Investors should watch for potential structural changes to the industry post-pandemic, spurred by the growing role of technology, evolving preferences around remote work and rising costs for property owners.
Much like the asymmetrical impact of COVID-19 on the global economy at large, the pandemic’s toll on U.S. commercial real estate is a tale of two markets. While some properties proved largely impervious—warehouses and distribution centers, medical science facilities and multifamily rental residences—the usage and corresponding value of others—hotels, retail buildings and corporate offices—declined modestly.
That most U.S. commercial real estate sectors are now rebounding or accelerating—albeit at different paces—amounts to an overall rosy outlook, according to James Flaum, Global Head of Morgan Stanley’s Commercial Real Estate Lending group. But some paths to recovery are still murky. “Big picture, we’re bullish on commercial real estate,” he says, but important questions remain regarding structural changes to the industry and the potential obsolescence of some commercial real estate post-pandemic.
Investors should watch factors that could have potential long-tail effects on commercial real estate, Flaum says, including the growing role of technology in facilitating transactions, evolving preferences for working from home and online shopping and the possibility of rising costs for commercial real estate owners—and any effect inflation may have on the Federal Reserve’s near-zero interest rates.
Uptake of Technology Since COVID-19
As in many industries, the pandemic quickened the uptake of technology in commercial real estate, a trend that’s likely to continue and help characterize the recovery, according to Flaum. At Morgan Stanley, the pandemic only sped up an initiative already years in the making: A new tech-enabled platform for the firm and clients to manage data, helping assess risks, minimize costs and increase transaction volumes for commercial real estate loans.
Within one of Morgan Stanley’s global Technology groups, 20 engineers—many of whom were recruited through the firm’s Technology Analyst Program—helped Flaum’s team respond to a rapidly-changing market. “We’ve been focused on how Morgan Stanley and our partners can better manage data that parties such as appraisers, property inspectors or insurance companies provide,” says Stephen Scott, Executive Director in the Institutional Securities Technology group at Morgan Stanley. “Commercial real estate lending is a unique technology challenge. There’s no central exchange or marketplace driving uniform innovation. We found where we could make an impact and created commercial real estate technology that’s much more efficient—for the firm as both loan originator and asset manager and for end borrowers.”
Because the pandemic underscored the hazards of catastrophic events and the key role technology plays to keep pace with a fast-changing market, there’s appetite for more ways to innovate, Scott says. Looking ahead, the Technology team is focused on developing a wide range of capabilities from natural language processing for document analysis to integrating forecasting and disaster data to help assess climate-change related extreme weather events and their impact on commercial properties. “We’ve built powerful tools that help manage risk, and this is really just the beginning as we work to stay ahead of the rate of change.”
Hard-hit Sectors on the Mend
As the percentage of vaccinated Americans increases and businesses reopen or ease social distancing measures, revenue streams for select commercial properties are returning. One area of commercial real estate experiencing a robust rebound is travel and leisure, Flaum says. “We’re seeing strength in drive-to resort locations and non-convention center hotels. This area of the market could recover strongly over the next six to 12 months,” he says.
Retail is another slice of the market that’s bouncing back strongly as people return to shopping malls. Still, investors should monitor continued growing demand for e-commerce compared to brick-and-mortar retail, Flaum says.
Green shoots are sprouting in other areas of the market, such as commercial office buildings, though many investors are still assessing how changes in corporate policies around employees working in-office vs. at home will affect the sector. “That’s still a big question mark,” according to Flaum, “but we still believe that companies are going to operate out of offices long term.”
Inflation: The Biggest Risk to Recovery
As the reopening of industries spurs hiring, wage gains, consumer spending and economic expansion, the prospect for a continuation of rising prices is casting doubt on a straight path of recovery for commercial real estate, especially for sectors hard hit by the pandemic. “There could be a lot of economic growth this year, and because of that the biggest risk to commercial real estate could be inflation,” Flaum says. “If you’re a hotel company, and wages and the cost of materials are going up, that has an impact. But hopefully, cash flows will go up faster than expenses.”
There could be a lot of economic growth this year, and because of that the biggest risk to commercial real estate could be inflation.
In addition, inflation that runs too high could cause the Federal Reserve to raise interest rates, which may also stymie the commercial real estate rebound. Near-zero rates facilitate easy access to credit for commercial real estate borrowers, and more lending helps the market recover faster.
Still—even in the face of rising prices—investors may continue to allocate to real estate at large as a hedge against inflation, for which it has served effectively over time, according to Flaum. Plus, institutional investors, which comprise an ever-growing segment of real estate allocators, may keep raising capital for the asset class as an alternative to bonds and stocks. “With fixed income returns so low, we continue to see investment from institutional investors,” Flaum says.