All Forum Posts by: Tom De Napoli

Hi Casey,

First off, I hope you are staying well and safe in Tokyo.  My wife and I visited Japan for the first time last September and fell in love with the country and your city.

Your question is timely as I'm in the process of writing an article for my investors about the near-term impact of COVID-19 in multifamily assets and the long-term outlook.  Here are a few data points I am referring to from a 2019 CBRE research report on the resilience of the multifamily asset class during recessions:

• U.S. multifamily property rents declined less than those of office and industrial properties during the 2001 economic recession and their growth rate was considerably higher post-recession.
• During the 2008-2009 recession, multifamily rents were more resilient than those of office, industrial and retail.
• Multifamily rents have outperformed those of the other major property sectors during and after the 2008-2009 recession in three ways. The sector experienced the lowest level of rent decline, the fastest recovery to pre-recession peaks and the longest post-recession period of rent growth.

The short answer to your question is that it's too soon to tell. 

Real estate, unlike stocks, does not reprice constantly, so we can’t see what’s happening with pricing for buildings yet. Deals take many months to source and close.  For this reason, we don’t yet have data from the private real estate market on how pricing has changed.  It's probably going to take several months to gather and analyze that data.

In the meantime, we're looking at apartment REITS to gauge how investors are pricing real estate assets on public markets in real time to provide insight into how property values may change in coming months.  The REITS are far off their highs, and may continue trending downward when the next set of unemployment numbers are released this Thursday, the day before May rents are due across America. 

The other indicator we've been tracking are the jobless claims I referred to and, which as you've probably read, continue climbing to alarmingly high rates. as the most sudden deterioration in labor markets in U.S. history continues.

The impact on renters will vary between buildings and sub-markets.  Apartments rented by tenants with jobs that allow them to telecommute to work at companies that have not been as severely impacted will continue paying rent.  With many of the layoffs taking place in hospitality, tourism, and restaurants, we will see a more acute impact tenants’ ability to pay rent, particularly in Class C apartments, often termed as workforce housing, and in areas of the country where  the employment base is more heavily skewed toward hospitality and tourism

However, we think that multifamily is resilient enough that in spite of this historic downturn, it will still take some time before multifamily operations are impacted to a level that causes owners to exit voluntarily or under distressed scenarios. The question is, which investors will have the capital and credit lines available to buy when those opportunities arise.

It's 7pm and I just leaned out the window of my Brooklyn apartment to cheer for front line heroes in my city's and the world's fight against the COVID-19 Crisis.  This is a new routine I could not have imagined just one month ago. 

The impacts of the novel Coronavirus on so many aspects of our society have been sudden and profound.  A few weeks ago my partner put some thoughts down on it's implications for real estate investors like ourselves across these categories:

• Retail
• Hotel & Hospitality
• Multifamily
• Office
• Warehouse

I wanted to share it with the Bigger Pockets community:

By now every American is aware of the unprecedented public health emergency and economic disruption caused by COVID-19. While we remain in the early stages of both the pandemic and the likely severe recession that will result, we can begin to assess the impact on commercial real estate as we position ourselves to capitalize on potential opportunities. Before doing so, I want to first express my gratitude to those on the frontlines fighting the pandemic and helping the sick. Thank you. I also wish well all those who are affected by the virus either directly or economically. My thoughts are with you. Our primary concerns should be with those who are helping and those who are affected. I work from the comfort of my home, writing about a topic that is clearly secondary. My purpose in writing this is to begin to organize my own thoughts and research in attempt to begin for formulate a plan for future acquisitions. As a real estate investor during these times, it is hard to both react to the problems within one’s existing portfolio and simultaneously begin looking for new opportunities. These two things can feel contradictory. The problems at properties we own are real and immediate, while the potential opportunity in theoretical. I try to compartmentalize the two and not let one affect the other. So what is happening out there and what should a real estate investor do?

Real estate, unlike stocks, does not reprice constantly, so we can’t yet see what is happening with pricing for buildings yet. Deals take many months to source and close; those that close today were deals consummated prior to COVID-19. For this reason, we don’t yet have data from the private real estate market on how pricing has changed. Every broker and investor is trying to figure it out.

We have begun to see the disruption in property operations, though, and this will eventually impact pricing. For example, many retailers are closed and asking for rent relief, hotel revenue has cratered, showings are down for vacancies, and office buildings are empty as workers attempt to work from home. If these impacts are short-lived, pricing may not change much, but if many stores never reopen, renters lose their jobs and can’t pay their rent, and companies that occupy office and warehouse properties begin to go bankrupt as revenues fall, we can expect significant re-pricing for the affected real estate. For now, we can continue to monitor these initial impacts and we can look to the public markets pricing of Real Estate Investment Trusts (REITS) to begin to understand how investors are pricing the underlying real estate assets.

To translate a REIT share price to the value of the underlying real estate, I calculate the market cap and add it to the long-term liabilities, which provides the current cost basis of the underlying real estate portfolio. We then take the REITs representation of Net Operating Income from its 2019 annual report and divide it by the current cost basis to arrive at the current market cap rate for the real estate. We can then compare the current implied cap rate for the REIT's assets with its recent high to see the change in how the public markets are valuing the real estate. This can provide some insight into how real estate values may change.

Retail

With about three-fourths of Americans in some form of stay-home order, tens of thousands of retail establishments are closed. As of March 23, over 47,000 chain stores in the U.S. had temporarily closed. In addition, thousands of independent retailers have also closed by choice or state mandate. Many of these retailers are asking for rent relief or are simply not going to pay rent in April. Some may never reopen. Retail landlords can likely endure a short-term reduction in rent, but longer-term fundamentals may be impacted by retailers going bankrupt.

Based on my analysis of the change in valuation for Realty Income Corporation, a REIT focused on triple-net retail properties, the value for these properties, long perceived as safe, has fallen by 28%. Retail Opportunity Investment Corp, an owner of grocery-anchored centers on the west coast, is down 33%. Clearly the public markets are pricing in a severe disruption to retail real estate.

Hotel

Without long-term leases, hotels must re-rent their space each day, so any change in performance is realized immediately. According to a March 26 webinar from STR, a hotel data company, for the week ending March 21, revenue per available room (RevPAR) was down 69.5%, the third week in a row of double digit declines and the largest ever in 30 years of data. Corporate demand for meetings is now down to zero and U.S. occupancy is down from 65% to 30%. China's occupancy fell to 10% during its lock down. As a result of this decline in performance hotel franchisors Marriott and Hilton are down 47% and 39% respectively as of March 27. With this level of revenue deterioration, hotels are going to face distress much faster than other types of real estate. Values for hotels seem the most uncertain.

Multifamily

Jobless claims for the week ending March 21 hit a staggering 3.28 million, more than four times the previous weekly high. Some experts project unemployment to reach 20%. With many of the laid off workers coming from shuttered businesses, such as hospitality, tourism, and restaurants, these layoffs may begin to impact renters’ ability to pay rent, particularly in Class C apartments, often termed as workforce housing, and in areas of the country where the employment base is more heavily skewed toward hospitality and tourism. With Congress set to pass a $2 trillion stimulus package that includes increased incentives to keep workers on the payroll and an additional $600 in weekly unemployment benefits from the federal government, these effects could be somewhat ameliorated, but only for a short period of time. If the retailers, hotels, and other employers don’t re-open and quickly ramp up to their former revenue level, many jobs may be permanently lost, which will in-turn impact apartments.

While this is the most sudden deterioration in labor markets in U.S. history, it will still take some time before multifamily operations are impacted to a level that causes owners to exit voluntarily or under distressed scenarios. The extent of this pain will determine the ultimate impact on pricing. Equity Residential, one of the best-known apartment REITs, has seen the value of its real estate decline by about 24% based on my analysis of its current stock price.

Office

Like multifamily, the impact on office properties will be determined by the ultimate level of economic impact resulting from COVID-19. Many office workers are now working from home, which should allow companies to limit the short-term, direct effects of the pandemic. As the impact to the economy works its way through the system, though, office demand is likely to wane as companies are forced to cut costs as business activity declines. This will eventually result in some companies failing to pay rent and impact property revenue. As this plays out some property owners may elect to sell or will be forced to sell, dragging down prices.

Franklin Street Properties, an office REIT focused on properties in the Sun Belt and Mountain West, has seen its underlying real estate decline by 20%, according to my analysis. The market appears to be more confident in future of office properties than retail and hotel. But office carries the risk of a faster shift towards work from home as more companies have been forced to adapt to this during the stay-at-home orders.

Warehouse

Warehouse appears to be best positioned to weather a recession as vacancy rates are low and demand for logistics and e-commerce has been strong. With more people forced to stay home, e-commerce companies, such as Amazon, are increasing their hiring and look poised to increase their market share. But as overall demand in the economy goes down and consumer spending declines, companies operating warehouses are going to declining sales. Some companies will be well-positioned but others will be unable to pay rent, impacting operations and eventually property pricing. Even ProLogis, a class-A warehouse REIT, has seen its implied real estate values decline by 19% as the public markets anticipate impacts on warehouse properties, according to my analysis.

Conclusion

With property operations quickly deteriorating at retail and hotel properties and future reductions in occupancy and rental revenue likely for multifamily, office, and warehouse, it is not surprising that the public markets have devalued real estate by 20-30% depending on the asset class and location. Real estate investors must be careful as they move through this uncertain environment. Sellers are likely to continue to insist on pre-COVID pricing until they are motivated by or forced by deteriorating operating income. As a result, some firms have put new acquisitions on hold as they wait for the impacts to be reflected in pricing. Every person who is interested in investing in real estate should see this as a time of caution, but one that should eventually give way to opportunity, just as was the case in the Great Recession over ten years ago. The investors that are active coming out of the recession will be those positioned to provide market leading returns.

Bigger Pockets Community,

Before the COVID-19 crisis, my investing partner and I were analyzing deals for neighborhood strip centers in our home region.  What a difference a month (or three) makes.  Over the past several weeks, I've been doing a lot of research and analysis of how the crisis may create new opportunities (and amplify existing threats) for several retail categories as well as for retail real estate investors.  I wanted to share the results of the deep dive with whoever might be interested in neighborhood retail or macro-trends.  I hope you find it useful.

Retail Real Estate and the COVID-19 Crisis

Retail has developed a serious image problem in the past decade-- one that will be further complicated by the shock to the economy and consumer behavior caused by COVID-19. Over the ten plus years between the Global Financial Crisis and the current health crisis, Retail underwent a radical transformation driven by the growth of e-commerce and many companies failed to evolve and took on too much debt, resulting in numerous bankruptcies and thousands of store closures. During this period there have been over 35,000 news stories written about the “retail apocalypse.” Coverage has been narrowly focused on a limited number of chains that were heavily concentrated across a few segments that were most vulnerable to disruption, such as apparel, consumer electronics and department stores. The poster children for this are the department store anchor and the dying mall. As a result, the perception is often that retail is broadly in decline and that our future lies with e-commerce and its network of warehouses and trucks. This of course is an oversimplification and real estate investors would be well served by appreciating the nuances within retail that will determine the winning and losing concepts and locations during the next ten years, and specifically in the aftermath of the COVID-19 recession we have just entered.

The Evolution of Retail

Rather than showing absolute decline, the numbers tell a story about retail evolution. Consumer spending accounts for more than two-thirds of U.S. economic activity, with retail purchases making up approximately 25% of the average American’s annual spending, according to the Bureau of Labor Statistics. Retail sales have been growing by almost four percent annually since 2010, with over five times as many companies opening stores as closing them. Last year, a steady increase in consumer spending, bolstered by record low unemployment helped to sustain GDP growth even as business spending declined across the second (1%), third (3%) and fourth (2%) quarters. Through the last quarter of 2019 and start of 2020, the pace of retail spending was showing signs of slowing but continued to grow steadily. IHL Group, a company focused on research in retail and hospitality, projected strong growth in quick service restaurants, steady growth for restaurants/bars, grocery stores, drugstores, and superstores, such as Wal Mart and Target. IHL forecast a continued decline for department stores and specialty softgoods which includes retail apparel. Prior to the impacts from COVID-19 retail was continuing its recent trends with apparent winners and losers.

Any conversation about retail sales must also acknowledge the effect of e-commerce, which has been growing rapidly over the past decade, and makes up a significant share of overall retail sales growth. The rise of e-commerce has been enabled by an increasingly frictionless customer experience through the sales funnel from awareness to purchase in just a few clicks. E-commerce has also been bolstered by offering free-shipping and easy returns. External factors, such as low oil prices and a flood of cheap financing from venture capital and the public markets, have allowed some e-commerce companies to focus on driving exponential growth and capturing market share over profits. This has put acute pressure on the most vulnerable physical retailers, but many have continued to thrive. While e-commerce has been growing quickly and increasing its share of retail spending, Americans finished the decade making 84% of their purchases in retail store locations with the total dollars spent in-store increasing by over 26%, from $2.4 Trillion to $3.2 Trillion, over the past 10 years.

As retail has changed, the distinction between a purchase made through the internet and a physical location has been blurred. Many traditional retailers have invested heavily in online infrastructure, allowing purchasers to do research online, shop, and pay, and then pick up their item in the store. Best Buy and Home Depot are two prime examples of this. Restaurants and grocery stores have internet purchasing infrastructure that drives delivery or pick-up from their retail locations. Amazon purchased Whole Foods and is looking to get into convenience retail. It is also investing heavily in using technology to reduce human interaction and labor costs within physical stores. This all suggests an evolution, not an absolute decline of retail locations and a complete move to internet driven transactions with deliveries coming from warehouses.

An Opportunity for Investors

While many investors have decided the evolving retail landscape is too risky and perhaps have been scared off by the overwhelming negative sentiment driven by the failing concepts and asset-types, such as enclosed malls, opportunities within retail remain, provided investors are willing to move past the headlines and perform the necessary due diligence that is required for any real estate acquisition: carefully analyzing the type of property, the tenants and the location characteristics. For investors who are willing there is an opportunity to find value in specific retail assets where net operating income is primarily driven by grocery, restaurant, convenience, fitness, services, and experiences--the most e-commerce resistant uses. These locations should be in dense trade areas with solid demographics. The long-trip to the mall or the outlet center might be going away, but people still enjoy getting out of the house and will continue to frequent these types of establishments within their communities.

We can see the potential opportunity in retail when looking at the cap rates (the relationship between the income the asset produces and its price) investors are paying for the assets. A higher cap rate indicates investors are anticipating more risk and slower growth, while a lower cap rate shows strong investor demand for an asset type and the expectation for future growth and lower risk. For example, prior to the impacts of COVID-19 cap rates for grocery-anchored neighborhood retail in top markets were between 5.50% for class A (the best) and 7.00% for class B (older, no longer the best assets), compared to 4.5% for Apartments and Industrial, which is primarily driven by the demand for e-commerce warehouse space. Apartments and Industrial were priced for perfection, with investors betting heavily on limited downside and continued rent growth. The spread in yields between these property types and retail is not totally unreasonable, but the best positioned retail assets appeared under-priced relative to other asset types due to indiscriminate negative sentiment.

Retail and the COVID-19 Recession: Permanent Changes and Severe Temporary Impacts

Retail’s slow start to the year turned into a sudden free fall as governments around the country and the world issued stay-at-home directives and ordered non-essential businesses closed to hasten the rampant spread of the virus. By the time 30 states had announced closures across the U.S. on March 30th, the S&P 500 had declined by almost 24% from a record high five weeks earlier, and SPDR S&P Retail Index ETF, which includes companies like Rite Aid, Kroger, and Dollar General, dropped by over 35% during that same period.

The crisis is having a dramatic impact on the public market pricing of retail real estate. For example, Retail Opportunity Investment Corporation (ROIC), which is a REIT composed of necessity-based neighborhood shopping centers, anchored by national or regional supermarkets and drug stores located in densely populated areas with strong income fundamentals across growth markets in the western U.S, has dropped by over 46% since the start of the year - down almost 20 percentage points more than the SPDR Retail Index ETF.

The value of retail real estate assets is largely dependent on the health of its tenants. Nearly all retailers are taking a direct hit, with stores in many parts of the country already closed, or operating under drastically different circumstances, for two weeks or longer. Many retail stores and services are seeing a sharp decline in demand or are totally closed, while others are adapting customer experiences and distribution channels to conform to new norms around social distancing, and a few are capitalizing on emergent needs, such as for consumer staples like packaged food, household cleaners, medication and home office supplies. While these changes are severe, many are temporary. Investors must separate these impacts and evaluate various types of retail differently.

Grocery, Drug Stores, Supercenters and Discount Stores:

Retailers in these categories have been outperforming initial forecasts for 2020 due to a surge in sales on par with the holiday season as customers flocked in store to stock up on essentials. These stores have been deemed essential services which will allow them to remain open and continue operations throughout the shutdown. Shopping centers anchored by these types of retailers should be well-positioned to weather the economic downturn. These retailers are not at risk of disappearing during the recession.

Department Stores and Retail Apparel:

Several retailers in these categories have already been in a prolonged state of decline for over a decade, but the shock of forced closures and lack of consumer demand will be the final straw that accelerates the demise for many. Malls and lifestyle centers anchored by these types of tenants will face dual challenges of a sudden loss of rent revenue, as many stores have already defaulted on April payments, and accelerated closures and bankruptcies combined with the costs associated with repositioning and leasing the large spaces they once occupied. Any asset where these tenants comprised a significant portion of income or where responsible for driving foot traffic is at high risk of becoming distressed during this recession.

Quick Service, Fast Casual, Bars/Restaurants & Fitness:

Service-based retailers that rely on face-to-face interaction with customers and social gatherings started the year strong and were forecast to outpace other retail categories in growth. These businesses are extremely vulnerable to forced closures and will likely be the first expenses consumers cut back during a recession. Quick service restaurants, which were projected to grow by over 7% in 2020, are now expected to decline by -5%. Shares in Planet Fitness, the largest gym operator in the U.S., fell more than 70% last month. This will certainly cause near-term financial strain for the operators of these mainly franchise-owned service businesses and their landlords. However, dining out and fitness are often the first categories to snap back in an economic recovery as people prioritize convenience, wellness and simple indulgences again. The locations that can survive the temporary closures will likely see steady growth as we begin to emerge from the social distancing restrictions and the recession. Investors can proceed with caution in the short-term but this may become an opportunity to acquire assets that will recover sales quickly and are likely to emerge as winners during the longer-term retail evolution.

E-commerce:

Although this constitutes a sales and distribution channel and not a specific category, the rise of online shopping and food delivery exerts a tremendous influence on brick-and-mortar retail and service businesses. Images of grocery stores running out of essential items circulating on social media, mandated restaurant closures and government issued stay-at-home orders, have all been significant recent drivers of online shopping. Last week, eMarketer cited a CivicScience poll of US adults and their digital grocery shopping habits, the percentage of those who said that they increased their online grocery shopping jumped from 11% to 37% in the first 3 weeks of March.

Brick-and-mortar retailers that previously invested in e-commerce fulfillment channels are best-positioned to capitalize on accelerated shifts in purchasing behaviors and emerge even stronger from the situation. According to a recent report from IHL Group, the traditional retailers across grocery, drug stores and supercenters that were growing their businesses by 10% or more prior to COVID-19, were many times more likely to have invested in offering the following customers journeys to make their physical locations complimentary to e-commerce:

Click & Collect: 13x

Buy Online, Return in Store: 1.6x

Ship to Store for Pickup: 1.3x

Ship from Store: 1.6x

Similarly, the Wall Street Journal reported that restaurants are seeing a surge in online ordering via platforms like DoorDash, Uber Eats, Grubhub and Postmates. Americans more than doubled their spending on restaurant delivery between February and March. However, many of these services offer unfavorable terms, such as 30% pre-tax commission and forced discounts to lure customers, that cut into food service business owners’ already low operating margins, as reported by TechCrunch. Although these services are an economic lifeline in the short-term, their unit economics are an unsustainable model for restaurants to rely upon over the long-term.

Conclusion

The effects of COVID-19 on public health, the economy and as a result retail real estate remains a fluid situation which I will continue to monitor in the weeks and months to come. In the meantime, my takeaways thus far are:

• Public market values of retail real estate with otherwise strong fundamentals have dropped dramatically which may imply a coming drop in private market pricing and open opportunity for investors to find value.
• Different sectors of retail, and therefore different categories of tenants, are experiencing the crisis across a broad spectrum. Neighborhood retail anchor tenants, like grocery and drugstore chains, appear to be thriving. Experiential services that provide people with a compelling reason to leave their homes, like restaurants and gyms, are suffering but poised for a comeback during a recovery. Categories that were already in decline like department stores may not recover.
• E-commerce is picking up the slack for some retail where store shelves are stripped due to hoarding, and is fulfilling a necessity for shipping goods to people who cannot leave their homes. Brick-and-mortar store and restaurant locations are proving to be a key component of last mile delivery, indicating a future where e-commerce compliments but does not close physical retail.

Finally, a note on human nature. There is a lot of speculation going around about how our behaviors may change as a result of the global health crisis - that we will become an anxious, homebound society which favors working remotely, homeschooling its children and ordering everything online. While that may be the case for some aspects, such as more flexibility to work from home or increased adoption of online learning, for many they just want to get back out there. Many people may now have a greater appreciation for their water cooler conversations at the office, the trip to the grocery store to hand-pick their meats and produce, a haircut at a barbershop, a workout at a gym, or a meal with their family in a restaurant. The social distancing rules have shown the need for human interaction in physical spaces and the limitations of ordering everything online and largely staying at home.

Google Trends: Web Searches for Cabin Fever (YTD)

As all of us in the Bigger Pockets community know, rent is due today for millions of businesses and ordinary people, across America.  My partner and I are commercial real estate investors with multifamily properties in Denver and are active in other markets.  We've been closely studying how coronavirus is impacting several sectors of the economy, including retail, hospitality and housing.  We plan to share what we learn in the weeks and months ahead as a resource to fellow investors.

Here's a link to our first article, A Perspective on What's Next for Real Estate Investors, which provides a broad overview of how the COVID-19 pandemic and likely recession will impact real estate and what investors should do.

Stay well,

Tom

@James Carlson

Thanks for the reply.  My partner and I are big believers in the continued, sustained growth of the Denver metro area. We started syndicating multifamily deals in Lakewood in 2015 and have similarly cast our search into first and second ring suburbs around the region.

Have a great weekend and get in some runs at A-Basin for me!

@Justin Gottuso

Thanks for the reply and congrats on your pending move to Columbus, which is beginning heavily featured on many superlative lists of places for millennials to live.  My full-time job is in media and I have several LA-based colleagues facing the same issues about housing costs as you.  I’m also married to a mid-westerner and keep an eye on prices in her hometown.

Full disclosure, my partner and I have expanded our investment focus from Denver multifamily to New Jersey suburban neighborhood retail precisely because we see demand in transforming many aspects of suburban life, including retail, for the millennial migration that’s underway.  Research and data show that the housing stock in the suburbs is old and in short supply, but it really becomes apparent when we drive those markets.  I have not yet seen a lot of new development, but based on calls to local contractors to survey them about their availability, and the growth in share prices of stocks for home improvement stores like Home Depot, we’re definitely seeing a trend towards fixing up existing inventory on those markets that will probably last until new building starts — again, that’s specific to the submarkets we are focused on.

@Maurice Smith

As a citizen:

• Practice good hand hygiene
• Stock up on a two-week supply of water and non-perishable food
• Stay home from work if you have signs and symptoms
• Be a good neighbor by checking in on elderly or vulnerable people in your community

As an investor:

• Resist the urge to panic sell (or panic buy)
• Understand that over time the market rises and falls, but it inevitably rises again — assume you can’t time either 
• Assume that some financial media sites and bizfluencers are incentivized to post headlines that appeal to the irrational part of your brain - try not to rise to the (click)bait

Mainly, keep calm and carry on...and wash your hands