The projections for the next three years, released May 1, aren’t exactly pretty
Projections released by Moody’s on May 1 envision a relatively bleak future for the country’s retail and office sectors over the next three years, but the apartment and warehouse/distribution spaces are expected to remain stable.
The headline number was a projected 11% decrease in retail rents in 2020 if the post-COVID-19 recovery falls into the category Moody’s describes as a “protracted slump”, which Moody’s Analytics REIS senior economist Barbara Denham defines as the morass that could result if long-term unemployment leads to lower consumption and a wave of foreclosures that limits banks’ abilities to keep capital flowing. Or, put another way, the exact situation the country is on the precipice of.
“There are so many people who are going to lose their jobs permanently,” Denham says.
An 11% drop in rental income is a nauseating prospect for any retail landlord, but before COVID-19, Moody’s was already forecasting a 9% decrease in retail rents, meaning COVID-19 is just one of many challenges facing the sector.
Even the relative stability expected in the retail vacancy rate, which is expected to recover (“recover” might be the better way of phrasing it) to 2020 levels by 2023, will be the result of landlords reducing rents to the point where tenants will be willing to sign long-term leases.
“Landlords, when there’s so much insecurity, will probably do whatever they can to secure a tenant,” says Denham.
With lower rents and higher vacancies on the horizon, lending in the retail space will be sure to take a hit, potentially hastening the so-called ‘retail apocalypse’.
“For business continuation lending, I hope that banks will still do that kind of lending,” Denham says. “Certainly with the [Paycheck Protection Plan], hopefully a lot of retailers have applied for it and gotten it already. In terms of retail development? I don’t think there’s going to be much lending at all in that area. I don’t think anyone will be building any new retail any time soon.”
Certain cities’ retail markets are expected to be hit especially hard, including Los Angeles, Phoenix, New Orleans, Austin, and Denver. The common thread for most of these cities is their appeal as tourist destinations or their status as regional hubs. The reduction in the number of people visiting and consuming their way across these cities will further deteriorate retail profitability in each one.
“A lot of retailers will hopefully come back. The nail salons, the restaurants, the hardware stores – most of those will come back. But the clothing stores and the more specialty gift stores are a little more dicey,” Denham says.
The office sector is also set to experience some pain in the short-term. Rents were already expected to decrease from their 2019 level of $27.89 per square foot to $24.95 in 2020 – a 10.5% drop – prior to COVID-19. The best-case scenario going forward sees office rents rising by just over 50 cents per square foot by 2023. Regardless of what happens post-COVID-19, office vacancy is expected to hit between 19.7 and 21.3% by 2023. It was 16.8% in 2019.
Denham says companies negotiating office space who recently had to trim their staff numbers will be forced to take on smaller footprints or sublease the space they’ve secured.
“It’s really space we’re talking about. More space on the market. But that is equivalent to job losses for sure,” Denham says, adding that an increase in remote work options will also contribute to shrinking demand in the sector.
The apartment and warehouse/distribution spaces seem best positioned to weather COVID-19, but neither is set for runaway growth. The unprecedented amount of new apartment product hitting the market in 2018, 2019 and 2020 means rents and vacancies were already set to start travelling in opposite directions.
COVID-19 has done little to change that. The worst-case scenario sees the effective rent for apartment properties falling from a 2019 level of $1,427 to $1,347 by 2021, with the vacancy rate potentially ballooning from 4.7% to 8.2% over the same period. But by 2022, both metrics start trending the other way. All forecast losses are expected to be recouped by 2023.
“I think hospitality, office, retail, restaurants – all of those areas are going to have a bad time because of the mental impact that COVID-19 has had on people,” says Ari Rastegar of Rastegar Property Company. “Social distancing and having to track consumers are really going to damper sales. But multifamily is attractive because people need somewhere to live. And if they don’t have the money to buy a home, they'll be moving into these apartments.”
Market-watchers expecting millions of online shoppers to provide a jolt to the warehouse/distribution sector may be disappointed by Moody’s projections for the sector. Even without COVID-19, the firm was projecting a decrease in effective rents and an increase in vacancy for 2020. A protracted slump scenario sees rents falling from $5.20 per square foot in 2019 to $4.90 by 2023. The vacancy rate, which was 10.1% in 2019, is expected to be between 11.1% and 12.3% three years from now.
With virtually everyone awaiting packages from Amazon, why isn’t this sector exploding?
“It’s not all about e-commerce,” explains Dunham. “Trade is a big part of the warehouse/distribution space. If clothing stores are going out of business, yeah, there’s more e-commerce, but you don’t have the bulk transportation of clothing sales that you had in the past.”
The fact that even warehouse space is becoming less valuable at a time when warehouses are arguably the liveliest part of the economy is emblematic of the unique, ongoing challenges faced by each commercial asset class, COVID-19 or no. Each sector was on its own voyage – apartments were overbuilt, retail was taking a beating, office had a case of the blah’s, industrial was stable – but they’re all in the same boat now, and the water’s rushing in.