COVID-19 and the Real Estate Market
There is no doubt that the COVID-19 pandemic has affected the real estate market in a whole host of ways, and there is a high probability that some of the changes that are occurring will be permanent. Today I want to discuss what we see happening in real estate due to COVID-19 and how those things may affect not only the real estate market but also the stock and bond markets.
Types of Real Estate Affected by COVID-19
Let’s start with a little discussion of the different types of real estate, and the two we’re going to focus on today. The two basic types of real estate are residential and commercial. Within those two are multiple subsectors. In residential real estate, there are single-family and multifamily properties. Within those two subsectors, we can break residential down further into existing homes and new homes, in urban, suburban, and rural communities.
In the commercial real estate arena, there are multiple subsectors as well. For instance, retail, industrial, medical, manufacturing, assisted living, and long term care are all subsectors of the commercial real estate space. And there are more, but you get the idea. I’ll be referring to residential and commercial real estate throughout, and I wanted you to have a broader understanding of the depth and breadth of content within those two sectors.
Commercial Real Estate and COVID-19
We’ll start with the commercial real estate sector, because it stands to take the biggest hit in the short term, and undergo some significant transformations over the next few years.
Working From Home
The COVID-19 pandemic has, in the span of just a few months, changed the notion of working from home forever. Before COVID-19, it was a novel perk that companies offered some of their employees, on a limited basis. Whether offered to ease the burden of commuting or to allow parents to care for sick children while still getting their work done, no one EXPECTED to be able to work from home. It was a privilege that generally required the permission of a supervisor at some level. Today, that’s all changed. Working from home now, for a lot of people, is mandatory. They can’t get into their offices if they WANT to. A good friend of mine says it will likely be January before he’s allowed to come back to his office.
COVID-19 and the Service Economy
As our economy has become more and more of a service-based economy, this poses some real problems. Think about all the commercial buildings you see along any highway in the Kansas City metro area and every metro area in the country. Usually, those buildings are bustling with activity. A variety of businesses set up shop in those buildings to house their employees and serve their customers. Whether it’s a call center, an insurance office, a medical records office, it doesn’t matter. Much of the work many businesses do today can be done from nearly anywhere in the world with an internet connection, a computer, and a cell phone. We’ve always suspected as much, but the lockdowns due to COVID-19 just proved it.
What Does All of This Mean for Commercial Real Estate?
So, if all those who have been working from home for the last few months don’t ever need or want to come back to their offices, what happens to the value of that real estate? Will the company they work for continue to need all that space? If not, will they voluntarily continue to pay rent for a space they don’t need? Will the company eventually mandate that their employees return to the office, or will they take the opportunity to cut their overhead associated with office space? I don’t think there’s a blanket answer here, as I believe some companies will mandate their employees to return to the office eventually. But I am 100% certain that a good number of companies will jump at the opportunity to give up the costs associated with existing office space that they no longer need. It just makes good business sense.
These decisions, which you can bet discussions are happening as we speak all across the country, will be the driving factor in declining occupancy for a lot of commercial real estate. This will lead to lower revenues for the building owners, which then leads to declining values of that real estate as potential buyers won’t be willing to pay a premium price for an unprofitable building. Instead, those potential buyers will decide to wait for the prices to come down before investing. At some point, I believe that process will begin. It will become a destructive cycle of declining commercial real estate occupancy, revenues, and values, followed by more waiting on the investor side. And it will feed itself until it finds the bottom. All because we now know a lot of us can effectively and efficiently work from home due to COVID-19.
Rent is a Reality
There is yet another side to the COVID-19’s effect on commercial real estate. That is the inability of some tenants to pay their rents as their businesses have shuttered due to local orders, in a myriad of cities across the country. Some states have done better, and some have gone completely off the deep end with their regulations. Still, they’ve all affected the ability of a large swath of existing businesses to meet their rent obligations on a timely basis, or at all. This is putting a lot of stress on the commercial market and is the first blow in what will likely be many for the sector.
The New York Times published, Tenant’s Troubles Put Stress on Commercial Real Estate on June 9, 2020, detailing many of the troubles occurring. The San Diego Tribune published one on June 20, 2020, titled Coronavirus Fallout: Is Commercial Real Estate Headed for a Crash, which paints a similar picture. Read them both if you have time.
Technology Needs Space Too
But there is a flip side to the commercial real estate story as well, and this is where the eventual changes begin to take shape. Think about what allows us to work from home so effectively and efficiently. It’s technology. Were it not for programs like Go-to-Meeting, Zoom, Skype, Facetime, and Teams, just to name a few, none of what we do today would be possible. We’d still be lugging physical files from the office to the house and back again, needing cumbersome copy machines and fax machines in our home offices, otherwise known as spare bedrooms and basements.
However, most, if not all, of our data is digital today. But that digital data still takes up physical space, LOTS of physical space. In July of 2016, a report by Gartner Inc. estimated that Google had approximately 2.5 million servers. Four years later I’m sure that the number is much higher. And that’s just Google. Amazon Web Services is looking to build a 1.75 million square foot data center outside Dulles Airport on 100 acres of land they purchased for 73 million dollars last year. That area is already home to more than 18 million square feet of data center space. The demand for physical space for data storage and cloud access gear is going to be incredible.
From Technology to Utilities
The market impact of all this is going to be rather significant as well. First of all, tech is the new industrials; it’s just a fact. And all that tech requires massive amounts of electricity. Not only is it needed to run all the servers and associated gear, but all of that generates a lot of heat, so it has to be in a climate-controlled environment.
The more reliant we are on technology, the more reliant we are on electricity. One doesn’t exist without the other. So, while electric utilities may be out of fashion to some politicians, they’re going to be in demand for a long, long time to come. I believe that tech of all kinds, and the energy sector, which powers that technology and innovation, will be market leaders for the foreseeable future.
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Residential Real Estate and COVID-19
Let’s move on to the Residential side of the real estate market and take a look at what’s happening there.
First of all, the obvious, with everyone forced to stay at home for long periods, you eventually have to start looking for things to do. EVERYTHING has been cleaned, multiple times, the pantry and the closet are organized, your lawn is finely manicured. What are you going to do? Answer; home improvements. Home Depot, Lowes, Ace, True Value, Menards, etc. have been on an absolute tear during this pandemic.
There were lines outside, taking 30 minutes to an hour to get into the store, and they were there every day. This has led to something I never thought I’d see, a shortage of lumber of all kinds. Want to build a cedar picket fence? You can’t; because there are no cedar pickets to be found, ANYWHERE. Want some treated lumber for an outdoor project or where the wood may come into contact with concrete? Sorry; because there’s no, or very little treated lumber available.
It’s insane. But that supply is going to have to be replenished, and it will be. The resupply effort is going to take every piece in the supply chain to get it done. So, sawmills, timber, transportation, energy (there’s energy again), and all the ancillary industries associated with this are going to have to produce at full capacity for some time. That will be good for those sectors of the economy.
What’s Not Obvious About Residential Real Estate During COVID-19
Now let’s take a look at what is happening in the Residential real estate market that isn’t quite as obvious, but may not surprise you all that much.
This CNBC story from April 27, 2020, says the millennials who flocked to the urban districts to be close to amenities like the Power and Light District here in Kansas City or its equivalent in any city USA, have figured out that living in a congested area like that, in a pandemic like this, just isn’t all it’s cracked up to be. And they are figuring it out en masse. As the story mentions, if they are going to be working from home, they need more space than they need the convenience of being able to walk to the corner grocery or the corner bar in an urban setting.
They need to set up an office, have a place to exercise, and even a little bit of privacy. This trend hasn’t become a full-blown exodus yet, but it may. And if it does, those pricey urban apartments will become an albatross around someone’s financial neck. The evidence that the trend is growing comes in another CNBC story that was published two months later. The Flight to the Suburbs is Real details how home searches in local zip codes jumped 13% in May, double the pace of growth in urban areas. It also points out that millennials are now the largest cohort of home buyers, and they’re reversing their trend of piling into the urban areas. Again, this doesn’t bode well for the urban rental real estate market in the long term.
What About Gen-X and the Baby Boomers?
It’s not just millennials, the Gen-Xers and Boomers are moving too. They’re just moving farther out, much farther out. This story from Fox Business details how the older cohorts have begun leaving the suburbs for smaller towns, just as the millennials are moving to the suburbs. I don’t believe there’s a correlation there; rather, I think it’s coincidental.
Both groups are ready to move someplace quieter and roomier, with a somewhat slower pace of life, as they process the changes occurring in their daily routines due to the COVID-19. This is driving the existing homes market to some record gains. According to a CNBC story from July 22, 2020, existing-home sales in June jumped 21%. That’s the most significant single-month gain since the National Association of Realtors began keeping track.
I have several friends who are in the real estate business and work in smaller towns. One in particular, who works in the Table Rock Lake community of Shell Knob, Missouri, told me that it’s a record year for sales at the lake. He said people are selling everything in the city and purchasing a house at the lake to be their full-time residence, not just a vacation home. And it’s all because of the fallout from COVID-19.
Escaping to Quieter Horizons
The lake is calm (during the week), and things haven’t changed there much, so it feels normal to them, and they’re craving normal. I think that’s what’s driving a lot of the millennials’ movement, too. Most of them who’ve moved into the urban areas actually grew up in the suburbs somewhere and want to get back there to raise their families. The Gen-X and Boomers, in large numbers, came from smaller communities now nostalgic about that time in their lives, and have the wherewithal to recreate it.
My guess is the losing battle in this evolution of the residential real estate market will be fought by the urban apartment complexes and, to a lesser extent, the multifamily complexes erected all over the suburbs. As the millennials begin to raise families, with a new sense of what is essential due to the effects of the COVID-19 pandemic, the flight to the suburbs and existing or new single-family dwellings will be a robust economic engine for the next several years. Just think of all the stuff that goes into a new home or remodeling an existing one. That’s where the opportunities will exist, as long as the lumber shortage is rectified soon.
In closing, I believe it’s not a question of whether or not COVID-19 changes the face of real estate as we know it. Rather it’s a question of how dramatic a facelift the real estate market undergoes.
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The views expressed represent the opinion of Modern Wealth Management an SEC Registered Investment Advisor. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Modern Wealth Management does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.