Chris Urwin and Jonathan Bayfield look beyond the near-term disruption to real estate to assess the longer-term prospects for the retail, office and logistics sectors.
5 minute read
As Europe moves from intensive lockdowns to a second stage of containment of the coronavirus, economic activity can finally start to recover. But it is likely to remain well below previous levels, with the speed of recovery varying significantly across sectors. This has significant implications for real estate investors.
It is still difficult to say when many assets can return to their highest value purposes. For example, modern offices succeed when they bring together people to share ideas and collaborate to creatively solve problems. Where offices are used during this second phase, offices will serve a functional purpose – providing a space for people to work, and in much smaller numbers than they were built for.
In retail too, experiential assets that combine leisure and shopping activities are unlikely to rebound quickly as people limit social contact. Stores will, instead, play their traditional, transactional role and little else.
It will take a significant drop in infection rates to exit this second phase of containment
It will take a significant drop in infection rates, most likely through pharmaceutical interventions, to exit this second phase of containment and for life to return to something like normal. For investors underwriting an investment over a 10-year hold period, it is reasonable to assume these conditions will prevail for most of that time. Here, we consider what that ‘new normal’ could look like for real estate in the office, retail and logistics sectors.
Retail: Short-term pain in store, but demand for experience will endure
With the exception of the grocery sector, lockdown measures have hit retailers particularly hard, with many forced to close stores. The second stage of containment will be difficult too. Re-openings are likely to be partial, social distancing measures will remain necessary and rising unemployment is likely to reduce consumer spending sharply.
Many weaker retailers will go out of business. Balance sheet strength, ability to reduce costs, access to funding and the type of retailing will be key factors in determining which retailers survive. A smaller pool of financially robust tenants will reduce rental tension and the value of many assets will decline.
Retailers are increasing their e-commerce capacity to meet higher demand
The crisis will hasten the move towards e-commerce. Where they can, people are already shifting their spending online to avoid social contact and retailers are having to increase their e-commerce capacity to meet this higher demand. In the grocery sector, for example, many consumers may not return to physical stores. Investors in long-lease supermarkets must consider this when underwriting deals.
More broadly, European retail will need fewer and smaller stores. For low-engagement retailing – the type that competes directly with online shopping – retail sales in physical stores are likely to decline much faster than previously anticipated. Discretionary retailing will transition to platforms for discovery, engagement and interaction. Certain stores will remain part of a multi-channel strategy as online and offline retailing blurs.
The most resilient high streets will tend to be those that combine shopping and leisure
Against this backdrop, the most resilient high streets will tend to be those that combine shopping and leisure; in other words, places where people choose to spend their time. In more valuable locations, the crisis is also likely to quicken the pace of obsolescence and repurposing of assets for other uses, such as residential and logistics.
Longer term, real estate’s central role as a location for socialising will not be diminished, whether that be for leisure-based retailing or eating out. Demand for such space will rebound as the crisis eases and spending power improves.
Will working from home end the office market as we know it?
In cities across the world, offices are currently highly underutilised, with only a fraction of workers using their space as normal. The crisis has pushed businesses to experiment with working from home en masse. For many, the experience seems to be going better than expected, aided by new technology, which is raising questions about future demand for office space.
Technology has not been a substitute for face-to-face interaction
The rise of remote working and corresponding fall in the importance of office location has been predicted many times in recent decades. Today’s debate is around the impact of tools like Teams and Slack; similar discussions happened previously with fax machines, emails and mobile phones. However, by and large, technology has not been a substitute for face-to-face interaction, but a compliment. As technology has improved, the importance of location has grown, particularly for the knowledge-based economy that depends on collaboration to create ideas.
History suggests commentators may be overestimating the impact of new technology, but space for employees carries a major cost. Providing office space costs most employers in central London something in the region of £10-15,000 per person each year. When an economy is in recession, occupiers typically look to cut costs, including real estate. With the European economy going through the deepest recession in decades, they are likely to be particularly motivated to do so. Where working from home can be made to work, many businesses will see this as an attractive way to cut costs.
Working from home is attractive to many employees too. Most importantly, the cost savings – both financial and temporal – of commuting are significant. Perhaps that is why many countries, including the UK, have seen an increase in the number of people working from home ahead of this crisis. But it would be premature to declare the end of the office era as we know it. Working from home could exacerbate social inequality – not everyone has a luxurious study in which to base their new workstation. Working and living in the same space has other drawbacks, as many parents trying to balance childcare, home schooling and work deadlines will testify.
Clearly, there is downside risk for office demand. However, this will vary by the type of activity undertaken by an occupier. While there is greater scope for routine, codifiable tasks to be undertaken remotely, it is less true of many higher-value activities.
Instructions can be given and received remotely, but it is much harder to build trust without human interaction. Similarly, while relationships can be maintained at a distance, it is difficult to build them without being in the same room. Furthermore, while it may be possible to continue to do a challenging job while working from home, it is far harder to learn (or teach) a complex role without sitting alongside colleagues.
Collaborative problem-solving is best done by small groups in the same room
Ultimately, face-to-face interaction is a highly efficient means of communicating. Competing technologies cannot match it when it comes to facilitating socialisation, learning and motivation. Given today’s knowledge economy depends on successful idea generation, collaborative problem-solving is best done by small groups in the same room.
Even firms that are best suited to remote working and have a fully distributed workforce still use real estate to bring people together. Team building is still done primarily face-to-face, as is client relationship building.
Before this crisis, we were seeing polarisation in the office market. Lower-value locations have been challenged by the prospect of greater automation, and demand for commoditised space has been hit by the rise of co-working. Increased working from home will add to these stresses.
But in higher-value locations, office space that facilitates collaboration will continue to be sought after. Those that offer easy accessibility attractive amenities do this best. Office design will continue to evolve to ensure that they succeed in creating places where people want to be and work with others.
Logistics: COVID-19 exposes weaknesses in supply chains
In recent times, manufacturers’ supply chains have generally been built around offshoring and outsourcing; minimising inventory to achieve cost efficiencies. The pandemic has exposed the vulnerability in this strategy and highlighted the need for supply chains to be more resilient.
When China went into lockdown, it quickly became apparent that many European companies, including pharmaceutical businesses, were dependent on the production and movement of goods there. This experience should nudge manufacturers towards several changes to their supply chains.
This crisis is likely to accelerate the structural trend of moving manufacturing to near-adjacent locations
Firstly, this crisis is likely to accelerate the structural trend of moving manufacturing to near-adjacent locations, alongside near-shoring. This could increase demand for industrial space in European countries, particularly those with a plentiful supply of relatively cheap labour.
A greater focus on supply chain resilience is likely to result in operators diversifying and holding more inventory. In aggregate, this is likely to positively impact on overall demand for space.
There may also be an increase in shared facilities; for example, on-demand warehousing where different companies occupy shared spaces. This enables cheaper, more flexible, and lower capacity storage space and may become a cost-efficient way to hold additional inventory.
Furthermore, there may be increased demand for automation. Many logistics operators are highly dependent on the availability of labour. Whether it be due to lockdown mandates, quarantines or illness, the crisis has demonstrated how vulnerable occupiers are to a fall in supply.
Automation is not new: many firms have been implementing different technologies, from robotics to warehouse management systems. The pandemic is likely to accelerate the establishment of essential technical infrastructure to form a more robust and digitalised supply chain.
Focusing on logistics facilities that serve consumers is a more attractive option
While increasing automation could lower the importance of being close to labour supply, being within a short distance of consumers will continue to be essential. Indeed, with increased uncertainty about the location of production globally, focusing on logistics facilities that serve consumers is a more attractive option. Urban locations will continue to relatively attractive, particularly given the boost the sector is enjoying from increased e-commerce.
The song remains the same
Every crisis tends to generate expectations of significant and lasting change. In time, such expectations typically prove overstated. In our view, COVID-19 will not radically transform how real estate will be used in the long term; the best assets should continue to see strong demand. Nonetheless, we are likely to see an acceleration of structural changes; from falling demand for weaker retail and poorly located office assets to logistics’ operators’ prioritising supply-chain resilience.
The future is coming fast. Real estate investors need to adapt quickly to these trends to ensure their portfolios are resilient against any lasting economic fallout from COVID-19.