The economic ramifications of COVID-19 are affecting almost all commercial real estate operators’ ability to collect rents and generate income, albeit in varying degrees of severity. Income matters because it’s what allows real estate owners to pay their debts, and, hopefully, send distributions to investors. However, while generally all occupied commercial real estate assets produce some amount of income, the dependability, or “durability,” of a property’s income stream can vary greatly, especially now. As our Investment Products & Portfolio Manager, Thomas McDonald, puts it, “Not all real estate income is created equally.” Understanding the durability of real estate income allows investors to better identify which assets may have a higher likelihood of delivering returns, even during periods of great uncertainty.
What makes income durable?
While there is no way to say for sure which property will generate the most durable income, two contributing factors are the creditworthiness of the tenants and the longer weighted average lease term (WALT) . Most commercial real estate operators are always looking to rent to a “credit tenant,” which is any tenant that has an investment-grade credit rating deemed by one of the three major credit rating agencies (S&P, Moody’s or Fitch). Credit tenants usually have the operating experience and balance sheet strength to outlast volatile markets like the one we are currently facing. The Wall Street Journal reported that a REIT with larger buildings and larger and, presumably, more creditworthy tenants, collected 90% of April rent. Meanwhile, a REIT consisting primarily of 1960 office buildings and older, which tend to attract small to medium size companies, collected only 73% of April rent. Non-credit worthy tenants can still have durable income depending on their line of business: online entertainment, insurance, technology services, healthcare, and e-commerce are still performing relatively well even in the wake of COVID-19. The largest outlier would be food and beverage, where even credit tenants are laying off staff. 60% of the jobs lost nationwide in March were food and beverage related, likely due to the massive shuttering of restaurant doors. ( BLS ) Meanwhile, WALT is how much time all tenants have left on their leases proportionate to how much space they occupy in the building. A weighted average of all tenant leases provides insight into how predictable future revenue streams will be over the course of investing in or owning a building. In short, the longer the WALT, the more predictable the future revenue stream and more durable the income.
Essential vs non-essential businesses
In the wake of COVID-19, real estate income has been dramatically impacted by whether or not a business was designated as “essential.” Retail, in general, has been one of the hardest-hit asset types; although the tenant base, diversification, lease terms, and lines of business really matter. According to the U.S Census Bureau , grocery store sales, an essential business, posted a 27% increase from February to March, and we expect those numbers to rise drastically for April’s sales. Meanwhile, non-essential retail businesses will have a difficult time unless their balance sheet can sustain liabilities without income for several months. We have already seen the casualties mounting as notable groups such as Neiman Marcus and J. Crew have filed for bankruptcy. Even credit tenants like these major retailers are struggling because of the niche in which they operate. As for small business owners, the National Federation of Independent Businesses (NFIB) reported that one-quarter of them believe their business will not recover to pre-COVID levels until 2022. Further bifurcating the difference between essential and non-essential business, brokerage firm Marcus & Millichap stated landlords with mostly non-essential stores collected only 10-25% of April rent while landlords with at least some essential stores such as pharmacies and grocers collected 50-60% of April rent. For investors, this means that properties occupied by tenants with essential businesses provided more durable income streams and less volatile distributions. However, businesses that were deemed non-essential but had the technology in place to operate in a “work-from-home” environment are likely still able to pay rent, even if they’re not using their office space. Similarly, omnichannel retailers that don't rely solely on in-person transactions still need warehouses and last-mile distribution centers to store, package, and ship their goods. Multifamily has suffered minimally so far, but that may change in the coming months depending on how long the U.S. suffers from extremely high unemployment rates and more workers struggle to pay rents. The National Multifamily Housing Council stated 94.6% of multifamily tenants paid April rent. However, high multifamily rent collections could drop as stimulus checks and PPP loans dry up. Commercial real estate, like everything else, has taken an economic hit in the last few months, but some level of operations–depending on the asset class–continues amidst the uncertainty.
What lies ahead?
It’s important to note that those non-essential businesses with adequate cash reserves when COVID-19 hit will be able to survive for some amount of time. However, if 90 days turn into 270 days, businesses may have to find new ways to preserve capital. For commercial real estate operators and owners, this could mean suspending distributions, reaching out to lenders to request forbearance–essentially pausing their repayment schedule–or applying for government assistance. Whether a commercial real estate investment performs well or poorly depends on how essential the businesses occupying that property are to our daily lives, and how well those businesses can handle an extended economic downturn and the slow, staggered re-opening of our economy. Ultimately, commercial real estate operators and properties with a good tenant base, strong lease terms, and the professional expertise to weather this storm are the most likely to protect revenue streams and generate income, ultimately delivering returns to investors.
