U.S. commercial real estate: quarterly market outlook

March and April saw the U.S. economy take its deepest dive on record due to shutdown mandates in order to contain the COVID-19 pandemic. A record 22.2 million jobs were lost from February through April with unemployment soaring to 14.7%—the worst since the Great Depression. In May and June, the economy started to recover as shutdown orders were lifted and preliminary estimates showed employment surged by a record 7.5 million¹ jobs between those months. The rebound in activity also materialized in the manufacturing sector, with the June Purchasing Managers’ Index (PMI) climbing to 52.6%, indicating an expansion was under way for a second straight month.²

Looking out into the second half of the year, most indicators are showing that the economy will advance in the near term; however, we doubt the initial recovery will match the economic plunge. Social distancing requirements will likely continue to constrain business operations until an effective vaccine for COVID-19 becomes widely available. We also expect bankruptcies and business closures, which were casualties of the outbreak, to keep unemployment elevated throughout the rest of 2020, and possibly into 2021.

The high levels of government transfers, including stimulus checks and expanded unemployment insurance benefits, helped cushion the blow to personal incomes from lost employment. In fact, total transfers more than offset wage loses, resulting in a net increase of $1 trillion in personal income in the second quarter.³  However, as stimulus payments expire or are reduced throughout the rest of the year, the impact of employment loss on personal income will become more apparent. Low interest rates should, to some extent, come to the rescue to help encourage both consumer spending and business investment.

Following the COVID-19 outbreak, markets reacted with a flight to safety and quickly repriced a wide range of assets, including commercial real estate. In the first half of the year, economic headwinds affected property valuations with investment activities falling far below normal levels. While today some uncertainties around real estate pricing remain, improving economic conditions are helping restore market confidence.

Preliminary data⁵ indicates that overall transaction volumes for main property types⁶ fell to $35 billion during the second quarter, a dramatic 70% tumble on a year-over-year basis. While most property types experienced a similar drop-off in activity, investments in industrial real estate held up slightly better, falling by 55% on a year-over-year basis to $9 billion in the second quarter.

Looking out into the second half of the year, it’s likely that historically high occupancy rates in most U.S. real estate markets will provide a buffer by absorbing some lost demand before severe supply-and-demand imbalances can materialize. The long-term nature of commercial leases may act as a property income shield against short- to medium-term market fluctuations. Multifamily and industrial may benefit from exceptionally strong property fundamentals and solid long-term demand drivers, while retail, hotel, and some segments of the office market could see a more pronounced impact.

While there is no doubt real estate will continue to be affected by the pandemic, investing in this space remains a compelling proposition given the low interest-rate environment.

In the second quarter of 2020, office real estate was significantly affected by COVID-19 as the limitations imposed by social distancing and an uncertain economy depressed leasing activities and saw national office net absorption fall to negative 11 million square feet (SF). While construction activity was also delayed due to mandated work restrictions, developers still managed to complete 8 million SF of net new office space. This together saw average national vacancies rise by 20 basis points (bps) on a quarter-over-quarter basis to 10.1%.

Despite muted leasing volumes and rising vacancies, office asking rents held up, registering positive year-over-year growth of 1.5% in Q2. Overall, office rents may experience some pressure throughout the rest of the year, but the impacts are likely to vary by building class. The current greater emphasis on employee health and well-being may translate into increased interest in high-quality, well-located assets. As a result, rents and occupancy levels for these assets may experience more resiliency than the rest of the market.

On the supply side, construction activity has been trending upward over the past three years and is currently at 161 million SF, equivalent to 2.0% of the total office inventory. New projects are concentrated in tech hubs – Austin, San Jose, San Francisco and Seattle—which are better positioned to return to the upswing and absorb new supply once the economy starts to reenergize. The ongoing ban on some construction, as well as logistics impediments, will inevitably push completion dates further out, which may have the benefit of reducing the impact of new supply coming on the market.

As a result of COVID-19, office demand fundamentals will be tested. The widespread work-from-home experiment prompted by the pandemic could prove that many employees can continue to work from home and be productive. While we do envision that employers will be more flexible around the employee workplace arrangements, we feel that priorities such as preserving a firm-wide culture and maintaining collaborative/creative functions will depend on having employees under one roof. The right office space can help attract talent, establish credibility, and provide prestige. De-densification of office space and increased provision for social areas and larger collaboratives spaces can help offset some of the negative impacts associated with COVID-19.

While it’s uncertain whether demand for office space will be substantially affected, we do expect demand-based structural changes will take place. For example, the desire for a shorter commute and economic constraints could result in a revival of demand for office space in suburban markets. 

Industrial real estate has shown great resilience during this downturn, with demand for space and leasing activity advancing. However, with near-record-high development activity, market vacancies have also continued to rise. This was the seventh consecutive quarter when supply outpaced demand with Q2 net absorption of 26 million SF, and net completions of 66 million SF, resulting in average national vacancies rising by 20bps to 5.5%.

Construction activities remain elevated at near historic highs. At the end of Q2 there was 305 million SF of industrial space under construction, equivalent to 1.8% of the total market. Supply is concentrated in a handful of national and regional distribution centers, with the top five markets accounting for a third of all construction.

Even with elevated construction activity, the industrial market has experienced supply constraints over the past few years. As a result, this market has seen exceptionally low vacancy rates and rapid rental rate growth. While industrial rent growth slowed in Q2 2020, it maintained a relatively healthy growth rate of 3.9% on year-over-year basis.

The bright spot in this market is the pace of leasing, especially given the constraining effects of social distancing. As consumer demand and the flow of goods gradually resumes through the rest of the year, we expect to see businesses show greater confidence in lease commitments, and therefore an improvement in space absorption.

The steady build-out of retail distribution networks and e-commerce fulfillment platforms has helped bolster demand for industrial spaces from both existing and new tenants. Large-bay, high clear height warehouse spaces and smaller, lower clear height facilities near urban areas, which can serve as last-mile delivery facilities, are especially benefiting from e-commerce-related demand.

Going forward, industrial real estate may experience an increase in demand driven by structural changes in manufacturing and supply chains. For example, with COVID-19 challenging global trade and supply chain networks, businesses are likely to pay more attention to local manufacturing and the build-up of inventories in local markets rather than outsourcing and importing from abroad. These changes could result in net positive demand drivers for industrial real estate in the long term.

While demand for multifamily tends to be less cyclical than for other property types, sizable job losses and social distancing measures are sure to put a check on leasing activity in the short term. In Q2 2020, the multifamily market experienced a net addition of 92,000 units, while demand was at 56,000 units. As a result, the average vacancy rate rose, for the third consecutive quarter, by 20bps on a quarter-over-quarter basis to 6.9%.

Construction activity in this sector remains near historic highs. As of Q2, there were 621,000 units under construction, equivalent to 3.6% of current stock.

In Q2, rents for multifamily generally held in despite rising vacancies with annual rental rate growth at 0.2%. Average figures can be deceptive, however, as they mask variations across product types. For example, expensive high-end urban-core products encumbered with less favorable supply and demand conditions are experiencing rent pressure, while cheaper suburban products are showing greater rent stability.

On the demand side, economic constraints combined with an increase in workplace flexibility may shift some demand away from expensive high-end urban-core products to suburban products that offer larger units at a more affordable price point. These high-priced urban products are also facing increased competition from new supply hitting the market, which may further put pressure on occupancy and rent growth in this segment.

Overall, the outlook for multifamily remains favorable. The federal government’s relief package includes direct payments to low-income households, which should help cushion the impact on rental income. Multifamily rentals also benefit from several secular demand drivers that can help reduce occupancy volatility: an overall shortage of housing options, homeownership affordability challenges, and demographic trends such as an increase in both the median age of marriage and the number of single-person households.

1 U.S. Bureau of Labor Statistics, as of July 17, 2020. 2 Institute for Supply Management, as of July 2020. 3 Moody’s Analytics, as of June 2020. 4 All market fundamental statistics, including vacancy, absorption, completion, under-construction, and rent growth sourced from CoStar, as of Q1 2020. All capital market statistics, including transaction volumes, cap rates, and price index sourced from Real Capital Analytics, as of Q2 2020. 5 Real Capital Analytics preliminary data, as of July 15, 2020. 6 Main property types include: office, industrial, retail, and apartment. Transaction volumes for development land and hotel and senior housing are not included in the data.