The correct answer to most economic questions is always “it depends.” That's especially true when the question is how severe will the impact on the economy be from the coronavirus outbreak known as COVID-19. As of this writing, no one can say for certain how long the outbreak will last or how severe it will be.
Of course, the hope is that the virus is contained soon and patients recover quickly. However, with the Centers for Disease Control not optimistic about a quick resolution, it is prudent to consider what the probable economic and commercial real estate effects of an extended outbreak in the United States would be.
Using past viral outbreaks such as SARS and swine flu as a guide, coronavirus would probably impact the U.S. economy the hardest in the form of slowing consumption, as a mixture of increased medical costs and decreased economic activity negatively impacts travel and shopping.
A drop in domestic consumption would hurt corporate earnings, while also temporarily reducing the available labor force as workers call in sick for extended periods of time, reducing production. Chinese production is vital for global supply chains, and with the vast majority of cases having been reported in China and with entire Chinese cities under quarantine, importers, who are already feeling the pressure from tariffs, will continue to shift supply lines.
Business investment will also slow as supply chains are strained and uncertainty takes hold. Investors have already begun to flee to safety, which has resulted in a stock market correction and the yield on the 10-Year Treasury reaching record lows, temporarily inverting the yield curve.
While these are some of the continued impacts capital markets will probably see if the virus becomes more widespread, it is impossible to measure the magnitude without knowing its extent. Some economists say the impact will be transitory, with post-virus growth returning to normalcy, while others suggest a pandemic has a good chance of dragging us into a recession.
The true threat to the economy from the virus is not the direct hit, but the knock-on effects caused by the outbreak. In 2008, the collapse of the housing bubble delivered a body blow to the economy. But the credit crisis was amplified by the exposure of banks to the crisis, and the spillover effect it had into other parts of the economy.
A slowdown in economic activity can expose and exacerbate other problems. For example, corporate debt has been building up as low-interest rates have made debt financing attractive. In November, the Federal Reserve reported that half of all outstanding investment grade corporate debt is rated BBB, or just above speculative-grade. An economic downturn would lead to a downgrading and subsequent investor selloff of some of those bonds, causing liquidity concerns in the corporate debt markets.
The market has already begun to sour on high-yield corporate bonds, with the high-yield corporate bond indices in the United States and the European Union losing 2.5% during the last week of February. As of early March, it would require a prolonged bear market for there to be true problems in the high-yield markets, and the declines so far have been within normal bounds. However, a virus-induced recession is a significant downside risk.
The economy does not work in a vacuum and countries do have policy options they can use to support growth. South Korea injected 16 trillion won (13 billion U.S, dollars) into its economy and China has used a bevy of fiscal and monetary actions in its response to the virus.
The International Monetary Fund made $50 billion available to emerging market nations while Congress allocated $8 billion to respond to the expanding threat posed by the coronavirus. The Fed did not wait for its planned March 18 meeting and made an emergency rate cut of 50 basis points on March 3. It is the first time the U.S. central bank has cut rates in between scheduled policy meetings since the 2008 financial crisis, further illustrating the seriousness of the economic situation presented by coronavirus.
However, the Fed is limited in its response capabilities. On average the Fed cuts rates by 550 basis points to shore up a faltering U.S. economy, but rates were only 1.6% before this week’s cut, leaving the Fed with little room to enact conventional monetary policy in the case of further economic deterioration.
Industrial May Face Biggest Risk Exposure
U.S. policy response should aid in propping up parts of the economy. But their tools, especially rate cuts, are blunt instruments and sectors of the U.S. economy could still face problems.
American manufacturing often uses Chinese intermediate goods in their own production processes, and U.S. production has already been restricted because of an insufficient supply of labor. The trade war has also taken a toll on manufacturers and importers, as they have had to shift supply lines to compensate for the additional cost of imported goods.
Any further decline in the supply of labor or materials because of coronavirus both in China and the United States would set the already struggling manufacturing sector back even further, which could impact local economies in some U.S. metropolitan areas.
The virus is already affecting the world economy, even though the majority of cases are still in China, South Korea, and Italy. The Global Manufacturing Purchasing Managers' Index, a survey used to gauge manufacturing activity with a value above 50 indicating growth and below 50 indicating a decline, fell from 50.4 to 47.2 in February, driven mainly by the Chinese PMI decline from 50 to 35.7, a record low.
Chinese production declines have already begun to affect the U.S. economy, with the Institute of Supply Management’s manufacturing import index shrinking from 8.7 percentage points in February to its lowest level since May of 2009, with respondents citing coronavirus as one of the main reasons.
Despite the decrease in imports, U.S. manufacturing indices showed essentially no growth in February, an improvement from the decline seen at the end of 2019. However, this is expected to deteriorate as a China slowdown should result in demand-side and supply-side shocks rippling through the world economy. China, which has accounted for 40% of total world GDP growth in the past decade, is responsible for about 10% of the world’s imports and 14% of world oil demand.
The effect has already been seen in the energy markets, where Chinese demand has slipped 20% by the end of February and West Texas intermediate crude oil prices have dropped below $50 a barrel, presenting challenges to an already struggling U.S. oil industry, and to major metropolitan areas such as Houston and Oklahoma City, which have large concentrations of energy firms.
On the supply side, the U.S. imports more than 20% of its goods from China, and U.S. manufacturers have already suffered supply chain problems because of the ongoing trade war. The port of Los Angeles is expecting a 15% decline in volume in the first quarter, while the Port of Long Beach expects a 12% decline. According to Alphaliner, the inactive fleet size has increased to 8.8% of global capacity, a result of the combined impact of coronavirus and the trade war with China.
If these import problems continue, everything from electronic parts to transportation equipment might begin to see shortages. The decline in shipping is not a West Coast problem either, as the majority of areas with industrial tenants focused on major Chinese imports, such as wood/paper, computers/electrical and transportation equipment are primarily located in the South and Mid-Atlantic states.
If China Offers Any Clue, U.S. Hotels Will Face Cancellations
China also offers clues as to which industries in the U.S. might be most affected by a virus-caused disruption. Our colleagues at STR found that mainland China, the epicenter of the virus, saw hotel occupancy drop into the single digits over the course of two weeks.
While it is unclear if the decline in hotel occupancy would be as severe in the United States as it was in China, the spreading virus is beginning to cause cancellations in business and recreational trips, which should spill over into hotel bottom lines.
STR also looked at the SARS outbreak in China and found that occupancy returned to normal within a few months of the outbreak being contained, though not without the long-term effects of previously canceled stays. Areas that manage to avoid an outbreak could benefit, as leisure travelers could shift plans instead of canceling them.
However, many businesses are likely to cancel trips and events as a precaution. Some major events have already been canceled, particularly on the West Coast, where most of the U.S. cases have been identified. Revenue per available room in airport hotels has already begun to show some cracks, shrinking in the last two weeks of February. Cities like Seattle, Orlando, Las Vegas and Los Angeles are likely already beginning to feel the impact from canceled travel.
Retailers Facing Sales Declines if Shoppers Stay Home
Fear is an important factor in any economic shock. Fear has driven down stock markets and popped asset bubbles. If people are afraid to be near groups, they will be less likely to travel, go to the office, or shop in a store. In an extended outbreak in the U.S., brick and mortar retailers would likely see sales decline, as customers avoid public places.
In affected areas of China, retailers shut down for weeks on end and residents relied more heavily on delivery services, exacerbating the e-commerce ascent over brick and mortar sales. This may force e-commerce companies to ramp up business faster, as Amazon Prime and Fresh platforms are reportedly struggling to keep up with incoming orders and have already announced expected delays.
With this rush of virus-spooked shoppers, the vast majority of physical retailers will likely see a decline as news of the virus continues to be negative. In particular, non-necessity based retail such as experiential or traditional apparel and general merchandise retailers, will likely be impacted more severely.
Malls, in particular, should be more exposed to losses if there is an extended outbreak. Malls have already suffered from increasing vacancy rates, as their tenants are generally more susceptible to e-commerce competition than those of the other retail sub-types, such as neighborhood centers.
In December, CoStar’s Advisory Services team predicted in its annual predictions webinar that announced retail store closures would exceed 100 million square feet for the fourth year in a row in 2020. A global pandemic would likely further impact physical retail sales in the first half of 2020, and could lead to additional announced store closures beyond this prediction.
Even if the U.S. does not have a massive outbreak of the coronavirus, many traditional retailers, such as apparel stores, rely on Chinese imports to stock their shelves because of shorter-lead-time replenishment models, and Chinese production has declined severely as the virus has spread. The shortage of goods could be further exacerbated by an already lighter than normal inventory, as uncertainty around the trade war has caused retailers to reduce inventory holdings in the hope of a truce and reduction of tariffs. At the end of 2019, the inventory to sales ratio was 1.43 for retailers, its lowest level since May of 2015.
Office and Multifamily Rents at Risk If Economy Slips Into Recession
While hotels, manufacturing and retail would likely see the worst impact of an outbreak, a slowing economy brought on by a virus outbreak in the U.S. would likely cause damage across all property types. If the novel coronavirus becomes a nationwide epidemic, which is in no way guaranteed but a probable scenario, companies and individuals would likely delay real estate decisions and wait to see how the economy emerges from the crisis. This would likely cause some weakness in leasing during the first half of 2020.
If the market views the coronavirus impact as short-term, the expectation is that capitalization rates, sales prices and leasing would likely pause in conjunction with economic growth, leading to a decline in sales volume. Most economists say this is the most likely scenario, with the U.S. enduring a short-term pause in economic growth and then experiencing a u-shaped recovery, which would lead to stronger growth in the second half of the year.
A bigger risk to both office and multifamily investors, however, is if the U.S. economy slips into a technical recession and companies are forced to lay off workers. In this scenario, office net absorption and multifamily rents would likely turn with the economy.
Office-using employment is typically more volatile than overall employment, falling 8% during the great recession compared to the 6% overall employment fell, and office net absorption is highly correlated with office-using employment. There is a chance that office demand could see a further, more permanent hit if employees are forced to stay home long-term, as it would provide companies with an opportunity to test productivity of working remotely.
U.S. Economy in a Vulnerable Position
The potential slowdown comes at a vulnerable time for the U.S. economy. Most economists expected a slowdown in the U.S. economy before the outbreak. U.S. corporate earnings had been declining throughout 2019, and corporate debt to GDP is at all-time highs. The manufacturing sector contracted at the end of last year and new job openings saw their first year of declines in a decade.
Without an epidemic outbreak, the U.S. was expected to slow down but sustain itself with a perpetually strong labor market and consumer. A severe outbreak could exacerbate or expose additional problems, and the Fed and the U.S. government are limited in their ability to effectively respond.
According to the Centers for Disease Control, the most likely scenario is that it will take months for the virus to run its course, and the impact on individuals, the economy and corporate earnings will likely be significant. The world economy is already feeling the effects of a China slowdown, and for the U.S. economy, businesses now have a new wave of uncertainty just as the presidential election season gets going in earnest.
As of now, there are still too many unknowns with the coronavirus to predict with any certainty the severity of its impact on the economy and commercial real estate market, but it is important for investors to begin to think through the downside risks presented by an outbreak.
As for how significant the impact might be, it depends.
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