Best characterized as an exogenous shock, COVID-19 has had unprecedented implications on the global economy and human behavior. For Commercial Real Estate (CRE) construction, confidence immediately fell once the disease was declared an epidemic. Construction contractors were beginning to show declines in sales, margins, and staffing levels as early as February.
Since then, the effects of COVID-19 have resulted in a +$10 trillion governmental response to stabilize the economy in the form of stimulus and quantitative easing. The measures taken on the national level include a reduction of interest rates to zero percent, a $2.3 trillion direct stimulus package, an additional $2.3 trillion loan pledge by the Federal Reserve (Fed), and a Fed mandate to buy an unlimited amount of securities. Moves directly taken out of the 2010’s economic playbook to act as market-wide “beta insurance”, saving small business, providing direct relief, and stabilizing markets by maintaining liquidity in crucial industries.
Construction and development are core tenets needed for a growing economy, and those actions contribute greatly both on a local and national level. Demand from an increasing population will continue to drive growth, and lenders will be anxious to place capital that meets that need. Yet, in a time when all facets of social interaction are re-examined, how can lenders pledge capital to construction projects when they are unsure of a project’s intrinsic value?
The comparisons to the Great Financial Crisis- a time most real estate developers gladly forget- are abundant. Questions such as, “are we in a credit crunch?”, “Will there be a mark-to-market event?”, and, “Is this project viewed as viable in the new-new normal?” are reminiscent of events after the 2008-era housing crash.
In short, the answer is that 2020 is not 2010.
Thanks to the 2010 Dodd-Frank financial reform law, many previously existing laws were amended, and new provisions were added, resulting in lasting reform in the U.S. financial sector. The Dodd-Frank changes meant that lenders slowed down taking on risk over the last decade. At times in the last five years, bullish critics suggested that such regulation should once again be lifted, arguing that lower-proceed loans were damaging the lending landscape. In hindsight, that de-risking along with a more balanced economy is why lenders still have dry powder. While there was, and still is to some extent, a retraction of capital for construction deals, capital still exists. As lenders learn how to become comfortable pricing risk in this new-new normal, more and more deals will pencil.
California has a well-documented need for new multifamily construction. Even during a potential period of increasing renter vacancy, major cities in California have failed to meet the needs of a greater population. Economic data since 2010 have indicated that new multifamily construction has been continuously unsuccessful to meet the housing targets in California jurisdictions. Even during the peak of economic activity in 2019, forecasts suggested that areas of Los Angeles would never achieve market equilibrium. Lenders are still enthusiastic to provide capital for the well-documented demand.
However, analogous to how the swiftness of the stimulus package held up the economy, full recovery is dependent on a vigilant return of normalcy for the labor force. The longer the quarantine’s time horizon the more disruptive the COVID-19 pandemic will become for lenders; when an aggregation of financial guardrails fall, a spiral of covenant trigger events can force lenders to pull back, no matter how well prepared.
The most important component for future construction development will be how quickly Angelenos and Americans are able to return to the labor force. Confidence through either herd immunity or a vaccine will be the single most important driver between lenders continuing to lend or going pencils down. If the lockdown continues, costs remain high, and financing pulls back, few new deals will break ground.
Less predictably, the value of land (unentitled, entitled, and ready-to-issue permits), will be difficult to assess. Volatility in the global economy will increase stringency on construction underwriting requirements, potentially lengthening the life of the contraction in CRE. Perhaps the brightest spot in this is Agency lending through Fannie and Freddie. 10-year loans on stabilized apartments have priced below 3.25% fixed rate as the Fed continues to use its resources to buy mortgage-backed securities. While that solves the take-out portion of the equation, net operating income (NOI) will still largely be driven by demand and pricing when projects complete.
As May 2020 nears, the capital markets are still efficient. The unanswered questions in response to COVID-19 are largely contingent on the extent of the shelter-in-place ordinance. For now, the future looks calm. Existing 2010 provisions have acted as a pacemaker and swift government actions have provided the necessary liquidity to steady the capital markets. Our hope is that we cross finish line in this crisis soon and unleash the American labor force in full.
Jonathan Lee is a Principal and co-Managing Director of George Smith Partners (GSP), a capital advisory firm based in Century City, CA. Mr. Lee leads a team that has arranged debt, preferred equity and joint venture equity structures totaling more than $10 billion including ground-up construction, bridge and permanent financing over his 14 year career. A Los Angeles native, Mr. Lee is a passionate advocate for all Angeleno stakeholders and serves on the Board of the Union Rescue Mission. He is active with the UCLA Real Estate Alumni Group, Mortgage Bankers Association, Young Presidents Organization, and Cornerstone Church West Los Angeles.