As COVID-19 changes the way people around the world live and work, it is having a unique impact on the Commercial Real Estate universe: indeed, the pandemic has shortened the “time to tipping point”, acting as an accelerant of pre-existing trends more than a creator of new trends.
By Barry Hammerman and Michael Kandarakis
The Pandemic Accelerates Trends in Commercial Real Estate
As COVID-19 changes the way people around the world live and work, it is having a unique impact on Commercial Real Estate (CRE). Indeed, the pandemic has brought us closer to the “tipping point”, acting as an accelerator of pre-existing trends, rather than as a creator of new ones.
Among the trends that we see accelerated by the pandemic are flexible work arrangements, population migration to lower-cost geographical locations, localization of production and supply chains, heightened focus on sustainability and wellness, and the digitization of the economy. These trends are having profound effects on the commercial real estate market. More specifically it impacts the demands that property owners must face going forward, as well as the market forces, investors must consider to ensure their real estate assets remain valuable.
While some of these trends have been affecting CRE for years, the acuteness and the simultaneous global reach of the pandemic, has provided an opportunity to test the strength of technological advancements and Environmental, Social & Governance Awareness (ESG) awareness. The combined effect of these factors has enabled the aforementioned trends to become key disrupters in the CRE market.
Technologies such as videoconferencing, remote networks, Voice over IP and web conferencing have existed for over 20 years. The pandemic did not create Zoom, rather the immediate need for widespread shelter-in-place requirements became a catalyst for massive adoption of these technological tools. In terms of commerce and services, these applications allowed many businesses to continue functioning outside the traditional office environment.
Corporate management was even encouraged by the reliability and functionality of these technologies, and their positive effect on worker productivity. From the employee’s perspective, once it became acceptable to work from home, it also increased demand for more flexible work arrangements resulting in less time in the office and a decrease in value for office space in general.
One Tablet Many Functionalities
So too, the extensive use of technology in other areas of our lives has had a game-changing effect on consumer behaviour, which also shapes our ideas of where things can or must be done. One can shop online via a tablet and then use that same tablet to participate in online spin classes. No longer is shopping restricted to the shopping mall, spin classes limited to exercise studios and work restricted to office buildings. Just as the use of technology during the pandemic reshaped people’s mobility and real estate’s functionality, so too have users and owners of CRE become more aware of the importance of ESG considerations in the real estate industry. Decision-makers are taking more responsibility for enhancing employee well-being, promoting facilities that reduce the spread of viruses and operating with greater respect towards the environment.
Varying Impact on CRE Sectors Carries an Uncertain Timeline
Structural trends are a continuing “fact of life” and challenge for property owners, who must ensure that their real estate holdings match evolving trends and avoid obsolescence. The difference between ordinary times and now is that change seems to have arrived more abruptly. Our interpretation of these early signs is that the pandemic is affecting countries, businesses and individuals in profoundly different ways. As a result, real estate is facing volatility and uncertainty, which inevitably leads to mixed results in:
Offices, Residential, Retail, Logistics, Hospitality, Data Centers:
Offices: There is a tug of war between working-from-home trends and the need to have offices which are healthier, offer more space per person and are designed for greater flexibility. As office space is used more for collaborative activities and less for individual work, employee productivity necessitates a different physical layout. Buildings that can be converted to satisfy the shift in office work culture are expected to outperform their competitors. Corporations’ willingness to expand their office footprint beyond centralized headquarters in traditional gateway business districts, combined with employees’ desire for a modified office/home-work model, may positively affect investment in corporate relocation to secondary markets. This includes a wide range of advantages such as a more attractive quality of life, offering more space, lower operating costs and shorter commutes.
Residential: Residential real estate is anticipated to exhibit a corresponding shift in space needs and space utilization. For example, residences will have some dedicated space to support working and learning from home. As the workforce becomes more mobile, we expect to see the advancement of a hybrid model – work from home supplemented by regional corporate offices or access to local co-working facilities. As a result, housing demand may continue to increase in less-dense communities where more affordable prices enable more space. Another major factor in this migration, is that proximity to the office is no longer a driving factor in the selection of one’s primary residence. Further, technological advances are enabling new product offerings, such as single-family rentals, to accommodate consumer preference for renting over ownership without sacrificing space or location.
Retail: One of the most deeply affected sectors which was already in a weakened state prior to the pandemic, retail should continue its transformation in the years to come, including shorter lease terms, increased penetration of revenue-share rent models, and higher demand for experiential space. As e-commerce develops, online retail will continue to gain market share; however, the impact may vary significantly across specific geographies and products. For example, considerably less people will purchase consumer products in a physical location, while food, discount fashion and other specialized sectors will continue to have greater stability.
Logistics: Already high in demand before the crisis struck, the need for warehousing space has exploded in 2020 and will follow the increased penetration of e-commerce. Overall, pricing has caught up with these expectations; however, multi-tenanted light industrial and warehousing continue to offer attractive entry points for those able to take on the operational challenges of this sector.
Hospitality: The short-term effect has been dramatic due to closures. Going forward, the assumption is for less business travel in the medium-term as people leverage technological tools to limit less-productive travel. Hotels dependent on large conferences may suffer a prolonged recovery until people build confidence in COVID-related therapeutics, corporations lift travel restrictions and corporate budgets return for travel and entertainment. Overall, it is likely that a noticeable percentage of hotels will fail and be converted for alternative use, creating reduced competition for the survivors. At the same time, the disruption in the industry is expected to generate numerous investment opportunities for “rescue capital” to provide owners with the time to benefit from a longer recovery period in certain types of leisure travel and smaller, locally-dominant properties.
Data Centers: The common denominator among all the asset classes and trends discussed is the proliferation of technology. The commodity resource of the current generation is information and big data. While consumers’ changing behaviours impact where one sleeps, how one shops or how entertainment is accessed, the support system for these changes remains the classic digital infrastructure. To some, data center and cell towers are esoteric assets easily exposed to obsolescence, when in fact, they have increasingly become the foundations of day-to-day life. Data center and cell tower Real Estate Investment Trusts have experienced increased acceptance from investors resulting in these digital infrastructure companies boasting some of the largest market capitalizations for real estate companies across the globe.
Take Advantage of the Latest Trends
While the long-term direction may become more obvious over the next few years, the path is likely to be bumpy, uncertain and varied. For example, physical limitations in building stock amongst cities may prevent wider-scale adoption of working from home. In contrast, different workplace cultures may impede change in more conservative economies, and long-term commitments to existing leases may prevent fast changes by renters. Regulatory initiatives may also facilitate significant changes going forwards.
Uncertainty and uneven outcomes mean that there will be a period of opportunity to re-position real estate portfolios to take advantage of the latest trends, including:
Buying the right assets – a disciplined thematic approach that matches bottom-up driven valuation with long term considerations about industry change.
Repurposing existing properties – through implementation of operational, management and capital improvements to maximize sustainable income and value, working with specialized and aligned expert companies. Those that specialize in real estate development may have the opportunity to build for the future and capture benefits against older assets.
Continuous Development of a City Icon
History provides us with some guidance in learning to anticipate changes and in navigating through periods of uncertainty. When New York City’s Empire State Building was developed in 1930, innovative technology enabled the construction of the world’s tallest building. Thus, ownership maximized the property’s value by replacing a luxury hotel with an office building that included a docking station for airships. For much of the 1930s, the building was mostly vacant, and the introduction of an observation deck and radio broadcasts generated more revenue than all of the office space.
The building continued to go through cycles of increased vacancy as tenant demands changed, with its retail space demanding increased importance. It is easy to look at the building’s location today and say that site selection is paramount in CRE investment decisions. However, the Empire State Building has been resilient for over a century, not merely because of its location, but also because the various stewards of the building invested in the property to keep it relevant throughout time.
In fact, over the last fifteen years the landmarked property has completed significant modernization programs including high-speed elevators, LEED-certified energy efficiency improvements, and high-tech entertainment features. This historic building has maintained its value for nearly a century, by evolving with how people live, shop, work, and play.
As former Microsoft CEO Bill Gates said, “We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten”. The Empire State Building’s history shows us that by harnessing the technology of the day, remaining flexible, and responding to market dynamics, forward-thinking management can take the firm bricks of commercial real estate and reshape them into a valuable portfolio asset.
Barry Hammerman and Michael Kandarakis
Barry Hammerman is a Partner in the New York Office and heads the Real Estate program at QCP; Michael Kandarakis is a Partner in the London Office. He is responsible for the RE group’s activities in Europe. They both manage the QCP fund “Quilvest Real Estate Opportunities.”
Credits: Photo #01 & #02 – Architect: Marques und Iwan Bühler, Hochzwei Luzern, 2010-2011. Photo #03 – Architect: Bearth und Deplazes, ÖKK, Landquart, 2012. Photo #04 – Architect: Herzog & de Meuron Architects, Actelion Business Center, Allschwil, 2007-2010