Follow the Money Part Two

HEALTHCARE

While pharmaceuticals and healthcare supplies/distribution companies made 15% and 29% returns to shareholders in 2020, respectively, healthcare facilities and services dropped deep into the negative from March through November, and only recovered to 9% returns in December.⁵⁸

Real estate investments in healthcare dropped 11% throughout the year,⁵⁹ indicating an investor retreat from healthcare facilities.

This downward trend seems counterintuitive — if demand for healthcare is so high, how could its real estate become so devalued? The primary answer is shrinking margins: while expenses for hospitals soared, profitable activities like elective surgeries dropped to last priority, with thirty states forbidding them and many patients voluntarily cancelling them.⁶⁰ Highlighting the magnitude of the decline, Harvard Business Review reports, “deferment of medical care has a broader impact on the national economy, as approximately half of the annualized 4.8% U.S. GDP decline in the first quarter of 2020 is attributed to health care services, especially delayed elective procedures.”⁶¹

The first wave had a severe impact on hospital finances. In an American Hospital Association study from March through June, “the AHA estimates a total four-month financial impact of $202.6 billion in losses for America’s hospitals and health systems, or an average of $50.7 billion per month.”⁶² Congress approved only $175 billion in healthcare provider aid, and major areas of need like rural hospitals and children’s hospitals were overlooked in the disbursement process.⁶³ By the end of October, no additional funds had been approved, and less than half the approved sum had actually been disbursed to hospitals. Meanwhile, projected losses had soared from $202.6 to $323.1 billion.⁶⁴

HOSPITAL LOSSES IN 2020

Financial consulting firm Kaufman Hall found in Q2 that operating margins for U.S. hospitals were negative 3% at the median — meaning half of hospitals were operating at even deeper losses.⁶⁵ An October update showed that hospital margins without CARES had fallen 6.5 percentage points YTD, or 1.4 percentage points with CARES.⁶⁶

The stress test of the first quarter revealed serious fragility in even the most successful healthcare providers. A Q1 study by the Commonwealth Fund of the nation’s four largest hospital chains found that just a 13.5% drop in profits caused economic damage throughout the healthcare systems.⁶⁷

Smaller networks and independent hospitals have had an even harder time weathering the storm, since their operations were already more vulnerable. A 2018 study found that “across US hospitals, the median operating margin was 2.0%… The median hospital had 53.4 days cash on hand… Many hospitals were in a considerably worse financial position: those in the 25th percentile, for example, had -4.4% operating margins and only 7.6 days cash on hand.”⁶⁸ With over a quarter of hospitals already operating at losses with little more than a week’s worth of cash — before the pandemic arrived — the specter of bankruptcy now looms even larger for rural and independent hospital systems.

Moody’s Analytics reports that while it’s too early to assess the exact damage in healthcare, they predict a 10% annual decline in gross revenues across the sector, with the worst impacts hitting rural hospital systems where reliance on Medicare and Medicaid is higher and CARES Act relief is lower or nonexistent.⁶⁹

In late December, amid yet another surge of cases, Congress passed the long-awaited COVID relief omnibus bill, which allocated only $3 billion for hospitals⁷⁰ — less than a tenth of the proposed sum,⁷¹ and less than a percent of the sector’s projected annual losses.⁷²

Nevertheless, design work in healthcare is plentiful — but the game has changed drastically from the past decade’s expansion. Healthcare providers are pushing to do more with less, focusing on flexibility, and many are aiming to redesign their existing footprints. Surge capacity, user safety, and staff wellness are growing concerns, while capital expenditure budgets are squeezed ever tighter. To thrive in healthcare design will take resourcefulness, research, and all-out speed.

Hospitality

With travel brought to a standstill, citizens cautioned to stay home, and many restaurants and hotels forced to lock their doors, the hospitality sector has incurred severe long-term damage.

An in-depth McKinsey study finds hospitality workers face the highest risk of unemployment.⁷³ Among the worst-performing real estate investments has been Lodging and Resorts, which took a 50% plunge in the second quarter, only recovering to -24% returns by the year’s end.⁷⁴ Jobs in hospitality, especially roles interfacing with the public, were the most likely to be laid off or furloughed, and return to normal has been sluggish.

JOB VULNERABILITY* BY INDUSTRY

By Q4, the year-on-year key performance indicators for the hotel industry were still discouraging: the daily average rate was down by over a quarter, occupancy by nearly a third, and revenue per available room by about half of 2019’s figures for the same period.⁷⁵

Restaurants were only slightly more stable than hotels, requiring less support from the travel industry to maintain demand — but social distancing and lockdown ordinances took a serious toll on volume, and consumer habits are not expected to return to normal soon. Though many dining establishments have reopened for business, seating rates have oscillated between 50% and 75% of their pre-COVID norms.⁷⁶ OpenTable’s public data show that in January 2021, though more than 60% of listed restaurants had resumed taking reservations, they still averaged less than half of the dine-in customer volume from the same period in 2019.⁷⁷ Simply resuming services and offering safety measures has not been enough to restore consumer confidence.

YEAR-OVER-YEAR CHANGE IN RESTAURANT SEATINGS

Looking ahead to what the pandemic will mean for investors in the hospitality sector, there’s no easy road ahead. CRE analytics firm Trepp predicts a cumulative debt default rate of 21% for lodging (35% in their W-recovery scenario), their worst forecast for any sector analyzed in the study.⁷⁸ In December, Bloomberg reported over 110,000 U.S. restaurants (about one-sixth of all restaurants in the country⁷⁹) had permanently closed,⁸⁰ with more closures expected in 2021.

PROJECTED DEFAULT RATES BY PROPERTY TYPE

For the hospitality sector to make a full recovery, many changes must occur. First, consumer sentiment would have to return to normal so that leisure travel — accounting for 80% of U.S. domestic trips⁸¹ — could rebound. With tens of thousands of new cases each day and the highest number of total cases worldwide,⁸² the U.S. is still a long way from making travelers feel safe. Surveyed travelers said they would need to see hotel chains implement safer practices that would inevitably raise costs, including deeper room cleaning with UV and disinfectants, and leaving rooms dormant for 72 hours between stays.⁸³

Second, the businesses that drive demand for leisure travel (e.g. theme parks, resorts, casinos, and sporting events) would have to fully reopen and return to normal volume. So far they have only resumed at a diminished capacity. Disney theme parks have reopened at only 30% capacity, and full recovery may take another 18 to 24 months.⁸⁴ Gaming industry analysts’ best-case scenarios project a three-year recovery for Las Vegas casinos.⁸⁵

Third, the hotel and restaurant industries would have to receive debt leniency and/or government aid in order to prevent more permanent closures and layoffs, which are imminent if no intervention is made. The Wall Street Journal reports that 20% of NYC hotel rooms could permanently close,⁸⁶ and the CEO of the American Hotel and Lodging Association predicts as many as 8,000 hotels in the U.S. may shutter for good.⁸⁷ If these closures take effect, recovery will then take much longer, possibly extending beyond 2023. ⁸⁸ From November to December alone, nearly half a million hospitality and leisure jobs were lost.⁸⁹

Congress’s December COVID relief bill allocates $325 billion to small businesses with fewer than 300 employees, mostly through the Paycheck Protection Program⁹⁰ — a measure that could stave off closure for many independent restaurants and small service businesses. However, the future for hotel chains, restaurant franchises, and entertainment venues remains grim.

RETAIL

A similar story comes to us from the retail sector, as many “non-essential” businesses were forced to close for weeks, and many people continue to avoid public shopping excursions months afterward.

Unsurprisingly, this dearth of revenue has already shuttered 8,325 stores, and 60% of the year’s closures are predicted to occur in malls.⁹¹ These mall store closures draw down foot traffic for the remaining mall tenants, reducing revenues and lowering property values. Meanwhile, consumer demand has repositioned to online retail, with e-commerce posting 32% growth from Q1 to Q2 of 2020. It dropped only a single percentage point in Q3, keeping web-based sales at unprecedented highs for the year.⁹²

These demand shifts are not assumed to be temporary. In a survey by Moody’s Analytics, 75% of first-time users of digital retail channels expressed plans to continue using them even after the pandemic subsides.⁹³ Reports from McKinsey & Co. similarly predict e-commerce’s persistence, citing that China’s buying habits have permanently changed: “Consumers forced to shop online because of closed malls and shopping centers may permanently adjust their buying habits for certain categories toward e-commerce... Early evidence from China shows some staying power in the coronavirus-driven shift to e-commerce.”⁹⁴

The real estate market has already begun to register the hit, with retail REIT values dropping 25% throughout the year.⁹⁵ The mall subcategory fell the furthest with losses at 40%, while shopping centers dropped 30% and stand-alone stores fell 15%.⁹⁶ Credit analysts predicted a 9% cumulative default rate for the retail sector as a whole in 2020 but cautioned that expectations should adjust downward if caseloads continued to rise through Q4⁹⁷ — which they did.

Investors can expect that the “new normal” will not entail as much brick-and-mortar retail growth (nor real estate) as the old normal. However, e-commerce and all its supporting infrastructure will continue to gain market share, including industrial and logistics real estate, data centers, and the businesses that handle delivery and marketing of online goods.

DIGITAL ADOPTION BY CATEGORY

OFFICE & MIXED USE

The workplace has been closed, reopened (selectively), and in some cases, closed again.

Office REITs lost 18% of share value for the year.⁹⁸ Motley Fool reports, “demand for office space declined by 33 million square feet (S.F.) in the third quarter... a larger drop than the financial crisis and the biggest decline since the dotcom bubble burst in 2001.”⁹⁹ Colliers International adds, “Following a second quarter that provided clear evidence of the pandemic-driven downturn, the leading U.S. office markets saw even greater contraction in Q3 2020. Net absorption was negative across all but one of the top 10 markets, with vacancy rising in the remaining nine.”¹⁰⁰ Projected cumulative default rates for 2020 were between 4.5 and 11.4%, depending on the severity of the pandemic.¹⁰¹ Putting these figures in perspective, the delinquency rate (the loan status that precedes default) has not exceeded 5% on commercial real estate loans since the height of the Global Financial Crisis, when it peaked at 8.76%.¹⁰²

While foreboding, these measures are hardly a complete picture; businesses need not default on their loans or leases before deciding to vacate office space. Apart from cases of bankruptcy, vacancies tend to occur only at lease termination; thus, present-day vacancy or delinquency rates can’t foretell what solvent tenants will do when their lease agreements mature. Since the average office lease term is 9.1 years,¹⁰³ tectonic shifts in the office landscape could take up to a decade to fully surface. How many workplaces will downsize or close completely at some later time?

For that insight, we need to understand how work culture is evolving. As one Fortune-500 global workplace director anonymously told DesignIntelligence in May, “the future of work defines the future of the workplace.” In other words, the office sector will conform to workers — not the other way around.

Industry surveys reveal that worker sentiments and employer strategies are rapidly shifting; in April, Gallup reported 59% of workers would prefer to work from home as much as possible even after the pandemic, while 41% wanted to return to the office.¹⁰⁴ By July, the Morning Consult found workers’ plans had already changed again. Only a quarter of the workforce didn’t embrace working from home at all, while nearly a third wanted to leave the office for good.¹⁰⁵ In November, another survey found that among new remote workers, the work-from-home arrangement was less popular than among seasoned remote workers.¹⁰⁶

In both the latter studies, those who preferred a mix of home/office work were in the majority, reflecting a trend that is sure to reshape office building use: a hybrid culture of solo work and teamwork, split between real space and cyberspace.

A Gartner survey of business leaders indicated that bosses are on board, with 82% planning to allow remote work at least some of the time, and 47% all of the time¹⁰⁷ — a figure that bears weighty implications for office real estate. It appears that most workplaces will lower their use of floor space and their daily average headcount — and close to half will be able to significantly shrink their office footprint.

What this means for real estate developers is a major strategic pivot, with 73% saying in June that Flex Space, and space as a service (akin to the WeWork model, though necessarily improved) will play some role in their strategies.¹⁰⁸23% indicate it will be a significant role — though we expect Flex to become even more prevalent as the culture of work adapts to the new normal.

In their July report, JLL Research names “workplace liquidity” (i.e. the ability to increase/decrease and refactor space usage) as a new determinant of business success: “flexible space demand will continue to increase as a result of COVID-19, although in a different form than it took before the pandemic. In fact, we believe 30% of all office space will be consumed flexibly by 2030.”¹⁰⁹ If true, the prediction would mean that 1.2 billion square feet, presently worth over half a trillion dollars, will be dedicated to flex space in the next ten years.¹¹⁰

Commercial Property Executive concurs that flex is on the rise, proclaiming that “the fallout from COVID-19 will pave the way for the sector’s rebirth.”¹¹¹ Notably, flex space owner-operators have suffered short-term losses just as severe as traditional office owners, but report a more positive outlook for the longer term.¹¹²

FLEXIBLE OFFICE SPACE

In the more knowable present, office owners face mounting credit problems. A Deloitte survey of commercial real estate investors found that out of all building categories, office was most expected to decline in leasing demand over the next 18 months and beyond.¹¹³ Office loans are a high-impact category, with downstream consequences for credit markets. Moody’s Analytics reported in July, “a universal decline in office utilization could considerably increase risk for office loans, the largest segment of commercial mortgage backed securities (CMBS)... Office loans account for about 27% of the $548 billion outstanding CMBS.”¹¹⁴ 

These loans, serviced directly by operating income, are now facing extreme risk from declining rent volume. Moody’s calculates that “a 5% net increase in unabsorbed office in [major urban] markets could lead to roughly a 23% decline in net operating income (NOI) on average.”¹¹⁵ A month after that message went out, Colliers International reported that U.S. office absorption had fallen not 5%, but 86%, with 60% of Central Business Districts seeing decline.¹¹⁶ Third-quarter office demand continued to slump, with vacancies rising to 17.4%¹¹⁷ and total occupied space dropping by 33 million square feet — the sector’s worst quarter since 2001.¹¹⁸

The news bodes ill for the financial system. In the past, when securities markets have faced this much untenable risk, the Federal Reserve has created emergency facilities to prevent domino effects. It’s unclear what will happen now — as noted in Part 1, the Fed’s balance sheet is already at its highest balance in history. There’s no historical precedent that would indicate whether the dominos can be backstopped at this scale. Investors are reminded of the lesson of 2008: global markets are all tied to MBS values in some way. Invest — or divest — accordingly.

HIGHER EDUCATION

Outlooks for higher education have been the fastest to change.

Higher education research firm SimpsonScarborough surveyed incoming college freshmen in both April and July, and the share of students saying they were “likely” or “highly likely” to change their minds about whether to attend jumped from 8 to 40% during the three-month span. In the July survey, 52% said their preference would be to take all classes online.¹¹⁹ One of the key decisions allowing schools to retain their students has been the switch to online classes, triggering an investment of $4.5 billion in edtech in the first half of the year.¹²⁰

Due to these online offerings, dropout rates were moderate. In November, enrollment for all higher education levels was down 3.3% year-over-year, while freshman enrollment was down 13%.¹²¹ For those colleges who remained open, 44% moved to primarily or fully online classes, while 21% adopted hybrid models. Public institutions were the most likely to offer classes primarily or fully online.¹²²

It seems that safety is a primary concern, even for students with low viral risk profiles. As reported by InsideHigherEd, “three out of four freshmen are very or somewhat worried they will contract coronavirus. And only 34% of returning students feel safe living in the residence halls.”¹²³ The University of North Carolina at Chapel Hill closed down after just one week of classes, as 177 students became infected.¹²⁴ Notre Dame and Michigan State also made last-minute closures as case rates ballooned.¹²⁵

These unexpected shifts also lead to unforeseen expenses, funding declines, reduction in revenues from sports, and vast changes in policy and culture. New York University residence halls even began to prohibit students from taking walks or visiting each other’s rooms.¹²⁶ With similar measures in place at schools around the country, enrollment drop-off and funding deficits were soon to follow.

COLLEGE REOPENING MODELS BY INSTITUTION TYPE

The pandemic strikes an untimely blow to many colleges’ already ailing finances. The 2008 financial crisis forced many US states to slash funding to higher education, and by 2019, only seven states had resumed funding at pre-recession levels.¹²⁷ 

A pre-COVID study by Hechinger Report of some 2500 U.S. colleges found that more than a fifth were in serious financial distress, and about half have had enrollment steadily decline for more than a decade: “Roughly 1,360 [out of 2500] colleges and universities have seen declines in first-year fall enrollment since 2009, including about 800 four-year institutions.”¹²⁸ 

COVID-19’s impact on enrollment, amenities, and programs is only making matters worse. Even for large school systems like Rutgers and the University of California, costs incurred through refunding students’ dining and housing fees can grow to double or triple the amount they receive in federal aid. In the latter case, the University of California was allocated $130 million in CARES act relief to cover $310 million in program refunds, $248 million in lost medical center revenue, and a 10% cut in state funding.¹²⁹

The relief bill signed in December provides a much needed $22.7 billion to higher education systems. Three quarters of its disbursement is decided by Pell grant enrollment at recipient institutions, and about a quarter by non-Pell-grant enrollment.¹³⁰ However, since the pandemic has cost US universities and colleges more than $120 billion “and counting,”¹³¹ the new relief package will not make them whole.

Overall, financial distress in higher education institutions means far less capital for expanding facilities, while declining enrollment and the move to online classes mean that less physical space is required. Declining enrollment also impacts off-campus student housing — although the category has widely been regarded as recession-proof, investors are still on the defensive, with student housing REIT prices dropping 8% year over year.¹³² S&P Global notes while it finds relatively little near-term risk in the commercial mortgages on these properties, it sees the growth outlook as negative.¹³³