Can Commercial Real Estate Recover From COVID-19?

In this article

“I’ve got good news and bad news. Which do you want first?” Everyone’s favorite question, right? Let’s start with the bad news, so we can end on a positive note. 

A recent Bloomberg article spelled it out under the headline, “The World’s CFOs Have a Dire Message for Real Estate Investors.”  

This piece explains a very serious investing situation: Many commercial real estate investment portfolios will be hurt by the fallout from COVID-19. And some will be devastated. 

But there’s some great news as well. There are a few potential solutions that could rescue your portfolio and even accelerate your returns. 

The Bloomberg article explains that many large and small companies worldwide are slashing their commercial real estate costs. They analyzed over 4,000 earnings calls in the last half of 2020 and found that many are in the process of breaking or renegotiating leases for office space, branches, data centers, and more. There’s also the devastating impact the pandemic has had on hotels, retail, malls, and more. 

“As the global recession deepens and companies brace for the new normal that follows, business will require less space than pre-COVID,” the article reads. “An October survey by the U.K.’s Institute of Directors found that 74% of companies planned to make more use of working from home once the pandemic subsides, with more than half intending to reduce the amount of workspace they use.”

The fallout from the pandemic and a host of other factors are to blame. And while vaccines may allow people to gather publicly again in 2021, there is one simple fact that changes everything: For the first time in human history, a large percentage of the population is able, and even encouraged, to work remotely. 

This, along with many other factors, is leading to a fundamental shift in where we work. And it’s driving a massive population migration that will leave many of America’s most populous cities devastated. BiggerPockets contributor G. Brian Davis lays this out well in this recent BP Insights Post. 

This is no small issue. Most of the world’s largest individual and institutional investors participate in commercial real estate. An estimated $10 trillion in worldwide capital is sitting in investment (non-owner-occupied) commercial real estate, and over one-third of that is in the U.S. 

What now? 

So, is it time to run away from commercial real estate? 

Not at all. Commercial real estate has the highest Sharpe Ratio of all asset types, dwarfing all classes of equities, commodities, and treasuries. (The Sharpe Ratio is a measurement of return divided by risk.) Commercial real estate is a preferred investment of the rich and famous, pension plans, life insurance companies, and more. 

So what are the factors to contemplate as you consider a commercial real estate investment? And how could thinking outside of conventional wisdom actually help boost your returns and decrease your risk? 

Asset type

Conventional commercial real estate wisdom gravitates toward historically safe and predictable asset types. Office buildings are a good example. 

But conventional wisdom may be out the window in the unprecedented circumstances we find ourselves in now. My firm has been looking for the most recession-resistant commercial real estate assets, and we’ve been very pleased with mobile home parks and self-storage. 

Mobile home parks are the only asset type experiencing a decreasing supply and an increasing demand every year. There is an affordable housing crisis, and the demand for manufactured housing is on the rise while virtually no new parks are being built nationwide. 

About 10,000 Americans turn 65 each day, but six out of 10 have less than $10,000 saved for retirement. Many have home equity, however, which they may be  willing to cash in for a mobile home park lifestyle. 

Self-storage has been thriving in up and down economies. The four D’s of downsizing, death, displacement, and divorce continue to drive this market. Raise an apartment tenant’s $1,000 rent by 6% and they’ll potentially move out rather than sign a contract for an additional $720 next year. But because storage rents are lower, tenants can more easily absorb increases. Raise a storage customer’s $100 rent by 6% and they probably won’t spend a Saturday and rent a U-Haul to move their stuff down the street to save $6 every month. 

Risk level 

Conventional wisdom here celebrates the lowest-risk asset types and “rewards” their investors with a higher price tag and lower returns. Low cap rates (high prices) on a Manhattan office building have long been accepted as the norm, and commercial real estate investors have happily paid for the privilege of owning assets like this. 

The stability and predictability of returns make it a safe haven for institutional investors like life insurance and pension funds. These assumptions are certainly being revisited in light of this crisis, and many of these investors are likely sweating bullets over the impending losses around the corner. 

For investors like you and me, certain value-add opportunities are actually far safer. Institutional investors would find more safety and stability in many of the assets my firm has invested in these past few years. 

Location 

Traditional commercial investors have paid a premium for historically stable locations like New York, Boston, Chicago, San Francisco, and Los Angeles. But people are fleeing these densely populated, high-cost-of-living locations and relocating to smaller cities and rural locations. This significant net migration into secondary and tertiary markets is creating fresh demand, especially in assets like self-storage and mobile home parks. 

Small towns are often ignored by commercial investors, and there are many good reasons for that when it comes to office, retail, industrial, and other asset types. But if you’re tracking with the thesis of investing in recession-resistant asset types like self-storage and mobile home parks, you may see this differently. These asset types typically flourish in all types of locations. 

Have you heard of Beeville, Texas? I hadn’t either. But we invested in a mom-and-pop-owned self-storage facility there in March of 2019. Our operating partner acquired this distressed asset for $2.4 million in cash, stabilized it in three months, refinanced it for $2 million, and sold it for $4.6 million. 

The return on equity was over 400%, with a hold period of just under two years. His investment was likely safer than many pricier and sexier commercial assets. And locations like this don’t draw national competitors like Public Storage. But it takes the right operator to do deals like this. 

Operator experience 

Conventional wisdom seeks institutional operators who know how to manage stable assets. While this is great, the strategy I’m promoting may require a different operator or investment partner. 

Our favorite operators utilize acquisition teams that fly under the radar to get deals few others have access to. And they have access to institutional buyers who are happy to acquire stabilized assets from them after successful execution of an effective value-add strategy. This strategy forces appreciation by creating investor value in both components (the numerator and the denominator) of the commercial value equation. 

Pro tip: The commercial real estate value equation

Value = net operating income ÷ cap rate

This powerful equation calculates value in the commercial real estate realm. This powerful equation calculates value in the commercial real estate realm. It allows operators and investors to determine the relative value changes from implementing value-add strategies. These strategies increase net operating income, the numerator. And selling to an institutional investor will often result in a compressed cap rate, the denominator, further increasing value.

It is widely known that there is a portfolio premium paid by institutional investors for stabilized assets. It is widely known that there is a portfolio premium paid by institutional investors for stabilized assets.  

Debt level

This is one area where we agree with the traditional wisdom. A safe level of debt is a powerful lever for income and returns. Excessive debt can put investors at great risk. 

Many institutional investors seek assets leveraged at about 50%. This will increase cash flow a good bit, but at the time of sale, it should effectively double the profit from appreciation since 100% of the value escalation flows to half of the investment (the equity only, not the debt). 

Get to know the Debt Service Coverage Ratio (DSCR, aka the Debt Coverage Ratio or DCR). This is a great measure of risk and can be a measure of overall health of the investment. The DSCR is basically the net operating cash flow (not including debt service) divided by the debt service (principal and interest). A typical minimum DSCR is about 1.3, which means there is a 30% margin of safety. We like to see a much higher level, especially after an asset is stabilized. 

The leverage arena provides another boost to this value-add strategy. By making meaningful improvements to net operating income, operators can see substantial boosts to DSCR. 

A case study 

I joined our operating partner on the ground in Louisville, Kentucky, roughly a year ago. We were performing due diligence on the purchase of a 311-site mobile home community. The park’s owner had passed away years before, and his wife had not visited the park since then. The operator’s acquisition team located it off-market through a call to the owner. 

The operator went on to acquire the asset on February 20, 2020, for $7.1 million. That consisted of about $3.5 million in cash plus $3.6 million in debt. He received an offer of $9.5 million for the property for five days later. He turned it down with no counteroffer. 

I was a bit surprised he would decline an opportunity for a 33% return on the asset, and more importantly, a 68% return on the equity. He told me the property would be worth much more than that after his team executed their value-add strategy.  

First of all, the lot rents were drastically below market (up to 35% lower). The operator raised rents modestly. But as we learned from the CRE value formula, a small increase in revenue (with no increased cost) can lead to a large change in value. 

Secondly, the water and sewer were paid by the owner rather than the tenants. This was common in yesteryear, but not so in large modern parks. The major local competitors all charged water and sewer to tenants. The operator’s team metered each mobile home and passed these costs back to tenants. 

Third, there were 50 or so vacant sites. This is a big problem for mom-and-pop owners. The most common solution is for the park owner to acquire and set up homes on site, then try to sell them to new tenants. This requires a lot of capital, effort, and risk. But there can be a large payoff from increasing occupancy (especially with new homes). 

The operator got through the first two of his three initiatives. He didn’t get around to the third before he received an unsolicited offer he couldn’t refuse. The operator accepted an offer from a large mobile home park operator and closed for $15 million last month. When including cash flow along the way, this project returned a 347% IRR (and a 3.4x multiple on invested capital) at the project level. 

Let’s briefly review this deal in light of the five factors above. 

1. Asset type. Mobile home parks are a recession-resistant asset with a large number of mom-and-pop-owned acquisition targets. It is estimated that almost 40,000 of the 44,000 or so parks in the U.S. are operated by small-time operators who don’t have the knowledge, resources, or desire to upgrade their assets. The operating partner paid the prior owner a fair price for this asset and his team did the work to improve the value. 
2. Risk level. This was a value-add asset. It had steady cash flow going in, but the obvious upsides provided a significant boost in income and appreciation. 
3. Location. The traditional wisdom for prime locations isn’t necessarily optimal at this time and the right asset in a less-competitive location can be advantageous to investors. This asset fits those criteria. 
4. Operator experience. Our operating partner has a dynamite acquisition team and a profound ability to locate under-performing assets with outstanding latent potential. This was one of the best we’ve seen in our partnership with him. 
5. Debt level. Our collective group of equity investors only funded about half of the purchase price. The bank footed the rest of the bill. But the bankers didn’t get to share the upside. The equity investors enjoyed the full cash flow (minus interest payments) and the full appreciation. And if this asset or the economy had taken a nosedive, we would have been quite safe with a DSCR of well over 2.0 (a 100%+ margin of safety). 

Has commercial real estate suffered from this pandemic? You bet. Is there a way to beat the downturn and make a profit at this point? Absolutely. You just need to be thoughtful and strategic on where and how you invest—and with whom. 

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.