CRE and Surviving The COVID Recession

Taking steps to evaluate the current situation and weather the storm

When it comes to hurricane season, Floridians know the drill: stock up on canned goods and water, fire up the generator for a test run, keep cash on hand, and ensure the storm shutters are in working order. It’s usually the same idea when it comes to weathering a bad economic forecast. For the most part, investors and tenants know the steps to take to somewhat manage an economic downturn. 

But hurricanes, as we all know, can be unpredictable—and the COVID recession is proving to be just as difficult to anticipate. The timing of a vaccine, lingering surges of infections, the prospect of a second wave, and the financial fallout of lockdowns and relief packages have resulted in the great unknown. And that, in turn, is creating uncertainty that surpasses that of the Great Recession.

A “normal” recession vs. a “new-normal” recession

Markets always go through cyclical changes, and these swings are usually separated into four distinct phases, with unique CRE impacts: 

• Recession: In a typical recession, sellers have accepted the economic situation (at about the four-month mark), and it becomes a buyer’s market. Real estate prices start to come down. A few months later, foreclosures peak and prices bottom out, creating an excellent time to buy. Property values on both residential and commercial properties are severely impacted.
  
• Recovery: This phase is marked by two consecutive months of decreasing unemployment numbers, declining rental rates, and a leveling off of vacancies. This phase’s beginning is pretty much rock bottom, still making it an excellent time to buy.
  
• Expansion: Low vacancies, higher rents and values, and booming construction switch the market to a seller’s one. Good deals are still out there but require a bit more effort to find.
  
• Hyper-Supply: The construction boom from above results in an abundance of properties combined with low rents and high prices—until these factors return to alignment. This is usually not the best time to buy. 

COVID-19, though, is making it difficult to predict any of these “normal” phases. 

The current factors are mixed. Technically speaking, for example, we have seen more than two consecutive months of employment gains. As of this writing, there have been four straight months of decreasing unemployment, from April’s astounding high of 14.7 million to July’s 10.2 million. But the combination of uncertainties, as well as a full recovery that may be dependent upon a vaccine, has made these “definitive” phases not so well-defined. 

Preparing for the long haul

The typical first step in grappling with a recession is determining what phase the economy happens to be in. But with so much uncertainty, that’s no easy task. 

With the onset of the school year and the potential for new outbreaks—as well as additional phases of reopening and closing—there’s a genuine possibility the market will behave more like a ping pong ball, bouncing back and forth between economic stages. 

But there are still ways to analyze the situation and take action:

1. Analysts have speculated about a V-shaped economic recovery (good) or a W-shaped recovery (less than ideal), with the shapes of the letters indicating the course of the economy. But it seems more likely that we’re in for a “K-shaped” recovery, where various sectors rise or fall based on fundamental changes to demand brought on by the pandemic. Thus, evaluate all CRE decisions based on your resources and the unique demand for a potential investment type.

2. Consider property improvements that make sense, if you can afford them. Some actions may not only help maintain the property’s value during a recession but also prepare for new tenant needs in a post-COVID world. Again, evaluate this through the framework of a K-shaped recovery; capital improvements in a smaller office space that make it safer for tenants are likely more valuable than doing anything to a large retail property.

3. Evaluate when and how to keep money on the sidelines, and when you should use it. This piece of advice is tricky, since trying to “time the bottom” of the CRE market is difficult to impossible. This maxim is especially true since specific sectors are trending upward, and we really don’t know what post-election economic sentiment and consumer confidence will look like. Also, record-low interest rates may provide a solid floor for property values. But this level may be broken if the broader economy, including the stock market, drops significantly due to longer-term factors. 

Thus, investors must again use the framework of whether an individual investment makes sense in a post-COVID world. Investing in a high-rise structure in an urban center is likely a bad idea, as social distancing requirements and a trend toward remote work make the viability of these properties questionable. Similarly, regional malls are probably big losers. In contrast, a modern office with a smaller footprint and great amenities may still make sense, and any well-located facility that can be used as an e-commerce distribution center is likely to do very well.

Evaluate each opportunity based on how it may play in the new economy—and deploy your capital wisely.

A final thought on getting through the recession and prospering on the other side of it

Perhaps no other bit of advice matters more than a reminder to be patient if you can afford to do so. The uncertainty of the pandemic demands a mid- to long-term view, along with the ability to adapt. 

Harbor enough liquidity to weather new challenges to investments that you maintain and scrutinize all potential opportunities in light of the pandemic’s significant social and economic changes. The advice that’s vital in any economy applies here, as well: base every decision on a diligent examination of potential ROI.

For assistance in determining how to proceed with an investment or to find the right property for your needs, call Morris Southeast Group at 954.474.1776. You can also reach Ken Morris directly at 954.240.4400 or via email at kenmorris@morrissegroup.com.

CRE and the True Cost Of Capital During COVID-19

The wisdom and ability to tap “cheap” capital for commercial real estate investments

There’s very little doubt the 2020 global economy isn’t pretty. Ravaged by COVID-19 and government actions to curtail the public health crisis, there is record unemployment, record stimulus-relief packages, and record-low interest rates.

Many view these “easy money” rates as sound economic policy to head-off—or at least better manage—the recession. That said, economists and lenders are looking at the long-term implications for a post-pandemic economy. And in practice, the rates set by lenders are often significantly higher than the target rate set by the federal reserve.

The LIBOR transition has not happened yet, and could be slowed

In addition to direction from the Federal Reserve, banks also look to the London Interbank Offered Rate (LIBOR). Based on five currencies (the US dollar, the euro, the British pound, the Japanese yen, and the Swiss franc), LIBOR determines the average interest rate at which major global banks borrow and was, at one time, considered the world’s most influential interest number. In the United States, it was the most popular index for adjustable-rate mortgages.

Then came the scandal. More than a decade ago, regulators discovered that traders were manipulating rates set by some of the largest banks in Great Britain. For 10 years, there’s been a phase-out process as countries worldwide seek alternative risk-free reference rates.

COVID-19, though, may be delaying this transition, which was expected to be completed in 2021. In a world of pandemic-related uncertainty, many officials in different markets are sticking with the devil they know rather than look toward something new. 

HousingWire states that a Moody’s Investors Service report shows that “Regulators such as the Federal Reserve have increased the nation’s reliance on LIBOR by using it as an index for emergency lending.”

Lessons learned from 2008

Not looking to repeat the harsh lessons of 2008, banks wandered away from collateralized debt obligations (CDOs)—since such loans made to homebuyers before the subprime housing collapse led to the Great Recession. Instead, lenders shifted toward collateralized loan obligations (CLOs). This has created a new vulnerability:

After the housing crisis, subprime CDOs naturally fell out of favor. Demand shifted to a similar—and similarly risky—instrument, one that even has a similar name: the CLO, or collateralized loan obligation. A CLO walks and talks like a CDO, but in place of loans made to home buyers are loans made to businesses—specifically, troubled companies. CLOs bundle together so-called leveraged loans, the subprime mortgages of the corporate world. These are loans made to companies that have maxed out their borrowing and can no longer sell bonds directly to investors or qualify for a traditional bank loan. There are more than $1 trillion worth of leveraged loans currently outstanding. The majority are held in CLOs.

Loans in a CLO are bundled together, and if they default, the risky bottom layer loses more. Once the lower levels are wiped out, the damage trickles upward to the safest loans. Right now, the CLO market is bigger than the CDO market at its peak. 

To offset these losses—pending and actual—banks have kept more capital on hand to protect against a downturn. But no one could have predicted the across-the-board economic wreckage caused by COVID-19. 

On their own, CLOs will not eat up capital reserves. But when they’re combined with losses in other asset areas and dried-up revenue sources, financial institutions could be looking at a Lehman Brothers-sized meltdown. 

This, of course, had caused them to look for ways to hedge this risk. This effort includes charging interest rates well above the fed target rate and carefully scrutinizing borrowers’ creditworthiness.

The inflation question

On the tips of tongues and in the backs of minds is the idea of post-pandemic inflation. In a sense, it could be the second gut-punch in the fight with COVID-19. In fact, the ingredients are already in the pot—trillions of federal dollars in the economy via loans and relief packages that translate into trillions of dollars of national debt, people out of work, defaulted loans, businesses either shuttered or skimming by, and disruptions in supply chains. 

The ingredient that’s missing is a vaccine. That will be a great and glorious day, of course. But once it exists, people could entirely leave lockdowns and resume their consumer lives, which will result in increased demand—but this could involve shortages and stagnant wages that can’t keep up with rising prices. The result is inflation.

It will then fall to the Fed—followed by the banks and other lenders—to determine a course of action to slow it down. Generally speaking, higher interest rates tend to lower inflation—and this, in turn, can slow down available capital for investing.

Easy money isn’t always so easy

When it comes to raising capital, most investors turn toward banks or private lenders. In general, banks are typically more affordable but have more requirements to be approved. Private lenders, although more flexible, are often more expensive because they get funds from investors looking for decent returns and/or banks that lend them money. As a result, the private lender’s cost is passed on to the borrower.

The uncertainties surrounding COVID-19, though, are forcing banks and private lenders to apply more stringent risk assessments to loans, and pricing accordingly. For example, while the Fed establishes a specific rate, LIBOR helps the bank determine points above that interest rate, making it more expensive to borrow money.

At the same time, loan standards have tightened to make the process even more rigorous. This includes more significant documentation, larger down payments, and higher credit scores.  

What’s an investor to do?

Investing in anything has a bit of uncertainty in the best of times. But the current environment has loads of it. To better prepare, investors need to ask themselves some serious questions before raising capital:

• How long do you plan on holding onto the asset? Short-term and long-term holdings can have different risk factors, and these have to be weighed against the best predictions for how long COVID-19 will last, when a vaccine will become readily and widely available, and the time it takes for the economy to rebound in a vaccine and a non-vaccine environment.
  
• Will the investment be a good hedge against inflation? Generally speaking, real estate values and rents increase with inflation. This, however, is a COVID world, and that creates its own set of questions: Will people be able to afford higher rents in a post-pandemic economy? Will small business tenants be able to secure loans? What will be the demand for different property types?
  
• Are my office/retail buildings going to be worth anything? Because of social distancing, lockdowns, and remote working, the office and retail sectors were especially walloped by the pandemic. Will that change with a vaccine? Will you be able to adapt your structure to meet the new conditions of the new normal? Are you prepared to work with new tenants to help them survive, for your own survival?
  
• If you’re unable to secure funding through a bank, can you afford financing through a private lending firm? Remember, these options are more expensive, and detailed due diligence and projections for the investment are still required.
  
• Are you able to weather the uncertainty? Because of uncertainty, values are expected to encounter volatility as the market adjusts and corrects. There will be significant opportunities, but the time horizons for anything are unclear.

A heightened awareness

Many of the issues raised here are nothing new. In many ways, they’re the same concerns and questions to have during any investment time-frame. COVID, though, demands a heightened awareness because of the degree of uncertainty. 

While the cheap cost of capital via low interest rates will drive some investments, an investor must also consider both mid- and long-term scenarios based on intended hold periods and the nature and future of the property.

For assistance in determining how to proceed with an investment or to find the right property for your needs, please call Morris Southeast Group at 954.474.1776. You can also reach Ken Morris directly at 954.240.4400 or via email at kenmorris@morrissegroup.com.

The Looming Legal Challenges of COVID-19

A pandemic for the litigious age

COVID-19 has come to mean many things to many people, from a global public health crisis to a logistical nightmare to a political hot potato. It has also presented a new set of legal challenges.

With lockdowns, re-openings, and a hodgepodge of rules, business owners are worried about lawsuits related to exposure, workplace health and safety, termination, and discrimination. As of this writing, more than 3,900 COVID-19-related complaints have been filed in federal and state courts.

At the heart of these issues is fear of uncertainty coupled with the lack of a national liability shield. This measure would protect entities from lawsuits if they took appropriate measures to safeguard customers and employees.

While national politicians on both sides of the aisle have presented arguments for and against such protection, their lack of agreement has resulted in some states enacting their own liability reform legislation. These measures have provided some assistance for businesses located in a specific state, but they have also created a patchwork of confusion for organizations with interests in multiple states.

A look at liability at the federal level

From the outset of the COVID-19 stimulus efforts, groups from all corners of the economic spectrum—the US Chamber of Commerce, colleges and universities, national manufacturers, independent business owners, and a host of others—embarked on lobbying efforts to get Congress to back liability reform.

The idea is at the center of the GOP’s most recent proposal, introduced in July. Senate Majority Leader Mitch McConnell has indicated that the liability protection included in the Safe To Work Act is non-negotiable. Democratic critics, on the other hand, see the effort as an infringement on workers’ rights, with wording that makes it nearly impossible for a suit to get to court. 

Consequently, the trick for Congress is to find a middle ground. And when, where, and if that will happen, no one knows.

States take their own steps

Without a liability policy coming out of Washington, many businesses and organizations began asking patrons and employees to sign waivers. States then rose to the challenge, and by the end of July 2020, 12 of them had enacted versions of liability reform to fend off frivolous legal attacks.

While each of the separate initiatives share similarities, they are nevertheless different—and this, in turn, can leave certain individuals and businesses vulnerable.

• To create all-encompassing COVID-related protections, many states have intentionally used broad language. The more general the language, though, the greater the room for error in its interpretation. Phrases like “reasonably attempt to comply with public health guidance” can easily lead to questions on what represents compliance and which applicable health guidelines are to be followed. Remember, we are more than six months into this, and we still can’t all agree on masks.
  
• Many of the state measures are not meant to act as a blanket liability shield. Businesses are still required to adhere to standards that forbid grossly negligent and reckless behavior.
  
• Legislation in Georgia contains a Rebuttable Presumption. Through warning signs posted at various points, patrons are essentially waiving civil liability claims against the business.

To avoid confusion, it’s in the best interest of businesses to perform their due diligence. Does their local jurisdiction have a liability shield? Does it protect those outside of the healthcare field? What type of infection is covered? Does it contain a rebuttable presumption, and what are the requirements?

The battle for insurance

In addition to liability reform efforts, another legal battle is also taking shape—this one between businesses and insurance companies that have been rejecting business interruption claims.

Typically, business interruption insurance covers three main areas: business income coverage, contingent business interruption coverage, and order of civil authority coverage.

These claims are only covered under specific circumstances, and at the heart of the matter is whether COVID-19 constitutes “physical damage.” Plus, as of 2003, most insurance companies added exclusion clauses specifically aimed at bacterial and viral incidents.

It’s also important to understand the practical reasons for insurance companies avoiding COVID-19 payouts: lockdowns created such widespread business interruption that successful claims would bankrupt the insurance industry.

As discouraging as that sounds, some business owners aren’t backing down and are taking their claims to court. According to the National Restaurant Association, lawsuits filed in both state and federal courts are “too numerous to count.” In Philadelphia and Chicago, more than 100 plaintiffs filed a federal petition to have all COVID-19 business interruption cases heard by a single judge.

At the same time, groups are lobbying Congress and states for business interruption insurance coverage relief packages. The essence of both efforts is two-fold: to include pandemics as part of business interruption and to eliminate coverage confusion.

Searching for a safe harbor

Anything related to COVID-19 is fluid—from the course of the disease to preventative measures to legal ramifications and legislation. In this environment, it’s essential to keep a close eye on developments, thoroughly understand your insurance documents and the ratings of your provider, and work with your professional organizations and their lobbying groups to advocate for political solutions.

Safe Harbor provisions have existed in various areas of law for years, including taxation, environmental regulations, and the Affordable Care Act. The time has come for a similar provision to be added to liability law at the national level. Until then, I’m advising clients to think carefully about re-opening, closely follow local and CDC guidelines, and consider having patrons and employees voluntarily sign waivers as a means of legal protection.

If you need guidance on re-opening or any commercial real estate issues, please call Morris Southeast Group at 954.474.1776. You can also reach Ken Morris directly at 954.240.4400 or via email at kenmorris@morrissegroup.com.

Potential CRE Property Improvements To Adapt To COVID-19

How the pandemic is changing—and could transform—commercial real estate spaces

In addition to everything else we can blame on COVID-19, the pandemic has altered what’s important in commercial real estate. Not long ago, landscaping, security, and lighting were among the key elements to increase property values, and often ranked high on the list of tenant wishes.

But with the pandemic and re-openings, the most significant concern is the health and safety of anyone entering a property. Much of that reflects growing health concerns and awareness of how the virus spreads. But there’s also a very practical interest in limiting liability and the potential for lawsuits.

To that end, preventative measures come in numerous shapes, sizes, and price points—and many of them are contingent on property usage.

Immediate steps for reopening

At the top of any reopening checklist is evaluating the floor plan of the property, followed by making adjustments based on the best practices outlined by leading health authorities, such as the CDC. Generally, this means keeping at least 6’ of space between people, limiting group interactions, and mitigating air-droplet spread.

Steps that some properties are taking include:

• Using furniture to create distance. Desks, for example, should be at least 6’ apart. If space is tight, some furniture may be removed or roped off. Bookshelves and other office furniture may be moved into positions that help maintain distance, while temporary walls and partitions can be brought out of storage and put to better use. In some cases, plexiglass partitions are attached to furniture to create boundaries.
  
• Since communal spaces are discouraged, converting that space into storage for any pieces removed from the main work area is an option. So is using it as a workspace for a portion of socially-distanced employees.
  
• Implementing foot-traffic patterns that make sense for the property. For example, signage can remind people to move in one direction when walking about the office, up and down the aisles of a retail space, or when entering or exiting a conference room.
  
• Steps to maintain distance can be as simple as signage, arrows, and colored tape on the floor, or as elaborate as “The 6-Feet Office,” which uses bold colors and patterned carpeting to delineate social distances for offices and traffic.
  
• Enacting policies that stress flexibility, choice, and wellness. These can include elevator etiquette reminders, the creation of cohorts or teams to limit the number of people actually in the office on any given day, hand-sanitizing stations, and a clean-desk policy so surfaces can be disinfected easily. Enhanced cleaning protocols are considered critical.
  
• One possible way to minimize COVID’s spread in interior settings is to open windows and allow fresh air to circulate. For many buildings, however, that’s not an option—either windows don’t open, or the weather is too hot and humid. But some companies are moving specific workspaces, such as conference rooms, outside.

Looking to hospitals for CRE inspiration

By reopening, many commercial properties and their occupants have joined others on the frontlines of the COVID-19 battle. It only makes sense, then, to look to the veterans of the war: hospitals. These facilities have valuable lessons for preventing the spread of diseases to others.

• For decades, we’ve been warned about the dangers of ultraviolet (UV) light, specifically UVA and UVB, which are responsible for sunburns and skin cancers. But there’s also UVC, which, because of its short wavelength, cannot penetrate Earth’s atmosphere. There is a subset of wavelengths (far-UVC) that has been shown to kill “99.9% of seasonal coronaviruses present in airborne droplets.” Handheld, mounted, and mobile UVC devices have already appeared in hospitals, nursing homes, and food establishments.
  
• Because weather and design keep many windows sealed, there is growing interest in how recirculating air from HVAC systems helps spread COVID-19. One potential solution is the addition of UV lights into HVAC ductwork to sterilize indoor air and improve ventilation. Also, proper air filtration (depending on the size and scope of the unit) and maintenance contribute to better indoor air quality.
  
• One of the challenges hospitals have faced in the COVID battle is having to increase Airborne Infection Isolation Rooms, also known as negative pressure rooms. Air from the positive pressure space is forced under the door opening into a room with negative pressure, where dangerous microbes are then “captured.” From there, microbes are released into the outdoors, where they disperse and eventually die. The fundamental difficulty for many commercial buildings, however, is in maintaining an even, positive pressure due to HVAC issues and building usage.
  
• COVID may call for leveraging Internet of Things (IoT) technology to make energy systems in the property smarter. With changes in the work dynamic, such as fewer in-house staff or staggered hours, owners may see savings by embracing an adaptive energy system. The building’s energy system knows when and how to operate based on the changed occupancy and hours of operation.

Reopening in SoFlo

While debates continue about states reopening too quickly, businesses are opening as cases are skyrocketing, and people want to get back to work. For owners, property managers, and tenants, the challenge is ensuring that enough has been done to protect the health and safety of occupants.

The complicating factor in COVID-based property improvements is that people are using commercial spaces differently—and the demand for some buildings is waning. And many of the most useful property upgrades—such as enhanced HVAC systems—are expensive.

Money may seem cheap due to very low interest rates. But many lenders are factoring risk into rates, and some institutions only lend to applicants with exceptional credit and significant resources.

In addition, the benefits of any property improvement must be balanced against the financial risk to owners. Installing a new HVAC system for a 10-story office building, for example, is a major capital investment. This expense may be unrealistic in light of diminished demand for a space and increased demand for shorter leases, which reduces the odds of recouping the investment. Then, there is the risk of lawsuits from customers and employees who may become infected on the premises.

We will cover many of these issues in future blogs. For now, sound advice for tenants and owners is to stay current on best practices for reopening as safely as possible. And everyone must carefully evaluate their financial and health-risk scenarios—and make decisions that make sense for their people and businesses.

At Morris Southeast Group, we stay on top of commercial real estate trends and will continue to update our clients and readers. As always, we are here for all of your CRE needs, including helping you evaluate potential steps to create or lease a safer property.

To learn more about what Morris Southeast Group can do for you, call us at 954.474.1776. You can also reach Ken Morris directly at 954.240.4400 or via email at kenmorris@morrissegroup.com.