near modes of transportation? Location has always been a critical attribute to real estate, but changes in how real estate is used may impact perceptions, and ultimately values, over the long term.
6. Investors will revisit their assumptions for risk vs. reward by property type.
Each investor has his or her own risk tolerance, whether the investment is in stocks and bonds, precious metals or real estate. The return on an investment is directly correlated to its risk profile. As commercial real estate assets undergo changes in demand or use, their risk profile may change. Investors will likely carefully reassess their risk tolerance for new commercial real estate acquisitions.
For example, after the pandemic, certain property types, such as suburban multi-family and offices with credit tenants on longer leases, may be perceived as lower risk investments. Properties that contain critical operations necessary to fulfill the tenant’s business enterprise – for instance, data and logistics centers – may also be viewed as lower risk assets. Alternatively, high-density assets, such as high rise residential, hotels and some retail, including theaters and large open restaurant space, may be viewed near-term as high-risk assets.
It is too soon to tell which of these trends will result in permanent change, and which operational techniques by users will become commonplace. In the interim, we recommend that investors:
1. Lengthen lease commitments and lock in current rental rates, where possible
2. Prepare for lengthy bankruptcy battles and newfound strength (or weakness) in their chosen property types
3. Review properties’ likely altered risk profile and acquisition criteria
While uncertainty is high and significant adjustments in the space are all but certain, carefully selected commercial real estate investments should continue to offer good risk-adjusted returns compared to other asset classes. For help assessing and realizing your properties’ long-term potential, learn more about our real estate services and contact one of our experts.
This information is not intended to be and should not be treated as legal, investment, accounting or tax advice and is for informational purposes only. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal, accounting or tax advice from their own counsel. All information discussed herein is current only as of the date appearing in this material and is subject to change at any time without notice.