As coronavirus spreads, pain goes beyond hospitality and travel
All real estate sectors watch the human and economic toll mount
INSIGHT ARTICLE |
As the human and economic toll of the coronavirus mounts, the real estate industry in North America is wondering where it can safely place its bets. The hospitality industry has taken the brunt of the hit so far, but other sectors of the economy have been nervously watching as the events unfold.
After the World Health Organization cautioned against nonessential travel to China on January 30, declaring the outbreak a public health emergency, travel demand was disrupted practically overnight. Travel insurance companies aren’t underwriting risks related to the coronavirus, and major airlines have reduced capacity and suspended routes to and from mainland China, in addition to largely suspending travel from Europe to the United States. Hoteliers like Hyatt, Marriott and IHG have waived cancellation fees within mainland China and other heavily hit countries.
The pain goes beyond canceled flights and hotel stays. The South by Southwest conference in Austin, Tex., was canceled, costing the area economy hundreds of millions of dollars in economic activity.
The Global Business Travel Association estimates the virus could cost the hospitality industry $46.6 billion per month.
The Global Business Travel Association estimates the virus could cost the hospitality industry $46.6 billion per month, which totals up to 37% of the hospitality’s total 2020 forecasted global spend. While it’s too soon to know the long-term impact of the outbreak, the disruption that has already taken place only highlights just how important not only the Chinese market has become for the global travel and hospitality industry, but it also points to the overall interconnectedness of our economy. While China took the brunt of its economic hit to hotel revenue per available room in February and March, with monthly decline reaching 90%, the majority of the impact in North America and the rest of the world is expected to be felt in March and April and estimated at 20% to 25%.
Chinese nationals comprise the largest tourist market in the world — a group that continues to grow. Quarantining a population to thwart the spread of the virus internationally may have come too late, especially to top international destinations. According to the U.S. National Travel and Tourism Office, 3 million Chinese tourists visited the U.S. in 2018, the third most of any country after England and Japan. Although that figure declined slightly last year amid geopolitical tensions, it has more than quadrupled since 2009.
Hotel companies like China Lodging Group and Marriott are intently focused on the growing Chinese market. By 2021, Marriott expects that 26% of its total hotel rooms will be in Asia. In its third-quarter earnings call, Marriott said that its Bonvoy membership increase of 12 million over the past nine months was predominantly driven by China, which accounted for 40% of that growth.
In the short term, those properties most affected by the virus outbreak are likely to be at the higher end of the market. Chinese travelers are staying in four- and five-star properties as they travel abroad and within the United States.
With leisure travel driving Chinese tourism, many will cancel plans as airports and properties amp up emergency readiness and Wuhan remains on lockdown. Domestically, conferences and meetings make up a substantial portion of revenues for hotels and the response of recent cancellations and delays in the U.S. market will result in a pervasive effect to operating results to large chains.
As contagion continues to evolve, investors exposed to the hospitality sector are reading the fine print in their business interruption insurance policies; in most policies, business interruption is triggered when the policyholder suffers direct physical damage to a property resulting in business interruption. Does an infectious disease that causes a property to shut down for potentially weeks at a time qualify? If traditional business interruption policies may not allow for coverage, insurers have come out with limited optional coverage for certain Covid-19 related losses as of February.
These policies would shield policy holders from losses in the event governmental agencies restricted access to properties, as with the case of large scale quarantines. An area the sector is already very aware of is the potential for claims against properties where individuals are sickened from exposure – policyholders in the sector would be judicious to review the scope of their insurance coverages for virus-related bodily injury.
- Downward pressure on average daily rate and occupancy
- Most severe impact to tourist cities dependent on travel and leisure markets, conventions and markets with significant community outbreak
- Increased use of video conferencing and alternatives for meetings
- Greater focus on insurance policies, business interruption, liability insurance and consideration of cancellation fees related to infectious disease.
- Review of debt agreements and potential impact to meeting financial covenants
- Properties with tight cash flows should stress test financial health
Other real estate sectors
Evidence is growing of a more significant slowdown in domestic and global growth; a recession would hurt broad-based demand for real estate. Preparing for a period of slowing growth, decelerating demand and easing pricing is appropriate for all investors in real estate.
In a spot of good news, the recovery after the Great Recession has not seen the overbuilding in the previous economic cycle. This discipline exhibited during the recovery will serve to thwart the severity of the next downturn relative to the last one. As investors seek refuge in real assets, traditionally more insulated than other sectors to a slowing economy, certain real estate sectors are better equipped to handle the headwind than others.
Even before the additional stress of a widespread virus, retail continues to experience an onslaught of closures, which, so far in 2020, have included household names like Pier 1, Bar Louie, Papyrus, and Bakers Square/Village Inn. Any social distancing or self-quarantines related to the outbreak will hurt retail as consumer spending at brick-and-mortar sites would undoubtedly suffer as consumers stay home.
Temporary closures of storefronts and restaurants will cause those already teetering on the brink of bankruptcy to fall into irreversible financial disrepair. The demand side of the equation isn’t the only concern – retailers heavily dependent on imports from China and other hard-hit locations will have difficulty keeping store shelves stocked, further complicating the equation.
Consumer spending at brick-and-mortar sites would undoubtedly suffer as consumers stay home.
As a result of these supply and demand shocks, landlords may experience financial stress with tenant rent delinquencies piling up and loan payments becoming more difficult to make. Given this backdrop, the emergency rate cut by the Federal Reserve won’t help retail investors stop seeing red and make good on loan payments they don’t have the cash flow for.
Conversely, what is retail’s loss has generally been e-commerce’s and industrial real estate’s gain. The outbreak of the virus will accelerate long-term trends to the heavier use of e-commerce. The risk for retailers is that those preferences may not shift back to traditional brick-and-mortar once the virus eases.
Industrial distribution facilities and related logistics providers could see higher demand as online ordering increases, but portfolios exposed to West Coast ports are already feeling the impact of the decline in imports from China.
- Uptick in e-commerce, supermarkets, grocery spend for food, drinks, sanitary supplies and daily necessities
- Downward pressure based on reduced foot traffic
- Discretionary spending hurt, especially in cosmetics, apparel and luxury goods
- Review of debt agreements
- Properties with tight cash flows should stress test financial health
- Further correction in the sector could occur, widening divide between performing and nonperforming retail assets;
- Potential increased speed of transition to e-commerce
- Greater adoptions of cloud-based gatherings in fitness, entertainment, banking and telehealth
Compared to other subsectors of real estate, the short-term impact for office landlords should be relatively muted. The leases are longer term in nature and less sensitive to the current volatility. Co-working operations are one section that will be at risk. Users will be much more inclined to complete their work from home.
While companies are limiting nonessential business travel, many top companies are also asking employees to work from home. While these policies on the surface may be aimed at helping curb the swift spread of the virus, they also serve as a way to test capabilities of computing networks in handling a broad-based work-from-home population if emergency protocols prove necessary.
A significant increase in employees working remotely will result in increased demand for data centers focused on supporting remote office technologies including teleconferencing and work-from-home technologies enabled by cloud computing.
Infrastructure focused investments, telecom towers and wireless infrastructure also stand to benefit. Investors with significant co-working exposure in their portfolios may be affected by a decline in short-term rentals as companies looking for flex space may forgo communal space.
Adding to the headwinds facing the office space sector are the continued increased density and shifting demographics as boomers age out of the workforce. In their place a much smaller population of millennials and Generation Z are showing up at work.
- Delay in capital outlays for significant leases
- Co-working could face decreased short term demand
- Increased pace of adoption for mobile workforce
- Increased density in office space
- Co-working stands to benefit from increased long-term demand
- Less demand for office as workforce stands to contract
Senior living and health care facilities are high-risk locations for the most vulnerable populations. An even greater risk to the senior living sector is the seasonal flu, which has resulted in lower occupancy in recent years. It is imperative that facilities provide emergency preparedness information to employees and work on tightening up standard operating procedures to control infections. Investments tied to such real estate needs to be concerned with making sure that protocols are in place to mitigate spread of disease to vulnerable populations.
- Sectors and brands tarnished based on outbreak at facilities
- Higher than expected turnover of units and longer lease up
- Heightened awareness of risks to aging populations
- Review general liability policies
- Adoption of technologies that allow seniors to remain at home
- Deceleration of senior living rents
Coronavirus fears have sent the 10-year U.S. Treasury rate into a free-fall, dropping from 1.92% to an unheard-of low of 0.32%. The 30-year fixed mortgage rates that are critical to funding home loans has followed, to an all-time low of 3.65%.
Even at a record low, the spread between the 30-year mortgage rate and 10-year U.S. Treasury rate is the widest it has been in a decade. As mortgage refinancings have skyrocketed, overwhelmed lenders have been reluctant to drop rates as low as the 10-year U.S. Treasury would suggest they could go, primarily because of concerns over capacity.
These low rates will provide a financial cushion to some current homeowners who are dreading reduced wages and layoffs, but it is unclear that new homebuyers will benefit.
As the 10-year rate has plunged, lenders have been reluctant to match it…
- Low mortgage rates will boost refinancing applications
- Potential delays in home buying and lagging sales
- Mortgage rates will be slow to rise
- Technology-centric homebuyer solutions, such as virtual tours will be accelerated
- Deceleration of multifamily rents as economy slows
Construction and development
While contractors may be reluctant to lay off workers, because of fears that they won’t find replacements when the market turns around, there will most likely be issues with workers being concerned about the virus. Furthermore, if the virus fears continue to limit international travel, the immigrant population that fuels construction jobs in the U.S. will be reduced.
Supply chains for construction materials that are still dependent on China could lead to delays and increased project costs for assets under development. But some of this is not new. The trade war had already caused many developers to shift their supply chains away from China to other markets in Asia and Canada.
- Delivery delays for materials supply chains
- Pressure on an already tight labor market
- Slowly rising mortgage rates will raise home ownership rates
- New ways of viewing homes such as virtual tours will be accelerated
Overall, the broad-based availability of dry powder earmarked for real estate investment strategies has been waiting for an opportunity to take advantage of favorably priced assets. Such strong balance sheet positions will serve to provide the liquidity needed for capital markets if buyers and sellers can find a way to get deals done, potentially without face-to-face meetings.
The virus is the black swan market event that no one saw coming. While nobody knows the full extent of the economic impact of the virus, one thing is for sure: Throughout the recovery, real estate investors have remained largely disciplined in their development and investment approach across sectors. Those investors and operators that have strong balance sheets will be able to capitalize on the ample market opportunities that are uncovered by those who are unable to weather the storm.