Last week, Wall Street experienced its worst seven-day stretch since the 2008 financial crisis. The S&P 500 fell by about 11.5%; the Dow by 12%. Indexes in Europe and Asia fared similarly. Then, on Monday, U.S. financial markets bounced back. As of Monday evening, the S&P 500 and Dow had recovered 4.6% and 5.1% of last week’s losses, respectively.
As we all know, the reason for this current spate of volatility is the outbreak of COVID-19, commonly referred to as the coronavirus. Over the past few months, the disease has spread throughout the world, with nearly 90,000 confirmed cases and more than 3,000 deaths, including several over the weekend in Washington state. We recognize and empathize with the tragic human toll of the outbreak so far, and we hope the worst is over soon.
Investors are also concerned about the impact of the virus. One major fear is that a widespread contagion could disrupt key components of the global economy and set off a chain of events resulting in the next major recession. Others are less worried about the virus itself and more concerned about an increasing public panic fueled by misinformation, half-information, and alarmist news stories.
We’ve been paying close attention to news about the coronavirus and its potential economic effects. So far, we’ve seen few reverberations in the commercial real estate market.
Commercial real estate operates on a different timeline than Wall Street. The public market’s short-term swings rarely correlate to what’s going on in our sector as we measure volatility not in days or weeks, but in quarters and years. Long holding periods (e.g. 5–7 years) mean investments in commercial real estate regularly experience multiple short-term market shocks and panics before they are realized.
This isn’t to suggest that the U.S. commercial real estate market hasn’t been affected at all over the past few months, but we’re not yet able to quantify it. There are, however, a couple of larger trends investors should note as we look to understand the potential effects of the coronavirus on the U.S. commercial real estate market as 2020 unfolds.
For one, economic shocks can move interest rates in the short term. When interest rates move up, newly-quoted deals tend to suffer; when rates move down, deals stand to benefit. In this situation, the shock has already led to two significant interest rate moves. First, we’ve seen a greater than 50 basis points drop in the 10-year Treasury Rate, now at all-time lows. Second, we all saw the Fed’s preemptive 50 basis point cut in the Federal Funds rate. Interest rate movements such as these can lead to a two-stage effect. In the immediate term, we could expect to see spreads increase between the 10-year Treasury and the rates quoted on commercial real estate loans (i.e. quoted loan rates remain the same despite the drop in the 10-year Treasury). An increase in spreads normally inserts some turbulence into capital markets as they work to digest the spike in spreads. Such turbulence could, in turn, result in a dip in transaction volume as certain deals fall out of contract or fail to reach agreed-upon terms.
However, if the 10-year Treasury Rate settles at the new lower level, capital markets typically adjust to the new normal, at which point spreads would tighten back to equilibrium levels. This would mean that, absent a diminishment in demand for properties, a reduction in the 10-year Treasury should ultimately bode as positive news for investors, who now may be able to lock in lower rates than previously assumed.
Second, it bears mentioning that some asset types are more sensitive than others to pandemics and fears. Leading commercial real estate services firm CBRE projects that for hotels,“there will be a modest reduction in demand in key gateway cities due to fewer Chinese tourists” and that “[f]ear of infection [could cause] a reduction in discretionary business and leisure travel … impacting hotel demand into 2021.” In other words, hotels in cities like San Francisco may experience a lackluster period due to cancellations by Chinese guests. CBRE also points out that retail and industrial assets could be affected by drops in exports and consumer shopping, but that the overall impact will be “minimal.”
Currently, there are reasons to believe the coronavirus will have negligible long-term effects on the U.S. and global economy beyond U.S. commercial real estate markets. Global markets have weathered numerous outbreaks over the past 40 years. From the SARS outbreak of 2003 to the more recent MERS, Ebola, Zika and measles outbreaks, history shows that the stock market tends to weather epidemics (PDF) with few lingering complications. Of course, history also teaches us that anything can happen.
For all of the above reasons, we are taking a measured approach when contemplating the potential effects of the coronavirus on U.S. commercial real estate. Regardless of what the future holds, we will continue to closely monitor the coronavirus outbreak and provide updates to investors as the situation evolves.