Commercial real estate owners are about to go through one of the most uncertain times in history over the next six months, and investors are starting to take notice. Some seemingly safe real estate investment trusts (REITs) have seen their stock plunge 50% or more as the market realizes that thousands of businesses will close up shop and stop paying rent because of the COVID-19 pandemic.
We've seen mall REITs like Simon Property Group (NYSE:SPG) and Brookfield Property REIT (NASDAQ:BPYU) plunge 61% and 50.9%, respectively, so far in 2020. Hotel REITs like Host Hotels & Resorts (NASDAQ:HST) and Apple Hospitality REIT (NYSE:APLE) are down 39.2% and 44.3%, respectively. REITs were supposed to be a safe place to put your money, even in an economic downturn, so what happened?
Look at the end customers
At the end of the day, REITs are no better than the consistency of the individuals or companies who pay their bills. If malls are empty, Simon Property Group and Brookfield Property REIT are in trouble. And if hotels are empty, Host Hotels and Apple Hospitality will be in the same boat. The same can be said for any industry REITs serve.
What makes the COVID-19 pandemic unique is that it's causing a correlated downturn in almost every business. Hotels are empty, malls have been shut down, and there may be millions of small businesses closed down over the next year. Karen Mills, the former head of the Small Business Administration, said recently that 20% to 30% of small businesses may fail "even in a good scenario."
These businesses are ultimately the ones that pay rent to mall owners and that organize business trips and stay in hotels. When they are failing en masse, it's bound to have a devastating effect on associated REITs.
The Catch-22 REITs find themselves in
The unenviable position REITs find themselves in is that they're part of the problem for small businesses. Rent is one of the largest expenses restaurants, retailers, and many small businesses have. They may be able to lay off workers and stop ordering raw materials, but rent keeps piling up even when operations are told to shut down.
What's challenging is that those small businesses don't keep the kind of cash cushion that publicly traded companies often do to pay bills in a downturn. Mills said that small businesses average just 27 days of operating cash on hand, and restaurants average just 17 days. Two months without operating could put them out of business before you know it.
REITs can either force these companies out of business or they can reduce or waive rent while operations are slow. If they force companies out of business, it's unlikely there will be an eager tenant willing to fill the vacancy given the economic backdrop today. But if they reduce rent, the REITs' cash flow (and dividend) will decline in the short term. No matter what they do, REITs are holding a losing hand.
Expect a big disruption in REITs in 2020
These are unprecedented times for all businesses, but REITs are showing some of the underlying risks that investors may not usually consider. The failure of businesses en masse is likely to happen over the next few months, and that will devastate cash flows and dividends from REITs. When looking at the sector, investors should understand where REITs' underlying cash flows are coming from because some real estate owners may not be on as solid a footing as it once seemed.