The COVID-19 Trends Fueling Changes in Commercial Real Estate

The COVID-19 Trends Fueling Changes in Commercial Real Estate

In “Midyear Economic Impacts of COVID-19 on the U.S. Commercial Real Estate Development,” commissioned by the NAIOP Research Foundation, Stephen S. Fuller, Ph.D., professor emeritus at George Mason University’s Schar School of Policy and Government, detailed changes in different commercial real estate sectors and described how CRE could drive the recovery of the U.S. economy.

We asked Fuller for even more insights into the trends that are fueling changes to office, retail, industrial and other sectors, and the conditions that could impact the speed and shape of the economic recovery.

Q: Which sectors of commercial real estate development are faring best in this economy and which sectors are performing worst?

A: The trends that were evident early in the year or last year are continuing but they have increased speed. The demand for retail storefront has been moderating over the last 10 years and much of that can be attributed to Amazon and everybody else who provides retail services via the internet. Clearly, that has been accelerated by the stay-at-home orders and shutdowns around the country.

Office space in many markets had a slow recovery from the Great Recession in 2008 and 2009. In the greater Washington, D.C., market, double-digit vacancy rates remain. In many other metropolitan markets, new office developments and net absorption have held everything nearly even, so vacancy rates have not decreased. Adding to this are the trends of remote work and the decentralization of the workforce. The office sector is expected to recover slowly as we move into next year and the year after, but we won’t see great changes in the vacancy rates for 18 months, maybe more.

U.S. manufacturing was already in significant decline in 2019, including flex space, and the demand for manufacturing space has fallen off dramatically. I think we will see retrofitting of existing manufacturing space, a repositioning of space.

Warehouses are probably the good news among commercial spaces – the e-commerce marketplace has created further demand for warehouses and data centers.

Q: Your report mentions that we can’t yet predict what will happen to the office market and the return of workers to their offices. Are you getting a sense of how that could evolve?

A: It will evolve back to a more normal market over the course of three years, not one year. That’s my guess. It’s going to be a slow trend back towards the pre-pandemic norm. I think the large office employers will bring their people back but they won’t work every day in the office; they will have more flexibility in working from home or from smaller, remote locations. So it is quite possible in some of the big metro areas, some of the adjacent suburban markets may experience some demand for sublet space, maybe Class A- or B+ space.

I think some of the small businesses that were downtown will decentralize and will be happy with less expensive space and they will be more flexible in the utilization of that space.

The office market is going to look less formal and more flexible. That probably means that developers of high-end, more expensive office space and iconic structures, particularly those downtown and in the suburbs, will find it a much more difficult market. I think that was already in the cards before the pandemic. Smaller footprints and less expensive spaces will be in demand in suburban, scattered and certainly mixed-use locations. It is going to be a different market when the pandemic is resolved.

Full employment isn’t expected until probably the end of 2022. We had 152 million or so workers before the pandemic, including self-employed workers. We are still at 130 million, so it’s a long way to go.

Q: Your report examines the impact of real estate development and construction on the health of the U.S. economy and on economic recoveries. Why do construction and real estate development play such a significant role?

A: The total construction sector – public, private, infrastructure and residential – is at least a fifth of U.S. GDP. Even though the construction industry only supports 4-5% of all jobs, its tentacles through the rest of the economy are enormous. Almost everything that goes into construction is manufactured so there is a large part of the manufacturing sector involved, especially as we see more off-site fabrication going into buildings and infrastructure. Then you have all of the electrical components, the pre-construction activity. Fifteen to 18% of total construction cost is site development. Then there are the tenant improvements and they are another 15-20% of cost. Then there are the multiplier effects because this industry is reasonably labor intensive and it has workers who have very high value add.

As that work filters through the economy, it supports a lot of other activity. In economic terms, it has a very complex vertical structure from the guys grading the land to the lawyers handling the transactions and the leasing. But it also stretches horizontally to every sector in the economy… Lastly, the finished inventory year after year supports the economy. That’s where workers go to work and that is where GDP is generated.

The message is not lost on a lot of elected officials, but they need to be reminded. Developers are a target of criticism by some, but they carry the economy more than any other sector that I can think of. Getting the construction sector underway is why public infrastructure is often viewed as stimulating economic growth.

This is the first in a two-part interview with Stephen S. Fuller, Ph.D., professor emeritus at George Mason University’s Schar School of Policy and Government, author of the “Midyear Economic Impacts of COVID-19 on the U.S. Commercial Real Estate Development” commissioned by the NAIOP Research Foundation. Read part two: Analyzing the Current and Future Impacts of COVID-19 on CRE.