But what challenges await the US and the wider world?
Over a year after the Covid-19 pandemic spread across the world and crippled economic activity, a recovery is underway. The consensus among economists is for the recovery to be strong, which has only been amplified in recent months and justifiably so. Vaccine efficacy, vaccine distribution progress and a substantial new US fiscal stimulus package have helped skew the balance of risks to the upside and should provide significant additional support to global activity. For property investors, this is all welcome news, but after being so focused on the fallout of Covid-19, new challenges await.
Along with the economic recovery, it is widely expected that dormant inflation is set to awaken. Hints of inflation have already appeared in the United States and inflation has emerged as one of the most talked about concerns among investors in 2021. Base effects, supply chain constraints and pent-up demand aided by robust fiscal policy have contributed to the recent rise in concern, but market participants and policymakers are holding onto the view that a surge in long-run inflation is unlikely.
For property investors, who tend to have longer investment horizons, trend or long-term inflation can help navigate periods of temporary turbulence. Cyclical oscillations around trend inflation have been well documented throughout recent history, while the long-term structural drivers of inflation identified pre-pandemic remain largely unchanged today. These factors anchor the belief that outsize inflation will be largely transitory. Nonetheless, there are still implications for the property markets.
“Lease structure can dictate whether scheduled rent increases will be able to keep pace with inflation”
Leases are one part of the puzzle where inflation can come into play for property investors. Lease structure can dictate whether scheduled rent increases will be able to keep pace with inflation, if landlords can pass on expense increases to tenants, or if increases in pass-thru expenses are capped.
As such, lease structure will have increased importance on asset and portfolio performance during bouts with inflation and may become a bigger point of contention in lease negotiation over the short and medium-term.
Construction costs are another touch point for property investors as it relates to inflation. When looking at budgets or cash-flow projections, we sometimes forget that commercial real estate is concrete, steel, lumber and the labour that puts it all together. When the costs of these inputs rise, it can erode developer profits and can act as an economic barrier to new supply with an absent corresponding increase in property values. These natural laws of economics have historically helped commercial real estate supply align with demand and kept property income growth well-balanced against inflation over the long run.
“Commercial mortgage debt pricing currently contains a cushion of spread that can absorb a considerable rise in underlying interest rates”
Over the past few decades, we have seen a secular decline in interest rates towards zero or lower in some geographies. The prospect for higher inflation may help reverse this trend. In the short and medium term, the risk relating to higher interest rates appears manageable for most property investors. In particular, commercial mortgage debt pricing currently contains a cushion of spread that can absorb a considerable rise in underlying interest rates. This cushion is the result of the slower adjustment in commercial mortgage rates to the covid-related drop in underlying interest rates.
Additionally, property cash flows are not fixed and the negative effects from higher borrowing costs on levered property need to be balanced against the positive impact of the stronger economic growth that generally coincides with increasing interest rates. This is unlike bonds, which typically have a fixed payment schedule. Therefore, the risks property investors face with rising capital costs are more centred around economic shock events that have the propensity to drive financial market spreads wider. Unfortunately for many property investors, the vaccine will not cure all their Covid-19 woes. Lag effects and uneven recovery prospects will weigh on portfolio performance in the years ahead.
As employers contemplate their future office models and long-term occupancy, they may decide that working from home part of the week will cut their office space needs or that certain locations are no longer appealing. These decisions will most likely occur as leases expire, two, three or more years out. Similarly, retailers who have held on through the pandemic may ultimately find their space less productive as the recovery fully materialises. These situations can lead to lost income during periods of downtime, unplanned capital expenditures, free rent incentives and lower income potential.
Additionally, the pandemic has created new structural challenges for property investors and has accelerated existing structural trends beyond property’s traditional cyclical sensitivities. The result has been highly differentiated performance across property sectors, property subtypes, markets and specific locales within markets. It is almost certain that the recovery will be highly differentiated as well. Hospitality lends itself as a prime example. There are signs of strong desire among consumers to resume vacationing post-vaccination. On the other hand, businesses have enjoyed the cost saving associated with video conferencing, and travel budgets are likely to be tighter going forward versus pre-covid. This positions leisure-oriented hospitality more favourably than business-oriented travel.
In conclusion, property investors are well advised to pay attention to very positive prospects for economic growth. Though uneven recovery prospects and lag effects require careful evaluation of deal and portfolio level idiosyncrasies to drive performance, commercial real estate appears generally well positioned to face post-pandemic challenges.
