Now, a year into the pandemic-induced recession, property values have not only defied expectations of a drop, they have moved higher.
Soon after the pandemic took hold last March and economic shutdowns ensued, real estate investors began gearing up for opportunities around distressed assets. Success stories of acquisitions following the Great Recession of 2008 were abundant, fueling expectations for a repeat. Now, a year into the pandemic-induced recession, property values have not only defied expectations of a drop, they have moved higher. The Commercial Property Price Index (CPPI) from Real Capital Analytics has increased almost 7% over the last 12 months.
Three reasons account for the real estate market’s unexpected resilience in the current environment: rather than a financial crisis, this recession was caused by the pandemic’s exogenous shock; the government’s policy response was stronger than in prior recessions; and demand for real estate remained strong as dry powder reached record levels.
Recessions typically percolate when weaknesses in the economic system become overexposed, creating bubbles that eventually burst. In the early 2000s, the dot-com bubble that arose from overpriced technology shares brought a shock to the system. Nearly a decade later, the subprime mortgage crisis that led to the Great Recession uncovered weaknesses in the housing market.
The current recession is different, brought on not by inherent financial weakness but a global health crisis. The fundamentals of the real estate market were on sound footing before the pandemic hit, with vacancies near record lows across all sectors, even retail, according to CoStar data. Loan-to-value ratios have maintained lower risk as asset values continue to climb. With these factors in place, lenders have not been as aggressive in foreclosing on assets. Once more people have received a COVID-19 vaccine and economic activity booms, many properties are expected to regain their success.
That isn’t to say that all sectors will recover evenly. Behaviors influenced by the pandemic will have a lasting impact. The rise of e-commerce is pushing property owners to rethink the use of retail properties. The shift to remote work may change the level of demand for offices. A fall-off in business travel means a full recovery may not come until 2024 in hospitality. Some lenders may not be able to wait that long, but to the extent that properties were operating well prior to the pandemic, many have looked to cooperate with property owners. To those that do end up acquiring distressed assets, it will be important to tread the waters carefully.
The government’s policy and fiscal response has allowed for stability in the property markets. Following the passage of the American Rescue Plan on March 11, the government’s total cost of pandemic relief efforts now tallies $5.35 trillion, according to the Peter G. Peterson Foundation, which focuses on fiscal challenges in the United States.
By September, rent collections had already stabilized in the industrial, office, and health care sectors, according to the National Association of Real Estate Investment Trusts. Collections in apartments and freestanding retail also remained at 95%. Combined with government policy, fiscal action was also important. The Federal Reserve was proactive in purchasing commercial mortgage-backed securities loans, which provided steadiness to the market. Amid this environment, the 10-year treasury fell below 1%, dipping to nearly .5% in August. Real estate cap rates remained relatively flat. This provided investors with confidence in the real estate asset class and a continued attractive premium.
Lastly, the fundraising market has kept demand high, and should continue supporting property values. Total dry powder for U.S.-based real estate funds currently sits at nearly $250 billion, according to Preqin, the highest level in the research firm’s 20 years of tracking real estate market data.
Funds are sitting with money, waiting to take advantage of distressed assets that still have not come to the forefront. Opportunistic real estate funds, in particular, continue to lead the pack in dry powder. With cap rates remaining steady, margins remain thinner to meet funds’ targets.
Meanwhile, average fund sizes continue to grow, resulting in greater purchasing power for larger real estate funds and fewer opportunities for middle market players. As properties start to come for sale, the vast amounts of dry powder indicate there will be strong competition in the real estate market. With property values perched up, it will be the larger fund managers that are able to keep bidding. Middle market firms should remain grounded by their models and not overstretch into bidding wars where purchase prices can no longer justify potential returns.
While many real estate investors may be waiting for the shoe to drop on distressed assets, property values have not followed the trend of previous recessions that were brought on by pitfalls in financial systems. Aggressive fiscal and government policy has provided a safety net to the economy, and record levels of dry powder will keep property values from falling. While some sectors may take longer to recover than others, it will be important for real estate buyers to recognize that expectations around distressed assets may largely go unrealized.
For more information on how the coronavirus pandemic is affecting midsize businesses, please visit the RSM Coronavirus Resource Center.