Fitch: Secular Shifts Force U.S. Commercial Real Estate to Adapt

Fitch Ratings, New York/London, said post-pandemic, many U.S. commercial real estate segments will be transformed by the way space is used, which will have long-term consequences for property performance and financeability.

The report, The Next Phase: U.S. Commercial Real Estate Coronavirus Implications (Office and Lodging Face the Greatest Post-Pandemic Uncertainty), said the pandemic has also introduced new challenges to social and business transactions that will affect retail, office, lodging, industrial and multifamily housing to varying degrees.

Fitch said with office shutdowns and social distancing, working from home became the rule rather than the exception in many cities, and Fitch expects it to continue on a much larger scale than prior to the pandemic. “As a result, both multifamily properties and office spaces will need to adapt to appeal to tenants who have specific space and amenity requirements,” the report said.

The pandemic has expedited plans to upgrade multifamily buildings to attract a more mobile, short-term tenant. Apartments historically had low capital expenditures as a percentage of net operating income, but Fitch expects these costs to increase over the long-term, pressuring margins as a result.

“[Working from home] reduced the importance of home and office proximity, and people are increasingly leaving urban centers for more affordable and spacious locations for families and home offices,” the report said. “Multifamily properties in cities experienced steep declines in rental rate growth during the coronavirus pandemic as demand has fallen. While cities will remain attractive places to live, the prime renter cohort of younger, childless professionals is growing more slowly, indicating a slow return to strong demand for city rentals.”

Similarly, Fitch said office owners will need to invest in space reconfigurations to adjust to density expectations, but fewer people will be working onsite at one time as working from home becomes routine for some employees. “Consequently, tenants are unlikely to increase their overall leased space by amounts material enough to offset secular WFH demand pressure,” the report said. “Office properties in markets with a large WFH employment base with less tenant demand or older Class B properties that are costly to retrofit could become obsolete and/or less financeable.”

In the near term, Fitch said landlords will likely need to offer concessions in the form of free rent or higher tenant improvements to entice tenants to enter into new leases or renewals. “Retrofitting office space to adhere to local health and safety department guidelines could lead to greater differentiation between building classes and a flight to quality as tenants seek space with these high standards,” the report said. “Longer-term, office net cash flows may decline due to rising operating expenses, lower occupancy and lower negotiated rents.”

The report said business travel plummeted during the pandemic, but Fitch expects this segment will rebound post-coronavirus as face-time is highly valued to cultivate business relationships. “Video conferencing will continue but will not fully replace in-person events and meetings,” Fitch said. “Domestic leisure travel demand is resilient and business travel will follow as conferences resume. Longer term, this should support a return to lodging occupancy to prior peak levels.”

The report noted the changes taking place in other segments of the commercial real estate industry are catching up to what retail has already experienced over the past few years.

“The secular shift from physical retail toward online consumption started over a decade ago, negatively affecting mall traffic and forcing brick-and-mortar stores to develop their online presence,” Fitch said. “The pandemic is further altering the retail landscape, leading to retailer bankruptcies and property cash flow volatility and long-term value decline for non-core properties. Fitch expects trophy malls will benefit as secondary malls and weaker competition close and are repositioned over time.

Meanwhile, Fitch said significant growth in e-commerce will bolster demand for big-box distribution space over the long-term, benefiting properties related to supply chain management and distribution of products direct to businesses and consumers. “New industrial development will increase and some obsolete Class B- and C-malls may be repurposed to industrial, although we do not expect this to be widespread,” the report said.