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Commercial real estate must do more than merely adapt to coronavirus

McKinsey & Company, reflects the views that Inospace have been expounding for the last three years.

Rael Levitt
Rael Levitt
April 14, 2020
Commercial real estate must do more than merely adapt to coronavirus

A recent publication “Commercial Real Estate Must Do More Than Merely Adapt To Corona Virus” by international business consultancy, McKinsey & Company, reflects the views that Inospace and I have been expounding for the last three years.

The article I penned on the 24th February 2020 titled “Real Estate Is Being Disrupted Faster Than What You Think” raises many of the issues that McKinsey refers to in their work. February was only two months ago, yet the world has been rapidly disrupted over this short period. Crises do that. A crises often fast forwards long-standing structural problems that are delayed or ignored when times are stable. Corona has already turned its economic virus on commercial real estate, and the whole industry is being forced to change and adapt quickly.

The last international economic crisis, known as the "Global Financial Crisis", began in 2008 with financial uncertainty starting from a downturn in residential real estate and triggering a subprime mortgage loan crisis which rapidly spread to the balance sheets of banks and financial institutions.

Crises force speedy changes

In the last crisis, over the US winter of 2008-2009, more than 750,000 job losses were recorded every month—a total of 8.7 million jobs were lost over the course of that recession. Thanks to massive US intervention of both monetary and fiscal policy, it did not become a deep and prolonged recession. After a contraction of 4.2 percent in gross domestic product, a recovery began in the second half of 2009. Unemployment peaked at 10% in October 2009.

Commercial real estate was mildly affected by the Global Financial Crisis. In countries regarded as "developing economies" it was hardly noticed. In South Africa local commercial property boom that had begun in 2004, had a 6-12 month hiatus and then continued unabated until 2017/18. It is thus no exaggeration to say that if the Global Financial Crises was a mild heart attack for commercial real estate, the Corona Crisis appears to be a full-blown seizure and cardiac arrest.

The 2008 global economic crisis will be mild in comparison to the 2020 Corona crisis 

Like many heart attack victims, there have been several concerning signals for some time and they have often been ignored. What has happened over the last few weeks is a manifestation of years of the good life. In February, before there was any talk of a global lock-down which triggered a sudden constriction of cash flow to many businesses, I stated that a “storm of global trends are coming together at the same time to cause real disruption to real estate”.

Permanent change for real estate will be felt long after a corona vaccine has been found

So, what does McKinsey say? They make the point that to respond to the current threat of Covid-19, and to lay the groundwork to deal with what may be permanent changes for the industry after the crisis, real estate leaders must act now. According to them many must centralise cash management to focus on operational efficiencies and must change how they make portfolio and capital expenditure decisions. Some players will feel an even greater sense of urgency than before to digitise and provide a far better and more distinctive customer experience. We have been saying for ages that it is time to focus on tenant experiences in an industry which too often does not provide solutions to its customers.

McKinsey explains that the smartest real estate operators “will now also think about how the real estate landscape may be permanently changed in the future and will alter their strategy”. Those that succeed in strengthening their position through this crisis will go beyond just adapting - they will have taken bold actions that deepen relationships with end users, and other stakeholders. In many ways real estate owners have often put end-users at the bottom of the stakeholder line. Bankers and investors demanding yields have been at the front of the line. That is no different to what happened in the 2008 sub-prime financial crisis.

McKinsey points out that over the last few years, commercial real estate investments have generated steady cash flow and returns significantly above traditional yield sources (such as corporate debt) with only slightly more risk. “Since the virus outbreak, this reality has changed, and real estate players have been hit hard".

Many property owners are suddenly facing drastically reduced income, and almost all are nervous about how many tenants will struggle to make their lease payments. “Relief” and “rental assistance” have quickly become the words of the day, and rent collectors are rapidly trying to figure out for whom rent relief will apply and how much they need to give.

Rental relief” and “assistance” have unexpectedly become new terms in property

McKinsey also believes that not all real estate assets will perform the same way during the current crisis. The market seems to have pivoted mostly on the inherent degree of physical proximity among an asset class’s users—even more so than on its lease length. Assets that have greater human density seem to have been the hardest hit: shopping centers and offices. By contrast, storage facilities, industrial facilities, logistics and data centers have faced less-significant declines.

Not all real estate types have performed the same way during the current crisis

According to McKinsey as of April 3, by one estimate, the value of real estate assets has fallen 25 percent or more in most sectors and as much as 50 percent in others. That said asset valuations are questionable right now because they should be based on income. It’s thus no surprise that when retailers, restaurants, and hotels closed their doors during lock downs that owning a non-income generating asset is a poor investment proposition.

The most critical point that McKinsey makes is that the Corona Crisis will permanently change the behavioral habits that will affect demand for many real estate assets such as retail, offices and non-leisure hospitality properties. As an example, even a short moratorium on business travel could have lasting impact on business hotels when alternatives such as video conferences prove to be preferable.The shift to e-commerce may affect all sectors of physical real estate.

The shift from physical space to e-commerce solutions may become permanent

It is possible that retail changes permanently with consumers now forced to shop online because of closed shopping centers. Consumers may permanently adjust their buying habits toward e-commerce solutions. Before the pandemic, consumers were already shifting their spending away from physical stores. This long-term trend may accelerate rapidly after the crisis—especially as many previously struggling brands are tipped over the edge into insolvency or are forced to radically reduce their footprint.

The shift to e-commerce may also further boost already high demand for industrial space. Relatively niche asset classes (such as storage and cloud kitchens) could see an improvement in their economics, as demand density goes up.

Behavioral changes will lead to significant commercial space becoming obsolete

The depth and breadth of economic impact on the real estate sector is uncertain, just as the scale of human catastrophe from the pandemic is yet to be seen. However, behavioral changes that will lead to significant space becoming obsolete in a post-corona virus environment seem imminent. Given the potential for transformative changes, real estate players will be well served to take immediate action to improve their businesses but also keep one eye on a future that could be meaningfully different.

Real estate players who don't reinvent themselves may fade or disappear.

As during the period following the global financial crisis of 2008, while some real estate players go beyond just adapting and flourishing, others may fade and disappear altogether. The ability of commercial real estate owners (both small, but particularly large) to weather the storm will depend on how they respond to immediate challenges to the industry - particularly the current declines in short-term cash flow and demand for space, as well as the uncertainty surrounding commercial tenants’ ability to pay their rent. In the medium to long term, the changed behaviors forced upon the industry will have likely altered the way consumers and businesses use and interact with real estate.The fate of commercial real estate is dependent on its stakeholders and leaders having the ability to reinvent themselves.