COVID is Not a Commercial Real Estate Crisis...Yet
As I’ve been thinking about the economic disaster that COVID has spawned, and its implications for commercial real estate, my thoughts keep returning to my mother.
She is 80-plus, thankfully in good health and lives in Jacksonville, Florida. As of February, she was not a citizen of the online world: she read print newspapers, watched broadcast television (no streaming or on demand), shopped exclusively in physical stores, and banked in person at her local BofA branch. In two months, she has been forced - like everyone else - to learn how to stream Netflix, order on Amazon and Instacart, and do her banking online. She still has a lot to learn (by mistake she watched and enjoyed “Love Is Blind,” but for some reason refuses to watch “Tiger King”), but she has pulled off an amazing transformation in almost no time for someone who had previously proved herself to be among the most resistant to change.
What does my mom’s COVID experience have to do with commercial real estate? Bear with me for a minute.
I have lived through (and often had a seat at the table for) a slew of economic crises in which real estate was generally the culprit: the Savings & Loan debacle of the 1980s; the California-centered real estate slump of the early 1990s; and the 2008 Global Financial Crisis. The correlation between real estate and financial shocks makes sense. The government and the capital markets allow very high leverage on real estate based on the assumption that it is a stable and secure asset class. When real estate values drop, that leverage converts any material dip into a rout. Commercial real estate also accounts for about 20% of the US economy, so what starts as a spark in real estate often lights the rest of the economy on fire. If real estate was the culprit in past crises, other parts of the economy - manufacturing, jobs, trade, etc. - were its victims.
Now comes COVID and its economic fallout. This time, real estate is clearly not to blame. But don’t breathe a sigh of relief quite yet. Since the late 1990s, our economy has been adapting to generational trends driven primarily by technology. Legacy ways of operating have been gradually ceding share to online-enabled alternatives: brick and mortar retail to online merchants; branch banking to online banking and apps; and traditional “one person/one desk” office configurations to remote working, video conferencing, and hoteling/shared space arrangements. Pre-COVID, inertia worked powerfully to maintain attractive opportunities for traditional physical commerce channels. Pressure on legacy ways of doing business has been growing, but slowly, as people like my mom stayed with what they knew well.
For example, it took 40 years for ATMs to reach full adoption. Even now, despite the ubiquity of ATMs and online apps, branch banking has proven surprisingly resilient. In the past decade, the number of banks fell by one-third but the number of bank branches fell only about 6%. One can see similar stories of long-term and inevitable trends moving surprisingly slowly in retail and office space.
If you have been benefiting from this inertia - for instance, if you own or finance related commercial real estate - your business model implicitly relies on the assumption that the transition from brick and mortar to online will continue to be slow and gradual. If this shift were to accelerate materially, demand for the space required to work, shop, or bank in person would drop rapidly as would rents and values.
Crises have a way of accelerating change. The acceleration of the shift toward digital and away from traditional print media in the wake of 9/11 is a good illustration. The Great Recession offered another acceleration when the steep decline in advertising pushed many legacy print media companies over the edge. COVID appears poised to have similar fundamental and transformative accelerating effects.
And now we return to my mother. She may not be a natural at online banking, Amazon, or Netflix, but she figured out how to use them - and does. Before COVID, my siblings and I had been trying and failing for decades to get her to take advantage of what the online world had to offer. COVID pulled that off, albeit imperfectly, in a few weeks.
What’s key here is that my mom’s crisis-driven imperative to learn to live and transact remotely has important parallels with some of the most sophisticated firms in corporate America. In a Bloomberg TV interview on April 16, Morgan Stanley’s CEO James Gorman remarked: “Clearly, we have figured out how to operate with much less real estate. Can I see a future where part of every week, certainly part of every month, for a lot of our employees will be at home? Absolutely.” Larry Fink, CEO of BlackRock, said much the same on April 26. And a recent Gartner survey shows that 74% of CFOs expect to move a material chunk of their on-site workforce to working from home permanently after the pandemic is over as a cost saving measure.
When my mother and some of the most sophisticated leaders in financial services have something in common, something important is afoot. For key sectors in commercial real estate - office, retail and bank branches at minimum - COVID seems likely to accelerate pre-existing trends, probably brushing aside years of inertia. That is bad news for investors in and lenders to these commercial real estate sectors. Anyone who benefits from “business as usual” in commercial real estate will need to think critically about how to adapt – and fast!