Talk of the Novel Coronavirus, or COVID-19 as it was named by the WHO earlier this year, has inundated our social media feeds and has become part of our daily conversations with friends, family, and co-workers. I first heard of this virus in early January. I saw people forwarding screenshots initially sent out by Dr. Li Wenliang, the doctor who is known as being the “whistleblower” that alerted his co-workers and friends about a “SARS-like virus” identified in some patients at the hospital where he worked. At the time, I figured there was no need for me to be too concerned as I was 600 miles away in my second home in Beijing, and there had been no major announcements or warnings from the Chinese Government. Soon after, there were reports the virus was spreading rapidly in Wuhan and began to spread in other provinces. Eventually, there were cases in Beijing, including in the high-rise community adjacent to mine. I originally planned to return home to the States late-January until Beijing got everything under control. Still, those plans changed after I saw a CDC report confirming asymptomatic transmission of the virus. I was concerned that on my return trip home, I would run the risk of contacting someone who was a carrier, and I did not want to be patient zero back home. I decided to stay put. During this time, I have been fortunate to get an inside view of the events unfolding here in China and observe the events taking place back home in the States.
Like me, I am sure you have been contemplating the impact COVID-19 may have on your life, the economy, and your real estate investments. While it is too early to develop any conclusions, I decided to take an exploratory look into the data and conjecture the multifamily real estate market response. Recent declines in the equity markets into bear territory, unscheduled actions by the FED and the U.S. Congress, and mass hysteria permeating through the country have both domestic and international investors flocking to safe-haven securities. Multifamily real estate asset prices tend to be more resilient and are uncorrelated to sudden fluctuations in the stock market. The U.S. has already enjoyed the longest bull market in history, breaking with historical business cycle trends, hence leaving a lingering question: is COVID-19 the Black Swan that is going to send us into recession?
In this article, I explore changes in some economic indicators and consider the impact the pandemic may have on the multifamily real estate market.
How Likely Is the U.S. Economy to Enter Recession?
After a slow and steady 11-year bull run since March 2009, investors are aware the music would have to stop at some point. The lingering question on many people’s minds is, what would be the catalyst? New shockwaves felt across the globe as COVID-19 continues its exponential spread, increased uncertainty, panic, and fear among the general populous, and draconian containment measures imposed by governments in many countries appear to be the tipping point. The U.S. has experienced nearly 30 percent daily growth in confirmed cases and is quickly approaching 3,000, as seen in Figure-1.
As U.S. financial markets tanked from their most recent peak in the past month, DJI, -28.26 percent; S&P 500, -26.74 percent; and the NASDAQ, -26.64 percent as seen in Figure-2; the economic outlook is becoming more evident that we may be moving toward a recession.
In the past month, Bloomberg Economics placed a 53 percent (see Figure-3) chance of the U.S. entering recession in the coming months, which is up from the previous month of 25 percent. When tracking Bloomberg’s recession algorithm back to 1992, it has proven fairly accurate in predicting both the 2001 and 2008 Great Recession.
As trade tensions between the U.S. and China eased towards the end of this year and a phase one trade deal was signed, the probability of recession had declined going into the first month of 2020. However, as COVID-19 spread throughout China halting production, and then later rapidly expanded globally affecting other markets, the probability of recession increased as investors feared the disruptions the virus may have on global supply chains and commerce.
Further adding recession pressure is the oil price war initiated by Saudi Arabia after failed talks with Russia to reduce oil output. Oil prices dropped 30 percent in less than a week following the announcement of Saudi Arabia’s price cut up to $7 a barrel. West Texas Intermediate and Brent Crude have fallen almost 50 percent from their most recent peak. The last time oil prices were this low, an increasing number of U.S. shale producers had to lay down their rigs and put a hold on production to cut costs. This time, the effect of the decline in oil prices could lead to a broader economic impact in the United States given the U.S. is the largest oil producer in the world. In 2018, the U.S. produced 17.94 million barrels of oil daily, which is 44 percent more than Saudi Arabia and nearly 50 percent more than Russia.
Figure-4 shows The United States, Saudi Arabia, and Russia comprise 41.4 percent of the daily world output of oil. U.S. daily demand for oil represents 20 percent of the total world demand at nearly 20 million barrels per day. Therefore, in 2019, the U.S. was a net importer of a little over 530,000 barrels of oil daily. U.S. shale producers need to the price of a barrel to be at least $40 on average to cover their costs, while Saudi Arabia has the advantage with the lowest production costs in the world hovering at $3 per barrel. Russia has the ability to produce and remain in the price war until oil prices fall between $15 and $20 a barrel, according to a Bank of America analyst recently interviewed by Bloomberg. This aggressive and bold move to grab market share could be a protracted one. As Saudi Arabia and Russia go neck and neck to gain more market share, it could mean a significant loss in market share by the U.S therefore, increasing the oil trade deficit.
The Federal Reserve Bank of Dallas concluded that the U.S. shale boom accounted for 1 percent of GDP growth between 2010 and 2015 and lead to an overall 0.7 percent increase in household consumption. While the oil sector makes up around 1.5 percent of the U.S. economy, it supports 10.3 million jobs and 8 percent of total GDP through spillover effects, according to the American Petroleum Institute. A significant number of jobs will be lost as U.S. shale production declines going into 2020, and possibly, both North Dakota and Texas, two states that have benefited the most from employment increases as a result of the shale boom could see hits first. The key will be the profitability of the well. Operators will scale down and stop drilling their least profitable wells first.
The credit spread between the 10-year Treasury note and 3-month Treasury bill has been declining since 2015. In early 2019, the daily credit spread fell below zero, as low as -0.5 percent. After the number of COVID-19 cases began to increase exponentially around the world and in the U.S., the spread dipped below zero again on February 18th and remained negative until the FED took action in an emergency 50 bps rate cut on March 3rd. After the rate cut, the spread increased 66 bps; however, this may be short-lived as investors continue to purchase safe-haven securities. Investors anticipate the FED will reduce short-term rates again to bolster the market as the COVID-19 numbers keep climbing and investors aggressively reallocate capital.
One important point to note is the reliability of this indicator given the unique nature over the past 11-year bull period has been unlike any other. After years of historically low interests rates across the board, the FED’s unsuccessful attempt at interest rate hikes in 2018, and negative interest rates in other economies around the world such as Japan, Switzerland, Denmark, Sweden, and the European Monetary Union, many international investors have flocked to long-term U.S. higher-yielding securities for safety. The negative dip in the spread could be less indicative of a looming U.S. economic recession.
Credit markets appear to be tightening as the threat of corporate default grows. The spread jumped sharply, by 58 percent, over the past 10 days, indicating anticipated higher risks. The current spread at 2.75 percent is greater than the spread leading up to the recession in 2001, and the Great Recession of 2008. The credit spread peaked at 7.51 percent on December 17, 2008. Investors should monitor the growth in the spread. In the year prior to the recession in 2001, the spread increased by 56.25 percent, and grew at a compound rate of 0.12 percent. The run up to the 2008 financial crisis was much faster over a shorter six month period at 0.36 percent daily. Currently, the trend in the credit spread over the past two months changed at the end of January and has a compounded daily growth rate of 1.71 percent, with a majority of the increase occurring over the past couple of weeks. With treasury rates potentially heading lower over the coming weeks, further fueling recessionary fears, the spread could continue to widen. See Figure-5 below.
Average Weekly Hours and Overtime:
While it is still may be too early to make a determination on the trend, the average weekly hours have remained around flat around 34.3 since December 2019. Manufacturing overtime hours have increased by 0.1 between January and February. While this is a minuscule increase, the increase despite the current global pandemic is a positive sign; however, again, we will have to carefully monitor the March and April data to determine whether there has been a change in the trend. Given some U.S. states have already begun canceling classes with more expected to follow, workers may be faced with a dilemma as their children will need a caretaker. Furthermore, should a partial or full nationwide quarantine be implemented, we will see further reductions in average weekly hours.
Purchasing Managers Index:
February 2020 PMI showed mild contraction at 50.1 percent, down 0.8 percent from the previous month. ISM reported sizeable 2.2 percent decrease in the New Orders Index to 49.8 percent, an even larger 4 percent decrease in the Production Index but it still remains in the expansion level at 50.3 percent, and an increase in Backlog of Orders Index to 50.3 percent, up 4.6 percent. A major part of this change more than likely came from supply disruptions as China had to place a temporary halt on business activity in an effort to contain the virus. The March data will be important to get a better gauge of the current trend direction; however, the U.S. manufacturing sector is still growing.
Supply Chain and Other Disruptions:
Many U.S. companies have experienced supply chain disruptions, which may worsen as the virus spreads, countries implement quarantine measures, and international shipping slows. The Institute for Supply Management reported the results of a recent survey completed the last week of February to March 5th as follows:
· 57 percent reported lead times have worsened
· Suppliers are currently operating at 50 percent capacity
· Staffing levels in China are half-staffed
· Revenues were adjusted downward by 5.6 percent
· 23 percent of the companies surveyed already reported having supply chain disruptions and another 44 percent do not have a contingency plan in place
· Half of the respondents say loading delays at Chinese ports
· More than half are not getting the information they need from China
GM is working closely with suppliers to minimize disruptions and keep its most profitable factories from becoming idle.
At the start of the COVID-19 outbreak in China, Apple closed down all of its China-based retail stores. The Chinese market accounts for 20 percent of Apple, Inc’s global revenue. The company plans to follow up by closing a majority of their 500 stores worldwide to assist in reducing community spread.
Airline companies, including Delta, United, and American suspended flights to China until late April. Flight suspensions will expand to other countries as the temporary travel ban was extended to include 26 European nations. Prior to this announcement, the IATA announced there could be an estimated $113 billion in lost revenues to the industry, with the US and Canada accounting for $21.1 billion. As airline stocks have plummeted upward of 20 percent, and they will soon need to begin reducing costs by temporarily laying off staff to preserve whatever available cash they have left in their coffers to get them through the next month. Time is limited, and companies have already begun borrowing money and tapping into their credit facilities. The New York Times reported, United borrowed $2billion, Delta raised an additional $1 billion, and American Airlines raised $500 million. Based on the current rate of spread and the mitigation and current enacted containment efforts, it is highly probable the travel ban may be extended through May. If we look to China as an example, from the time China began taking extreme quarantine measures, it took a month and a half to see improvement.
Multifamily Real Estate Market Impact
While it is too early to determine the impact recent market events may have on the multifamily real estate industry, there are some areas we can remain vigilant. I am speculating the short-run impact on the multifamily real estate market will be mostly unnoticeable; however, the long-term effect could yield significant consequences on cash flow, deal volume, and cap rates should this global pandemic take much longer than expected to contain.
The current spread of COVID-19 in the U.S. only recently began to pick up steam as the CDC rolled out nation-wide drive-thru testing, and the government relaxed testing restrictions. The extent of the spread is still yet to be known; however, overall real estate activity is expected to slow down in the coming weeks as people engage in self-distancing, conventions and conferences are cancelled, and international travel restrictions remain in place. The tangible nature of real estate assets is one of its most attractive features; therefore, investors prefer to make on-site visits to properties before making a purchase decision. At the moment, U.S. domestic investors will not be profoundly affected by the travel restrictions; however, that could change should the U.S. decided to implement draconian quarantine measures such as those used in China and Italy.
Properties that are recently under contract and currently in the due diligence period could experience closing delays, and buyers may find themselves paying hefty extension fees should sellers be unwilling to be flexible. Those that have recently closed or are currently being renovated may also see a slightly prolonged value-add timeline, which will also drive up costs.
Assets located in areas that have been heavily affected, and those with a disproportionate renter base consisting of non-salaried workers unable to work remotely may experience higher delinquencies in the coming months as people get laid off, bring home less earnings and struggle to stay afloat. 2020 rental growth projections may need to be revised down for turn units and lease-ups.
Increasing prepayment risk will affect yield maintenance. Syndicators that purchased assets using agency debt will see an increase in the yield maintenance penalty as rates head lower; therefore, there will be an increase in loan assumptions, leverage ratios will decline, and the blended cost of debt would be slightly higher.
Aggregate Q1 2020 investment volume in multifamily real estate may end lower than initially anticipated, which may flow into Q2, but rebound slightly in H2 2020. This year is particularly special given the general election set to be held in the fall. In 2019, CBRE estimated 2020 commercial real estate deal volume to be between $478 billion to $502 billion, which is on par with the previous two years levels. Cap rate compression experienced over the past few years will more than likely drive down the aggregate investment growth this year. Adding to pressures, investors are going to need to become more prudent in their underwriting and not pay rich valuations for properties given the increased level of market uncertainty. Cap rates will not change during this time. If the effect of the virus spread in the U.S. is short-lived, then cap rates should remain flat, but if we experience a prolonged pandemic, cap rates may rise marginally should capital markets experience disruption and cash flows fall. Otherwise, there should not be much change in cap rates as the demand and supply fundamentals have not changed.
COVID-19 is a Black Swan that investors are still trying to determine how best to price into assets. The FED is expected to reduce rates further as the situation unfolds and may inject liquidity into financial markets to ease credit concerns. Congress may need to consider a larger stimulus package to provide relief for those who lose their job and make up lost wages. As long as we can stave off a recession, there should not be a noticeable impact on multifamily properties.
I would greatly appreciate your constructive feedback and commentary so we can keep the discussion going to help each other better prepare for the future.
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