“The coronavirus disease (COVID-19) crisis has hit the commercial real estate sector hard. Containment measures implemented in response to the pandemic severely affected economic activity and reduced the demand for commercial property,” states the International Monetary Fund’s (IMF) April 2021 Global Financial Stability Report: Preempting a Legacy of Vulnerabilities. “Part of the adverse impact — particularly on the retail, office, and hotel segments — could be permanent, as some activities may continue to take place virtually in the future and others may relocate outside of large cities.”
The impacts of the pandemic on commercial real estate could be permanent, forever reshaping our cities and the economy as a whole. The vacancy rate for retail space increased to 10.6% in the first three months of 2021 as more and more consumers convert to online shopping as a standard for many forms of purchasing. In fact, the percentage of retail purchases made online nearly doubled to 20% in the last year, prompting experts, such as those at Moody’s Analytics, to project vacancy rates to climb to 11% or 12% as retail businesses reconsider their space needs.
Office space vacancies rose to a rate of 18.2% in the first quarter of 2021 and Thomas LaSalvia, senior economist for Moody’s Analytics now expects that to climb to 20% by 2022, before gradually declining to 17% by the end of the decade. While hotel occupancy, which averaged above 60% in 2019 and stood at 65.7% in February 2020, dropped sharply to around just 20% for extended periods as travel was restrained during the numerous waves of the pandemic. Be it retail, hotels, or office buildings, the pandemic has presented a huge shock to commercial real estate, and the impacts of that shock are not going away any time soon.
“We actually expect [the retail vacancy rate] to rise closer to 25% by 2025. Business travel is going to hold [hotel occupancy] back a little bit this year and it’s going to take maybe a couple of years before that really picks up again,” said LaSalvia. “We see such potential and plenty of anecdotes and early data of actual shifts in how we work and how we shop. The structural changes that are going on still give us pause to say that we’ve entered a recovery in terms of office or retail.”
The overall decline in the commercial real estate sector has the potential to affect broader financial stability across the economy. Commercial real estate is a significant part of every economy and because the sector relies heavily on debt financing, trends in the space tend to reflect the wider macro-financial landscape. Commercial real estate loans constitute a significant part of banks’ lending portfolios and banks remain the largest providers of debt funding to the commercial real estate sector globally. Therefore, any adverse shock to the sector can put downward pressure on commercial real estate prices, negatively affecting the credit quality of borrowers and straining the balance sheets of lenders.
“Looking at the impact of the pandemic, our analysis also shows that price misalignments have increased. Unlike previous episodes, however, this time around the misalignment does not stem from excessive leverage buildup, but rather from a sharp drop in both operating revenues and the overall demand for commercial real estate,” states the IMF report. “As the economy gains momentum, the misalignment is likely to diminish. Nevertheless, the potential structural changes in the commercial real estate market due to evolving preferences in our society will challenge the sector. A permanent increase in commercial property vacancy rates of 5 percentage points could lead to a drop in fair values by 15% after five years.”
Such significant declines in value not only force further constriction and decline in the commercial real estate sector, but they can also fundamentally reshape our economies, changing the physical and social characteristics of our cities. Over half of the world’s population lives in cities, including 60% of refugees and up to 80% of internally displaced people. Long-standing urban inequities have been deepened by the pandemic and the droves of urban dwellers working informal jobs are now part of the swelling ranks of “new poor” created by the pandemic, according to the World Bank.
“What COVID-19 did was make the problems [faced by cities] visible to those who are not working in local government,” Anuela Ristani, Deputy Mayor of the Albanian capital, Tirana, said at a recent World Bank event. While Jan Vapaavuori, the Mayor of the Finnish capital, Helsinki, stated that “One of the biggest lessons learned from the COVID-19 crisis is that sustainable, resilient cities were able to handle the pandemic better. It is actually worth putting even more emphasis on sustainability issues than before.”
This is where smart cities enter the COVID-19 recovery discussion as a new way to imagine our urban areas for this new world we now find ourselves in. Smart Cities are resilient cities and, through the integration of physical and digital environments, we can better identify and address existing issues and the failures of resilience exposed by the pandemic. Smart cities can tackle poverty, inequality, and reinvigorate urban economies based on hard data and actionable intelligence. Above all, smart cities offer us a way to quantify and understand the otherwise chaotic physical world around us, and when that world is forced to take on a new and unfamiliar shape, smart city approaches become more important than ever.
“Smart City transformation can no longer be seen as a ‘nice to have’ – COVID‑19 has resulted in us all experiencing different levels of isolation and a lack of connectedness. As we emerge from the immediate crisis, there is a unique opportunity to improve connection by embedding digital infrastructure and Smart City initiatives as part of the business‑as‑usual design, development, operation and maintenance of our cities,” states KPMG in its report: Smart City Transformation in a post-COVID world. “Importantly, successful re‑imagination of our cities requires adopting a human-centered design approach — tapping into the collective intelligence of communities in order to understand the human experience from the diverse perspectives of the people who live, work, learn, and play in cities.”