In a previous post, I focused on the changes taking place in lifestyle and consumer habits post the coronavirus lockdown. In this post, I want to focus specifically on commercial real estate. Are there still opportunities or is it a market to be avoided?
The Economic Fallout
The ramifications of the 2-month lockdown have yet to be fully appreciated. At first glance, it would appear that given the uncertainty of the economic recovery, that commercial real estate should be avoided. The most recent data suggests that the worst is yet to come.
In some states, legislation is being considered that would deprive owners of commercial property of their contractual rights. California is the most recent example.
Which Sectors of the Commercial Real Estate Market Should Be Avoided?
At the time of this writing, the travel industry remains dormant. Airports remain closed and governments around the world are formulating rules and regulations that will be implemented once the airports are reopened. Until such time as those rules and regulations are finalized, the uncertainty surrounding this industry dictates that this market should be avoided.
A significant part of the travel industry feeds into the hospitality industry. In many population centers, hotels, bars, restaurants, and cafes are highly dependent on tourists. However, that is not always the case. Many of these types of businesses are in the process of re-opening but it remains to be seen what restrictions will be placed upon their operations. There are exceptions which we will discuss later.
The retail industry is the second hardest-hit industry, behind the travel industry. Across many parts of the country, retail has re-opened.
As in the case of the hospitality industry, retail stores are currently operating under restrictions, such as the number of customers allowed in the store at any given time. It remains to be seen how consumers will respond to these restrictions. Will they view them as oppressive which in turn will incentivize consumers to avoid retail stores and purchase more online? Time will tell.
These are the primary sectors that should be avoided until such time that trends are more firmly established. The remaining industries are a mixed bag but there are opportunities available.
Criteria to Determine the Quality of Investment
Regardless of the sector, there is a common set of criteria you should use when considering the purchase of a commercial real estate property in the current environment. Let’s examine these criteria.
The first criterion is of course tenants.
a) Is the property currently leased?
Needless to say, you should not even consider purchasing a commercial property that is currently vacant, unless you can purchase the property for a huge discount. Even then, you need to have sufficient reserves to carry the property until an appropriate tenant can be found.
b) Who is the tenant?
Is the tenant an individual sole proprietor or is the tenant a large publicly traded corporation? If the tenant is a corporation, what is the state of their finances? Do they have sufficient reserves or the ability to tap credit lines to cover their overhead costs?
c) What are the terms and the length of the lease?
You should be wary of purchasing a commercial property if the tenant’s lease is expiring in the next 12 months. That introduces a serious element of risk.
Also, does the tenant have a triple net lease, i.e., does the tenant pay all the other costs such as property taxes, insurance, utilities, and maintenance?
Who is the ideal tenant that fits this criterion? A classic example is a Walgreens or CVS store. Most of these chains’ locations were built to their specifications and leased for a term of 25 years on a triple net basis. Both these chains have solid financials, rent payments are stable, and there is little risk that they will default.
Essential or Discretionary Products or Service
Once you have established the tenant profile, the second criterion is to determine if the service or products that the tenant is providing is essential or discretionary. In the worst-case scenario, unemployment may persist over the longer term. As such consumers will tend to restrict their purchases to essential products and services.
Take Away and Delivery
One of the few exceptions to this rule is food businesses that offer take away or home delivery. If consumers are put off by the restrictions imposed on restaurants, they are more likely to order food for pick up or delivery.
The third criterion is the capitalization rate. As a reminder, the capitalization rate or “cap rate” is defined as the expected rate of return on an investment in a real estate property. This measurement is calculated by dividing the net income before income tax by the property value and it is expressed as a percentage.
The average cap rate prior to the coronavirus lockdown was about 5.5% Needless to say the cap rate has likely tightened in the meantime.
Given the inherent risks in the current environment, you would be prudent to include a risk premium in your cap rate calculation. For example, if the current cap rate is 5.5% you might want to add in an additional 1 or 2% to compensate for the risk. That essentially means offering a lower price.
If the tenant criterion has been met, then you should offer a price that includes a risk premium. In our previous example, the risk of default by Walgreens or CVS is very low so a risk premium may not be necessary.
The Bottom Line
While certain segments of the commercial real estate market should be avoided in the near term, there are opportunities that can be exploited provided that the above criteria are addressed.
In this post coronavirus environment, the objective should be to maximize return on investment and minimize risk, with emphasis on minimizing risk. While the return on investment of a particular property may be very attractive, is the risk of default or loss really worth it?
If you manage to purchase a commercial property with solid long-term tenants, and an above-market capitalization rate, you should be in a good position to weather the recovery. As I have stated on numerous occasions, it is essential to have sufficient reserves to manage any unexpected developments in the market.