On February 19th, 2021, the federal reserve issued its semiannual “Monetary Policy Report” (1). A report that I am particularly interested in because it mentioned that “commercial real estate prices remain at historically high levels despite high vacancy rates and appear susceptible to sharp declines, particularly if the pace of distressed transactions picks up or, in the longer term, the pandemic leads to permanent changes in demand.”
I’ve been anticipating this sentence since the beginning of the pandemic as the governors of many states shut down the profitability of many commercial buildings. I fear, however, that readers may not be sure what the federal reserve is talking about or why one could interpret it with concern.
So in this article, I will paint a fictional but relatable and realistic scenario of why there might be concern for the commercial real estate market.
Let’s pretend that there is a yoga studio, owned by Sally, operating profitably in January of 2020. The previous year, the business had the following:
*assuming 49 weeks of working days less weeks of holidays / time off
You can see from the example above that the rent for the commercial real estate space of $54,000 per year or $4,500 per month was worth the cost to this business owner. It was worth the cost because the operating income was +$32,064 per year or an average or $2,672 per month.
Then, in our fictional scenario, a pandemic hits in 2020 and the governor of the state requires the studio to shut down. Meaning that during the shut-down the commercial real estate space has no value because it does not generate any income for the business.
Not only did the space not generate income, but it represented an enormous amount of risk to Sally because she was required to continue paying rent despite the governor’s mandate because of her lease. The space was not only worthless but it also represented a liability for Sally. It now cost her a significant amount of money to pay rent for a space that she could not support with revenue from sales, because she had no sales.
Let’s fast forward to the next year, 2021, and see where everything has landed. Now the business may open because it is in a state that has allowed restricted operations for the year, but there are big changes:
The business can only fit a maximum of 4 students in the class in order to keep all class attendees 6 feet apart from each other
Sally can only schedule an average of 3 classes per day in order to clean each room between classes and according to new standards
Here is what the projected financials look like with the new changes:
*assuming 49 weeks of working days less weeks of holidays / time off
Sally has the opportunity to choose at the beginning of the year either to renew her lease or cancel it. Based on the updated financials, what does it look like is the best scenario for Sally?
If she renews her lease she risks losing -$86,124 or more the next year.
If she gets a loan she risks losing -$86,124 or more the next year and will have to pay off the additional value of the loan.
if she does not pay the loan off it will most likely impact her credit score and ability to get a loan in the future.
If she does not renew her lease and closes the studio then her losses are only limited to what she has already incurred.
The best choice available to Sally is most likely to close the studio in that location. The cost of the lease for the commercial real estate space is no longer profitable for her because of the changes in market sentiment and new restrictions in running her business.
So how does this one scenario help us to understand the sentence: “commercial real estate prices remain at historically high levels despite high vacancy rates and appear susceptible to sharp declines, particularly if the pace of distressed transactions picks up or, in the longer term, the pandemic leads to permanent changes in demand”?
Let’s dissect it.
We now know that it is not profitable for Sally’s business or other businesses similarly affected by the pandemic to continue leasing commercial real estate at the same price as before the pandemic.
The commercial real estate is not worth as much as it was prior to the pandemic because it cannot bring in the same amount of revenue for businesses. It cannot bring in the same amount of revenue because of occupancy restrictions, personal safety sentiment, and other restrictions placed on the businesses ability to sell a product or service to its customers.
The report is saying that despite the fact that commercial real estate is not worth the same amount as pre-pandemic levels, landlords are still pushing for historically high rent prices. Usually, when a commercial property landlord prices their property to lease, a major component of the rental price is the expected future income the property may earn for the tenant. Landlords use this formula in order to raise the rental price of a property if their projections indicate that the property will earn the tenant higher income in the future.
Why then, are landlords not applying the same formula to lower the rent on properties given their loss of value? I can guess at a few reasons as to why, but the end result is that commercial properties are continuing to try and rent out their properties at the same rate or higher compared to pre-pandemic prices, even though the properties will not generate the same amount of commercial revenue.
The next part of the sentence suggests that many business owners, similarly to our fictional Sally, have decided that they do not want to sign a lease that almost certainly guarantees them to lose money given the current market conditions. As a result, there are “high vacancy rates”.
The rest of the sentence in the report suggests that either commercial landlords will have to drop their prices to reasonable rates OR demand will have to miraculously go back to where it was prior to the pandemic.
Overall, there seems to be a game of chicken going on between commercial real estate landlords and business owners. Will business owners sign a lease even though it most certainly ensures them a loss of income? Well that option doesn’t make sense for savvy business owners because why would someone channel money into a losing venture? Unfortunately, this happens all the time and is usually because of poor financial planning. Please schedule a FREE consultation call with me today BEFORE signing a lease or going into any business venture.
Or will landlords lower the rental price of their properties based on the updated value of their buildings? In part 2, we will discuss the effects that a large-scale decrease in commercial real estate prices might have on the U.S. capital markets.
References
1) United States. Federal Reserve Board. (2021, February 19). Monetary Policy Report; Report of the Federal Reserve Board pursuant to The Federal Reserve Act; February 19, 2021 report. Retrieved from the Federal Reserve Web site: https://www.federalreserve.gov/monetarypolicy/mpr_default.htm
2) Photo by Matthew Hamilton and retrieved on unsplash.com
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