Blog Post

IX Commentary: Coronavirus and Real Estate

David Austin • Jan 25, 2020

Coronavirus and U.S. Commercial Real Estate

Viruses and Economic Impact

Much like SARS in 2003, the coronavirus outbreak may have a general impact on world economic markets. However, it is unlikely to have an significant or immediate effect on U.S. capital markets or U.S. commercial real estate.

An NIH study on the economic impacts of the SARS outbreak, recently cited in an article by the New York Times, estimated that SARS cost about $500 billion in lost wages and mortality costs. Another study speculated that the potential long-term financial impact of world health events will cost the global economy $6 trillion in this century.

Consumer Spending

In general, equities markets were unaffected by the SARS outbreak in 2003, although consumer spending took a hit as potential buyers of luxury goods in China stayed away from malls and other public places to avoid exposure. Naturally, the stock price of luxury brands with exposure to China fell.

A similar effect can now be seen in Hong Kong, although it is difficult to tell whether consumer spending is down because of recent protests or from the health scare. Ancecdotal reports from our clients in Hong Kong confirm foot traffic at shopping centers has been greatly reduced. Especially during Chinese New Year, with large numbers of tourists and travel to and from China, coronavirus has stfiled consumer spending during one of the busiest times of the retail year.

Effect on U.S. CRE

We do not believe the coronavirus outbreak will have a noticeable impact on capital markets or investment in US CRE. Several weeks ago, Beijing again tightened restrictions on cash exiting leaving the China, as it does periodically, reducing Chinese inbound investment. Following the restrictions, Chinese investment fell sharply.

With a significant amount of undeployed capital currently held back by private equity, a general lack of good inventory priced to market right now, and reluctance by investors to deploy capital in what is perceivedas a softening market, we do not expect coronavirus will be to blame for the current state of U.S. CRE markets.

Finally, given the relative lack of liquidity when compared to equities, commercial real estate should be less susceptible to short-term investment swings caused by single events.

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Cap Rates and Valuation

By David Austin • 05 Sep, 2018

When I was in graduate school at Johns Hopkins, our analysis professor, a successful commercial real estate developer in Baltimore, railed against cap rates. He believed that internal rate of return (IRR) was the only viable way to look at an asset's performance and we were told to stay away from the dreaded cap rate. However, cap rates are too prevalent in the industry to ignore, so it's important to understand what they mean and how they're calculated. A cap rate is, at its simplest, the ratio between net operating income and value of the property. It really is just a snapshot of the unleveraged rate of return on an investment for a single period in time. However, there are many variations of the cap rate. Most of the time, brokers and investors look at the "entry" cap at acquisition and the "exit" cap at sale, but you can also look at building, equity, mortgage, and land cap rates. However, cap rates are not all calculated in the same manner and do not account for certain important variables. For example, taking a cap rate from current rental income (relatively less risk) and extrapolating it to future income (more risk) may result in an artificially inflated value. Some analysts include replacement reserves and some do not. It also may not be accurate to compare the cap rate from a higher risk property (without ample reserves, solid management) with that of a lower risk property. The bottom line is when comparing cap rates, it is important to understand how the cap rate was calculated. It is good practice to consistently apply the same protocol internally when looking at cap rates to determine what adjustments may be necessary, and whether cap rates were calculated using similar methodologies.