With the summer upon us, activity in the U.S. economy has begun to heat up, and so too have debates around the long-term impacts of the COVID-19 pandemic on the commercial real estate (CRE) market. Sentiment continues to strengthen alongside fundamentals, and we expect to see capital markets activity follow suit in the second half of the year. Sectors that suffered the most acute pandemic impact, including retail and hotels, are seeing the most rapid improvement in outlook. As the warmer weather coincides with a sunnier outlook for CRE, there remain significant uncertainties around the impact of the pandemic on different geographies and sectors that will both challenge investors and offer opportunities.
- Growth in the U.S. economy has been both incredibly strong and uneven.
- Property prices continue to rise, though growth in deal activity has been more gradual.
- With current fundamentals and market sentiment on the rise, investors are attempting to separate the durable pandemic trends from the ephemeral ones.
Economic activity accelerated during Q2 as expanding vaccination and declining COVID cases allowed people to reengage with the economy in ways that they were unable to over the previous 16 months. Sporting events are back to near full capacity, concerts have returned, and the number of daily U.S. air travelers surpassed 2 million for the first time since March 2020.1 This rapid acceleration is apparent in economic data, where retail sales continue to hit record highs and the ISM Manufacturing PMI is hovering above 60, an extraordinarily strong number. The positive sentiment surrounding both consumers and businesses is likely to lead to impressive GDP growth numbers over the next few quarters: Economists project annualized growth of 10% in Q2 and overall growth of 6.6% and 4.1%, respectively, in 2021 and 2022.2
While this strength is undoubtedly positive, the economy was not built to grow this quickly. As such, the rebound has been uneven in certain segments of the economy, most notably the labor market. Nonfarm payrolls have rebounded but remain 5% below pre-COVID levels, and many businesses have complained about a shortage of available workers.3 There are myriad reasons for this, and while we do expect the labor market to continue to heal in the coming quarters, labor costs will be an important data point to watch. Additionally, we have seen supply-side shortages lead to spikes in input prices; lumber and steel prices have risen 90% and 81%, respectively, since mid-2020, leading to concerns around inflation.2
Inflation has been the macroeconomic topic du jour, with the recent 5% y/y growth in the May CPI fueling concerns around rising prices.2 Certainly, the unprecedented policy actions of the past year make it difficult to shrug off inflation worries as completely baseless. However, much of the recent uptick in the CPI can be attributed to base effects and smaller, idiosyncratic supply issues. Traditionally, commercial real estate has been looked at as an attractive hedge against inflation. From a demand standpoint, property owners have historically been able to raise rents to offset higher inflation—CRE rents have shown a 0.34 correlation to 1-year lagged changes in CPI.3 From a supply standpoint, higher input costs can lead to less new construction, raising the value of existing buildings.
Strong economic growth has begun to pull through to CRE fundamentals and, ultimately, market sentiment. The Real Estate Roundtable, a CRE industry group, runs a quarterly sentiment survey of various market participants. The index for “current conditions,” which plunged to an all-time low in Q2 2020, recently rebounded to a record high just a year later. The index for “future conditions”—which never declined to the same degree, suggesting market participants believed the downturn would be severe but short—has also surged to near a record. To us, this suggests that we are entering the expansionary phase of the CRE cycle, in which current fundamentals and sentiment around the future are accelerating simultaneously.4
With economic fundamentals rapidly rebounding, the acute risks posed by lockdowns have begun to subside. Of course, there are still distressed situations that still must be worked through, but the systemic risk to the market appears to be lifting. This suggests that investors will now shift their focus toward the longer-term implications of the pandemic on property markets. To illustrate this shift, we have laid out for each property sector the shorter-term “good” along with the longer-term “uncertain”—and of course, we dive into more detail in each individual section.