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What Can CRE Operators Do to Survive After COVID-19? McKinsey & Company Offers Some Thoughts

The pandemic might permanently change some property sectors.

As state governments begin to tentatively discuss when parts of the economy might reopen, commercial real estate professionals are trying to figure out how the COVID-19 pandemic might impact the industry going forward. What types of spaces will tenants feel comfortable with and how can real estate owners and operators prepare to meet their needs to stay successful in the future? To try and answer those questions, McKinsey & Company has put together a study on how “Commercial Real Estate Must Do More Than Merely Adapt to Survive.” To discuss the topic further, NREI spoke to McKinsey Senior Partner in the New York office and one of the study’s authors Aditya Sanghvi.

This Q&A has been edited for style and clarity.

NREI: We are right now in the thick of the pandemic and feeling the impact of it, on the social and financial levels. However, psychologists have pointed out that human beings excel at forgetting pain once it passes. So, once the pandemic is over, how much lasting change do you think we will see in the commercial real estate sector?

Aditya Sanghvi: We are not psychologists, but there is a difference in terms of pain and trauma. Depending on how long this lasts it moves more from pain to trauma, and the more it moves to trauma, the more lasting the impact will be. The way we think about it is we believe that many of the changes that are happening now are accelerants of long-term trends that were already happening for a long time--for example, remote learning, e-commerce. Many people who have never used online retailers before are using them now and finding it very easy to do so. So, everything that was already happening before will continue. Another thing is office design, [where changes may or may not be lasting]. You can look at what happened at office buildings in Taiwan and there were a lot of changes after SARS in 2003 [like temperature monitors at office buildings]. But then a lot of that went away.

NREI: For the past several years, commercial real estate was seen as a very attractive alternative asset class. What is likely to be the impact of the pandemic on that perception and on investors’ interest in commercial real estate acquisitions in the medium- and long-term?

Aditya Sanghvi: You have to look at why real estate has been viewed as such an attractive asset class. Real estate provides attractive returns, particularly for pension funds and sovereign wealth funds that had to fill gaps in their funding.

On a going-forward basis, it’s hard to know exactly what the impact of all this will be on returns. If you look at the last downturn, given that real estate yields still outstripped yields on bonds and government assets, it was still attractive. If yields elsewhere continue to be low, it’s very possible real estate will continue to have a lot of demand. This is all the more so if you consider that negative interest rates could well become a feature of the investment landscape in the US. Real estate would become even more attractive in that case.

NREI: Which property sectors will likely experience the most lasting damage from the pandemic?

Aditya Sanghvi: We think that the ones that will see the most change will be retail, because of the e-commerce trend we talked about earlier. Before the COVID-19 crisis, the store still played a pretty important role in people’s decisions about what to buy—in roughly 80-90 percent of people’s purchases. We do believe there are a bunch of people using e-commerce for the first time and finding it very easy.

The second is lodging. This is really about what happens with business travel. Some of the highest paying travelers, whether it’s on airlines or at hotels, are sometimes business travelers who make one-day trips. And we are interested to see what happens with videoconferencing now, if people will just do a video conference instead of that one-day trip.

Seniors housing could see a negative influence, but we will have to see how that plays out. There could be a perception among seniors that being close to other seniors could lead to potentially a higher risk of infection. That perception could continue, or people could see it as, with seniors housing “hey, you get medical care on-site, you get monitoring on-site.” So, it could go either way.

Student housing could see more lasting damage, with hybrid education now available, you could live a little bit further from campus. It’s about where students live relative to campus. If more and more classes are happening online, it creates more options in where people need to live. Instead of a 10-minute walk from campus, it could be a 10-minute bus ride from campus.

NREI: Which property sectors will likely survive relatively unscathed? Are we likely to see some structural changes in those as well? What will they be?

Aditya Sanghvi: I should say that in every property sector, except maybe cell towers, the way in which real estate companies respond to this crisis and the services they provide to end-users will change and [that will make successful companies stand out.]

Multifamily will likely still have pretty high demand. There has already been a move away from homeownership in this country. The crisis only accelerates this trend. And that’s why multifamily stocks have come down less than other classes over the past month.

In industrial, a lot of these changes [toward e-commerce] mean there’s more demand for distribution centers.

And office is TBD. There will be a lot of changes in office in terms of remote working, people might feel more comfortable not coming in every day. But there will also likely be changes in design, with less densification, where there’s more space per person. So, office will see changes, but not as significant as the ones in retail or hotel.

This is the most important message that we hope real estate players take: we do know that the world is going to be different. And the expectations of tenants and investors will be different as well. And whoever can react to that better will be better positioned coming out of this crisis. One part of meeting those expectations is just, honestly, doing the right thing. End-users have loyalty to brands that do the right thing. Within real estate, there are some owners in multifamily that have been highly communicative, that provided support to seniors in need of it, who have been clear when staff members were sick, and people remember that. And the same thing in office.

With regard to commercial property, many tenants these days are going to ask for lease concessions. And for real estate owners, it’s going to be about “de-averaging” those decisions. For those who really do need the concessions, real estate owners need to work with them. But there are tenants who are doing fine. So, it’s about de-averaging that decision-making process.

And the last point is about digitization and elevation of customer experience. Think about your tenants as clients, not foes across the negotiation table. And in this moment in time, building scalable digital experiences to go with in-person experience is [key].

There are many owners who invested in the digital l leasing process, where you can do virtual walk-throughs of the property, and sign lease documents online. Those users are now able to do leases, and the ones who didn’t invest in those things, can’t. There are those who have provided the digital experiences for services in the home—access to telemedicine, packages that are delivered at the door. That digital kind of interface is a trend that we believe that Covid-19 is accelerating.

How this will play out in retail has been de-lineated by type of retail. Just to use a mall as an example, in a post-COVID world, in which [more] people have learned how to do e-commerce shopping, one thing is how to do the same kind of search in the mall. If I said I am looking for a red dress, and the mall said here are the stores that have it and here’s where in the store you can find it, [to cut down on the time I spend looking for it]. Another example in office and in retail is about capacity of people that can be at the property. You can imagine apps where you schedule a time to go in, where there are not a lot of people. A lot of our clients are thinking about how to have good [traffic] flow into elevators, not to have too many people in the elevator at the same time.

NREI: We are already seeing new distressed real estate funds appearing on the market. Which types of properties and entities do you think they will most likely pursue?

Aditya Sanghvi: First and foremost, there tends to be more interest that we observed from our conversations with clients in entity-level deals. In terms of types of deals, we are already seeing a lot of action in terms of acquisition of debt portfolios, we do believe there will be some take-privates of REITs. REITs were already trading at a discount to NAVs, and now even more so. And then we do think that in lodging and retail, there will be a lot of activity. If investors can find high-traffic grocery-anchored shopping centers, which are well positioned for when people come back, they are likely to find them attractive opportunities. However, it’s worth stressing that the focus of most investors at the moment is rightly on supporting existing investments, ensuring businesses and people pull through this difficult period successfully.

NREI: We’ve had almost a decade of stability and attractive returns in the U.S. commercial real estate sector. What’s your overall outlook for the sector going forward?

Aditya Sanghvi: It really does matter when we think about attractive returns, attractive relative to what? It was relatively easy to achieve good returns in real estate until now. What we will see over the next several years, we will see a lot more volatility. So, I think there will be a little bit less stability over the next several years as macro-economic trends play out.

Longer term, we know from our conversations with our institutional investors, their long-term outlook on the asset class hasn’t changed over the past two months. The view isn’t that there is going to be a significant impairment.

NREI: Anything you’d like to add?

Aditya Sanghvi: I think the key point I would emphasize is that who knows what changes will be lasting, but the changes that were already happening [before this] are the changes that our clients should focus on.

And there will be a big separation in terms of those who react well to this, and work with tenants and on de-averaging decisions and those who don’t do those things. Over the past several years, it was a bit easier to be successful in terms of what you’ve done.

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