Lower interest rates and commodity prices have traditionally been beneficial for real estate
The global financial volatility associated with the coronavirus, properly known as SARS-CoV-2 which causes COVID-19, has shocked interest rates to their lowest levels on record: the benchmark 10-year treasury traded below 0.70% today. Lower interest rates are arguably the most important indicator of higher real estate values, all else equal.
But interest rates aren't alone in their decline. Over the last two weeks, there has been a similar disruption to the price of lumber, which is widely used in housing production as well as the price of oil, which is a key ingredient and cost input for commercial real estate construction.
The decline in interest rates paired with the reduced cost of commodities raises an important question: could this very scary, humbling and devastating sickness cause an unexpected boost for the real estate market?
Two major recovery scenarios and the role of central banks
There are two major coronavirus scenarios worth exploration for real estate investors: a V-shaped recovery and a U-shaped recovery.
In the V-shaped recovery, life returns to normal quickly, corporate travel restrictions ease, a vaccine or cure is discovered and the same governments that are shuttering schools and major events around the globe feel confident to recommence.
In the U-shaped recovery, an abnormal level of consumer angst is met with evidence that the coronavirus is getting worse not better or the coronavirus is discovered to be more transmissible than we currently know. In this scenario, it takes greater than a few months for coronavirus to no longer be the most important factor in the global economy.
In either scenario, the central bank and government response has been, and will likely continue to be, robust. Notably, the fall in US stock markets started in earnest on February 24, 2020. With very limited information on coronavirus itself and not yet a full month worth of information on the direct impact of coronavirus on the US economy, the Federal Open Market Committee lowered the target interest Federal Funds by a 1/2 point (monetary stimulus) while the President signed an $8.3 billion bipartisan emergency funding package (fiscal stimulus).
While all this stimulus has been introduced in just two weeks, the true measurable impact for consumers and the Fed is the drop in the stock market, not the surprise increase of 237,000 jobs for the month of February with a drop in unemployment back to 3.5%. This is material for investors of all kinds and particularly those in real estate. Monetary policymakers are reacting to different data than they have traditionally relied upon.
Based on the Fed's swift actions this week relative to its December and January language and recent analysis from the Wall Street Journal signaling that another rate cut could be on the way, it is safe to assume that the global reaction from central bankers and governments will be coordinated, timely and fluid until there is better understanding surrounding the coronavirus.
When things eventually get better time has proven that the Fed does not move quickly to reverse stimulus. It is unlikely that within two weeks of a material recovery in stocks related to future positive news around the coronavirus that the Fed would increase rates by 50 or more basis points. And it is worth noting that inflation had already been running below the US Fed's targets, which is generally supportive of rate cuts. Ultimately, an adjustment back to the rates of two weeks ago is unlikely in any swift manner.
The timing phenomenon of quick rate cuts followed by slow rate increases will create some period of time where the then-current interest rate regime is more beneficial to real estate investors than what was true two weeks ago, particularly in a V-shaped recovery.
Coronavirus impact on corporate travel is crucial in both a V and U-shaped recovery
On February 28, 2020, my wife sent me the following text message highlighting the economic realities of the coronavirus:
"Babe, I love you very much. I support you in everything that you do and will always do so. I would like to know if you can reconsider going to the conference in a couple of weeks, please."
The conference is not in a city, or even a state, where there are reported cases of the coronavirus. But considering my wife’s wishes, I resolved to forgo the trip. The conference, travel, lodging and meals were going to total approximately $4,000-$5,000.
Upon cancelling, the conference managers stated that approximately 20% of the conference attendees would no longer travel because of corporate restrictions and/or personal precaution. The manager's post-cancellation email alluded to the sizable cancellations by stating, "I am working on vouchers for those who have asked to cancel. It may take a few days to get them all processed" which is further revenue lost for the conference, transportation and hospitality industries.
Additionally this week, Southwest Airlines, a predominately domestic US airline, cut its sales guidance by $200-300 million because of a drop in demand. In an interview on CNBC the CEO of Southwest Airlines noted that they don’t yet know the mix of deferring travelers that were business vs. personal, but that there is a belief that is likely to be more of a V-shaped recovery.
The two scenarios by major asset classes: Residential likely to fare better than hotel; office and retail to be mixed
Single family housing and apartments: Without a long-term impact on consumer confidence that fundamentally interrupts people's willingness or ability to pay for their own housing, the value of residential real estate rose significantly in the last two weeks as a result of the decline in interest rates and other inputs to housing values. Any temporary decline in deliveries for homebuilders and condo builders and their impact on rentals from a V-shaped recovery is likely minute. In a U-shaped recovery, people will likely find ways to hunker down at home more often including working from home and avoiding the activities that get them out of the home regularly. This could result in higher utilization of electricity and utilities, which is negative for investors that retain those costs. Additionally, increased time in the home would result in faster depreciation of building products like faucets which could increase the capital expenditures for residential real estate owners. In the harshest scenarios job and productivity losses result in lower demand and prices for homes and apartments.
Hotels: The travel bans hurt. The likelihood of a dollar for dollar recovery of lost revenues is low. Personal travelers likely can postpone their honeymoons or visits to friends, but a cancelled conference is merely lost cash flow for hotel operations. Interestingly though, in both a V-shaped and U-shaped recovery, the coronavirus will likely have a direct impact on hotel supply. Hotel projects that have not broken ground could very well be put on hold as astute hotel investors wait to see if the impact is short or long-lived. That reduction of supply in a V-shaped recovery, in combination with a sustained low interest rate environment, could result in a medium-term positive impact on the hotel supply/demand balance. In a U-shaped recovery, hotels will deal with struggles. However, the hardest hit sector will likely be the Airbnb market. It is arguably more difficult for the average traveler to feel confident about the cleanliness of an individual's home versus the institutional cleanliness at a reputable hotel.
Retail & Office: Retail is going to vary. In a U-shaped recovery, there could be a faster adoption of e-commerce than what has already been occurring over the last few years. Additionally, in a V or U-shaped economy, the biggest risk for a brand or chain is to become associated with coronavirus whether validated or not. Not only would it negatively affect the brand but it would also impact the owner of the real estate for the company irrespective of e-commerce adoption. Because of the long-term leases for office properties there is likely no negative impact on the office market in a V-shaped recovery. In a U-shaped recovery however, the negative scenario for office real estate owners would be associated with job losses or a fundamental shift in large corporations' approach to the office environment.
The coronavirus will have an unintended constructive impact for what was already a robust real estate market if interest rates remain low and the return to normalcy is only a few months. If it takes multiple quarters for consumer confidence, travel and job growth to recover residential real estate is likely to fare better than commercial real estate, but it could be unattractive for both. Aggressive and coordinated fiscal and economic stimulus in the US and beyond will continue. Most important is the improvement in health outcomes, however, regardless of the recuperation timeline, there will likely be a period when stimulus is still creating an impact that could be advantageous to real estate investments.