Commercial Real Estate Investing in COVID Times

Why Commercial Real Estate is not slowing down.

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Kelowna Commercial Real Estate in COVID times

Interesting times!

The rapid pace at which the COVID-19 pandemic spread and global actions to curtail it are having an unprecedented impact on the way we live and do business.

Since the second week of March, when COVID-19 was declared a pandemic, spreading globally and, particularly, across North America, financial markets have declined sharply. The S&P 500 and TSX declined by 13 percent and 29 percent virtually overnight. Brokers were panicking, the media was shouting ‘the end is near!’.

Rather than the typical lag, the Canadian Real Estate industry was affected immediately. Most businesses were massively interrupted or shut down.

Sales wise deals that began in early March are moving towards closing, though with extended due diligence periods. Meanwhile, sellers have taken a wait-and-see approach to how buyers will price assets.

Debt availability is now heavily relationship based. While 10-year Canadian bond-yields have fallen nearly 100 basis points this year, the cost of financing is higher, as most banks have introduced interest rate floors (Fortunately, we have those solid relationships in place).

These facts reflect the uncertainty of the current market and the sharp increase in corporate bond yield spreads. In many cases, re-financings are being deferred. This “push it off and wait and see” approach makes perfect sense in today’s market, where underwriting value is murky. It also suggests that we may not see many distressed sales of assets in the short-term.

All this sounds scary. It causes pause.

Yet, lots of good (economically and investment speaking, not talking about the human health component) opportunities have been exposed. Investment wise there is a still a lot of money to be made, both medium and long term.

While it is too early to fully understand the impact of these events, history can serve as a valuable source of information as we look forward.

Over the past century, external shocks such as an epidemic or a pandemic followed by an economic downturn have had an immediate to short-term impact on commercial real estate (CRE) asset prices, but minimal influence on transaction activity.

In all these cases the Canadian Real Estate Industry recovered from these events at varying paces: While event-oriented downturns showed a quicker rebound, longer-term events, such as the 2008 recession, resulted in a more protracted recovery. At this time, COVID came on so quickly that is created a PAUSE button like no other economic incident to date. This has actually turned out to be a good thing. When one sector continues to grow and another pauses, that creates an imbalance in the economy and many ripple effects.

In the case of COVID-19 we all hit the pause button. Other then short term cash flow no real fundamentals have changed.

Commercial Real Estate has definitely seen immediate impacts in the form of non payment of rents. Small businesses that worked more or less pay check to paycheck are suffering and closing doors. In the short term this affects rents of those spaces as the tenants are no longer paying.

In the short term… the good news! Historically when small businesses start to fold, the demand for that business does not reduce too much. It just shifts from being spread out over multiple small shops into a few medium sized shops.

Basic human nature needs to be factored in. While the media was screaming that the sky was falling a lot of households were holding off on purchases. As that fear begins to subside we are seeing more and more examples of those expenditures coming back. This past week with the next phase of softening the restrictions is direct evidence of this. People are getting haircuts, manicures, going to restaurants again… yes this is all at a reduced capacity, but it has only been a few months since the initial outbreak. It will take a bit of time. Fundamentally though, we humans want our creature comforts. Once the health threat has been minimized and people now look to continue on, they begin to buy non critical products again. The economy keeps turning.

So, while there has been a pause in growth during the crisis, the long-term fundamentals support growth in the long run.

The next steps

The Canadian government have taken multiple measures to respond to the impact of COVID-19, some of which impact the Canadian Real Estate (CRE) industry. With rising selling pressure and illiquidity concerns in the agency commercial mortgage-backed securities (CMBS) markets, the Feds provided short-term financing to investors.

They have further released a plan to help commercial landlords deal with defaulting tenants, whether through a series of tax breaks or incentives. Sales may be down but Billions of dollars are coming in from the Government into the economy, keeping the fundamental cash flow cycle going.

Further, the federal government passed a few Acts to boost cash flows and liquidity. The acts include several tax and business spending provisions that can be leveraged by CRE companies; it increases bonus depreciation, utilizes net operating losses from prior years, and allows companies to obtain cash refunds for carryforward of minimum tax credits. All things that can create very favourable conditions for investors if you are effectively positioned.

Right now we are in the respond phase of the crisis, when companies deal with the present situation and manage continuity.

Shortly we will be in the recover phase, when fundamentally strong companies learn and employ strategies to emerge stronger. Positioning yourself at this stage is what historically creates the most wealth. Then you are ahead of the curve for the “next normal” when it arrives.

This is where Commercial Real Estate creates enormous wealth. With low interest rates still in play and the ability to leverage off core fundamental numbers many positive opportunities exist. As an example, buying a 5M building that generates $350,000 in yearly base rents (then plus true triple net) can be acquired for as little cash in as $1,000,000, a 35% cash on cash return. That’s not bad at all!

The opportunities exist in companies that were slightly too over extended and now need to make the decision to sell off a prized asset at an opportunity loss in order to maintain cash flow in the short term. In the Okanagan many of these buildings were simply never available for sale. They were just too solid in the fundamentals and the owners were not willing to entertain all but the most outrageous offers. Now…Opportunities are coming up!

Even some of the local smaller businesses are doing well. Look at restaurants as an example. Some of the more popular spots I know have actually INCREASED business. Prior to COVID most sales came from patrons coming into the restaurant and taking a table. Profits were dictated by turn around time on the tables. Now, as people are tried of cooking at home very night, they are receiving more orders on a per hour basis then they ever would have produced in the pre COVID era. Other popular retail businesses are also reporting higher revenues as the items per visit ratio has dramatically increased. As an example 1/8th of the amount of people may go into the store now, however this group is buying 12, 15 times the amount of items they historically have. So revenues are actually up!

Back to CRE specifically. Further opportunities have been created. Having an effective and structured plan to transition back into different physical spaces such as offices, retail spaces, and hotels could be a differentiator as companies recover and return after the pandemic-related restrictions are removed. These improvements cost monies at a time when cash flow is the issue. If you are liquid, this also presents an opportunity. Offer to pay for the TI’s with payback (with interest) over the first term (typically 5 years). This helps out the tenants as they save money in the short term and can write off the monthly expense against operating costs and gives you the additional interest return on the monies used for TI’s. This is just one example I am giving away; we have many more revenue generating ways to be well ahead in the “next normal”.

Reach out! With our network in the Okanagan we have lots of hard money lenders, property owners and specialist to create unique opportunities that benefit everyone.

Chris Kotscha, Century 21 Assurance Realty Ltd

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-Chris Kotscha