Did You Know – March 2020

The cumulative risk of the travel bans, school and university closings, the closing or adjusted of hours to stores, restaurants and pubs, canceling of court trials and religious services, and postponing of all sports games and social events, could lead us into a negative feedback loop. A negative feedback loop is a reaction that causes a decrease in function. This loop, like in 2008, starts with a drop off of economic activity caused by the above closures, then spurs job losses and the potential for an increase of distressed properties/loans. This then leads to price declines and the potential for an increase in loan defaults, which in turn leads to bank losses and credit contraction before the loop starts over and continues. Being caught in this negative feedback loop like in 2008 would put us in a recession.

Many consider the U.S. to be in a recession, measured by two quarters of consistent economic downturn. ULCA economists have forecasted U.S. GDP growth in the first quarter of just 0.4%. They forecast second quarter GDP to decline by 6.5%, and by 1.9% in the third quarter. “With the assumption of an end to the pandemic and repaired supply chains by this summer, the forecast predicts the resumption of normal activity in the fourth quarter of 2020 and a GDP growth rate of 4.0%,” UCLA officials said in their report.

A recession is typically caused by excesses in the system (i.e., overbuilding, too much debt, etc.). Hopefully, this is a short-term medical pandemic; unfortunately, without containment of the virus, there will be job losses and other economic pains. In addition, with the economy in flux and stock prices down across the board, it seems likely that the U.S. commercial real estate property markets will hit a soft spot. Clearly, we will experience a short-term economic downturn.

Following the erratic stock market pricing in March as COVID-19 spreads, REITs have performed worse than the S&P. If we correlate the performance of REITs and their drop in share prices as an indication of lower commercial real estate property values, then we are down 20 to 35 percent from at least three weeks ago. Obviously, REITs focused on gaming and lodging having taken the largest hits, whereas REITs focused on the office, apartments, and industrial sectors being on the lower end of the range. Of course, given panicked wholesale selloffs, these signals need to be taken with a grain of sale. Nonetheless, given where we are in the latter portion of the cycle, real estate pricing likely will moderate and come down, varying by property types.

All of this volatility has highlighted the attractiveness of investing in hard assets like commercial real estate, especially secure triple net leased properties, to high credit tenants. But larger assets like hotel/resorts and malls are likely to be impacted by the virus due to increases in cleaning costs and a drop off in patrons and/or tenants. In addition, offices could be negatively impacted if rent payments get delayed; tenants will cut their space needs, or close their businesses entirely.

The good news? It is possible to adapt and overcome. It is doubtful that we will enter a negative feedback loop as described. This is hopefully a short-term biological pandemic and things are not destroyed. There is not a bubble with excesses to clean up or work through. Things have been halted, but provided there is a quick containment of the virus then all the financial economic stimulus will act as a crutch for the financial markets. The outlook is for lower gas prices, low interest rates, pent-up consumer demand, and positive economic growth buoyed by the huge stimulus by yearend 2020.

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