Follow the Money Part Two

Two Roads Diverged

Following a whole-market crunch on March 23, the overall picture has been a divergence between sectors: those that rely on in-person interaction and physical travel, versus sectors that facilitate sheltering, remote work, and leisure.

The hardest-hit North American sector, Oil and Gas, is no economic picnic, with a 35% decline in market cap and 32% negative shareholder return over the past year¹ — but the dark cloud of COVID comes with a silver lining: in response to this calamity in energy pricing, investors are showing new readiness to transition from fossil fuels and set benchmarks for renewable energy adoption, emissions limiting, and climate responsibility. 

Since the end of 2019, ClimateAction100, a multinational investor initiative for carbon reduction and corporate governance reform, has added 160 corporate signatories representing over $10 trillion in assets under management (AUM), bringing their cumulative totals to 545 signatures and more than $52 trillion AUM² (over ten times the market cap of the global oil and gas industry³). The commitments made by participants align with the Paris agreement and require ongoing carbon reductions, public disclosures, and internal governance reforms. Recently added signatories include Blackrock, CalPERS, BP, and Chevron.⁴

Even more ambitiously, the Institutional Investors Group on Climate Change⁵ (IIGCC) has launched a framework for investors to achieve net-zero portfolios, now with 70 signatories representing $16 trillion AUM.⁶ It seems a profound shift in investor activity is underway, divesting from major pollutants and transitioning the global economy toward a more sustainable future. To meet these commitments, many companies will have to significantly alter their physical footprints, making for plenty of billable work in sustainable design.

Most surprising, sustainable impact investing has surged,⁷ proving to be an unexpected shelter against risk. Morningstar research shows that through the first two quarters, while the pandemic ravaged all but a few sectors of the global economy, sustainable funds posted net flows of over $20 billion, nearly surpassing their flows for all of 2019 in half the time.⁸ InvestmentNews reports, “funds with the highest ESG [environmental, social, and governance] ratings not only outperformed funds with the lowest ESG ratings, but also outperformed the broader market.”⁹ Research from Fidelity International showed that sustainable funds outperformed the market in every month of 2020 except April.¹⁰ In a global crisis, it pays to be ethical, responsible, and transparent.

Forbes called 2020 the year that Environmental, Sustainability, and Governance (ESG) investing “came of age,” and predicts it has only begun its climb.¹¹ Companies hoping to court these impact investors will need to demonstrate their sustainability commitments, which means their buildings and processes will need to align with these values. Thus, we see architecture and engineering firms with proven sustainability services faring well in the years ahead.

GLOBAL ESG QUARTERLY VOLUME

Market Valuations

Graphic shows the 2019 market capitalization (height of the box) compared to the shareholder returns (width of the box) from February 3, 2020, at the start of the pandemic to January 11, 2021

Sustainability isn’t the only big winner in the COVID shake-up. Cresting the top of the wheel of fortune, the automotive and assembly sector leapt some 89% — mostly due to the meteoric rise of Tesla, whose stock grew by 681% in 2020.

The High Tech sector (already growing 2.5 times faster than GDP for the past 15 years¹²) saw breakthrough growth as well, with North American companies returning more than 60% to shareholders since the end of 2019.¹³ 

Not all tech is created equal, however; research from Gartner particularly favors the prospects of AI automation, device autonomy, edge computing, cloud distribution, and cybersecurity:

• By the end of 2020, companies that are digitally trustworthy will generate 20% more online profit than those that aren’t.

• By 2022, application integrations delivered with robotic process automation (RPA) will grow by 40% year over year.

• By 2023, over 30% of operational warehouse workers will be supplemented by collaborative robots.¹⁴

Those who anticipate and embrace these technologies within their design practices will undoubtedly increase their market relevance. Doing so will take investment in talented technologists with cross-disciplinary design knowledge, leadership foresight, and willingness to adopt novel processes and tools. The payoff will be a major adaptive advantage — like seeing around the corners of a maze where others can only wander.

Few business sectors were as well positioned to grow during lockdown as tech, but some have pivoted and prospered, carrying deeper implications for real estate, design, and construction.

BUILT ENVIRONMENT INDICATORS

The investment landscape for real estate and the design professions has been turned on its head.

In the past, economic shocks sent investors to the safe havens of retail and office real estate, but those prospects have proven shakiest of all this year.  Across all categories, unexpected windfalls and shortages have revealed the need for even more due diligence on every project. We begin with an examination of broad indicators — private equity investment, construction volume, and commercial real estate — and then narrow the focus to examine each market sector.

PRIVATE EQUITY SLOWS DOWN TO SPEED UP

North America saw a slowdown in merger and acquisition deals through the first half of 2020, with an 8% increase in the time it took for deals to close.¹⁵

Third quarter performance, while slightly better, was still 23.6% lower than the same part of 2019.¹⁶
Willis Towers Watson’s Quarterly Deal Performance Monitor showed that in Q3, North America closed its lowest volume of quarterly deals since the global financial crisis in 2009.¹⁷

Understandably, the pandemic has made acquirers more risk averse. In a series of interviews with private equity fund managers, McKinsey & Co. noted a marked increase in firms’ cash sensitivity: “Liquidity, of course, is paramount in a crisis... As one operating-team executive wrote to all portfolio-company CEOs, ‘priorities one, two, and three are safety and cash.’”¹⁸

Strategy has had to evolve at many firms. Surveying C-level private equity executives, Harvard Business Review discovered a massive overhaul taking place in their investment strategies. Most are halting progress, many are divesting to service debt, and less than a quarter are either continuing or accelerating planned deals.¹⁹

QUARTERLY DEAL PERFORMANCE MONITOR

Bain & Co. note a takeoff in scope deals — horizontal acquisitions that bring more capacities (as opposed to augmenting their scale capabilities in a single market) — as companies seek to diversify their interests and cross-pollinate their internal departments.²⁰ Since these complex horizontal deals require input from a wider array of experts, the due diligence takes longer, slowing deal volume. Scope deals have been especially prevalent in categories where modernization is happening the fastest:

PREVALENCE IN SCOPE DEALS

The share of all strategic deals (valued at or above $1b from 2015-2019) that were considered scope deals.

Also contributing to the deal making slowdown is the managerial tendency to require more communication among teams, companies, and executives — with companies who were already technologically prepared and integrated seeing the most agility and responsiveness now: 

Monthly or quarterly check-ins have quickly shifted to weekly—even daily—ones, and the data discussed have been more granular and standardized. Firms with an integrated, automated financial-reporting infrastructure across their portfolios have been able to monitor critical performance metrics daily, with minimal disruption to the finance teams of portfolio companies, and to engage executives immediately to determine appropriate responses to problems.²¹

The overall trend in private equity has been a slowdown of deal making, coupled with accelerated modernization and digitization – both inside P.E. firms and externally in the market. The lowest-volume sector in acquisitions was also the fastest-growing sector financially: high technology. Conversely, one of the sectors with the worst financial performance — energy and power — saw the greatest increase in acquisition deals.²² The gist is that struggling sectors with legacy demand positions are consolidating, while innovators in high demand are branching out, gaining independence, and seeing record growth.

For cash-stable design firms, the time is unusually ripe for adding new capabilities through business acquisition, especially capabilities in applied technology, sustainable design, and workplace redesign. Many smaller brands facing payroll pressure and lost revenue may nonetheless have deep rosters of rare talent; if done strategically, win-win mergers could combine raw creative capacity with long-term operational stability.

Construction Drivers Jitter and Lurch

While construction was quickly declared “essential work” in all 50 states,²³ construction progress has slowed on many fronts — especially financial ones.

By December, the FTSE Nareit index of home financing was down 25% for the year while commercial financing had fallen 14.5%,²⁴ revealing the magnitude of the decline in lending and developing activity. Since the market activity that creates demand for construction came to a halt, many contractors have struggled to make ends meet or even complete projects — with 8,169 projects delayed nationwide at the start of 2021.²⁵

While mortgage financing fell precipitously at the start of the pandemic, new construction volume dropped by more, and has recovered only part of the way. ConstructConnect reported that after some “welcome upticks” in November, nonresidential construction starts were still 28% lower than in the same month of 2019.²⁶

A common response from construction companies was to seek loans from the Paycheck Protection Program. National Real Estate Investor reports that construction was the biggest recipient of these loans: “Construction firms received approvals for 114,838 loans totaling $34 billion from the Paycheck Protection Program… a larger share of loans approved than other industries.“²⁷ This fact, combined with their 24-percent-larger average loan amounts than other categories, signals the construction sector’s deeper distress compared to the rest of the economy. 

As a result, investor confidence in construction-dependent business growth has remained tenuous, waiting for a medical breakthrough to reinvigorate the industry. At year end, Dodge Data & Analytics released their forecast for total new construction in 2021: a modest 4% rebound to $771 billion,²⁸ still 10% lower than 2019 volume. According to their projections, the smallest slice of this pie will be nonresidential construction, expected to grow just 3%.

NONRESIDENTIAL CONSTRUCTION STARTS

Commercial Real Estate Tightens Its Belt

The overall impact on commercial real estate has been severe, but not evenly distributed.

The hardest-hit asset classes are those that bring users into close physical contact, while those that support pandemic-resilient businesses like e-commerce are seeing uncommon growth.

McKinsey points out, “Not all real estate assets are performing the same way during the crisis. The market seems to have pivoted mostly on the inherent degree of physical proximity among an asset class’s users—even more so than on its lease length.”²⁹ GreenStreet adds another dimension to that analysis, showing how user risk due to contagion combines with renter risk due to recession to determine which sectors are hit hardest: “fallout is worst for lodging, gaming, senior housing, nursing homes, student housing, and most retail.”³⁰

SECTOR RISK IN A COVID RECESSION

Early in the crisis, analysts at Trepp modeled two pandemic scenarios to determine what the loan default risk would be in various sectors. In their low-risk scenario, which assumed infection rates would decline by Q3 and market vital signs would return quickly to baseline, “the cumulative default rate across commercial mortgages overall will rise to 6.5%, up significantly from the current 0.5% default rate.”³¹ That is, they saw loan default risk increasing 13-fold across all building categories. Their stated worst-case scenario, a pandemic resurgence and continued recession, predicted cumulative defaults at 14.3%, a nearly thirty-fold increase of the default rate. 

As of November, the cumulative default rate was between these two figures at 8.28%, about 17 times the pre-COVID baseline.³² While still extraordinary, the rate failed to meet more dire predictions due in part to lenders granting record numbers of forbearances, especially to retail and lodging sector borrowers.³³ However, default rates could continue to worsen as these forbearances run out. Since there is no precedent in the banking industry for global pandemic leniency, default rates in 2021 will be impossible to predict.

Even more serious for building owners were the projections of price decline, indicating a longer-term pressure on rents:

PRICE IMPACTS BY PROPERTY SECTOR

Sensing this increased risk and likely decrease of returns, investors have withdrawn considerably from real estate funds, with FTSE Nareit’s index of all equity REITs dropping by 7.3% for the year.³⁴ The broadly indexed real estate investment trusts (REITs) of Vanguard and Schwab contracted some 11%³⁵ and 20%³⁶, respectively. These contractions in capital directly impact construction, architecture, and engineering — but not in equal measure. Indeed, some fund types have even seen accelerated growth against this bearish backdrop.

With so much variation expected across the industry, the best way to understand the outlook is to drill down by category. In each, we combine quantitative data through REIT fluctuations with a multi-lens examination of each industry’s resources to develop a comprehensive picture of the sector. Looking out over the next three to five years, we’ve grouped the sectors together by prognosis: the Good, the Bad, and the Highly Uncertain.

The main criteria we considered:

• Debt – how much debt is outstanding on the sector’s key assets, due how soon? What is the default rate, and how is it fluctuating?
• Revenue – how much cash is flowing into the sector? How diversified are its resources? How stable are its cash flows?
• Demand – how elastic is the building type? How do the dual factors of pandemic and recession impact its affordability or desirability? How will changes in adjacent markets influence its perceived value? How are its real estate funds trading in response to the current crisis?
• Leadership – what are the frontrunners in the sector expecting? Where are they placing their bets? What evidence do they base their projections upon?
• Adaptability – how flexible, resilient, and agile are the sector’s organizational and regulatory structures? How fragile are its dependencies?

The resulting prognoses are not meant to indicate whether designers will find contracts in the following categories. Rather, these forecasts illuminate whether each sector is experiencing headwinds or tailwinds, which in turn will determine what design solutions they require.