As the spread of COVID-19 and government response continue to evolve, we analyse recent developments and how they could affect European real estate.
5 minute read
On 12 March, the World Health Organisation had identified Europe as the epicentre of the coronavirus pandemic.1 Governments across the continent are attempting to suppress the spread of the virus through unprecedented measures to limit social interactions. Though some are more stringent than others, these measures are disrupting economic activity in a way that has never been seen before – with major implications for real estate.
Growing evidence from China is showing that effectively pressing pause on large parts of the economy causes drastic falls in production. This gives us a clear indication as to where the European economy is heading.2
There may be some variation in the impact by geography. Some countries have a more elderly – and therefore more vulnerable – population; some have stronger healthcare systems; while others are more exposed to supply-chain disruption or have a greater dependence on tourism. The common link between all countries is that they are looking at the near future with trepidation.
Short-term responses are crucial
For real estate investors, some income streams are under threat as occupiers fail to generate sufficient revenue to make rental payments and, in extreme cases, sustain their businesses. Restaurants, cafes and bars are closing. Many shops are either closed for the foreseeable future or experiencing a major decline in footfall. Other businesses are suffering supply-chain disruption, practical barriers to normal business activity and sharp falls in demand.3
Investors are trying to estimate how long these strict government measures will remain in place
In such a challenging environment, investors are trying to estimate how long these strict government measures will remain in place and whether policymakers are implementing appropriate steps to sustain businesses.
The reality is that we do not know how long disruption to normal life may last. Much will depend on the ability of healthcare systems to sustain and, hopefully, add capacity where needed. The pace at which testing can be increased and accelerated is also critical. And while it is unclear whether pharmaceutical interventions can provide near-term mitigation, vast resources are being put to work to that end.
With regards to policy interventions, a measure of comfort can be taken from governments and central banks’ response to date. Large fiscal and monetary policy packages have been announced and, crucially, authorities have consistently signalled a willingness to do more.4
Today we are faced with a global health crisis that is having an immediate and direct impact on solvency
Some tools developed in the wake of the global financial crisis are available, and policymakers are deploying them at pace. However, this is a different type of crisis to prior ones. The global financial crisis was a liquidity crisis that brought forth a solvency crisis; in contrast, today we are faced with a global health crisis that is having an immediate and direct impact on solvency.
There are limits, therefore, to what monetary policy can achieve. Massive bond-buying programmes and liquidity injections help prevent disruptive financial market dislocation and keep the banking system healthy enough to maintain lending to struggling businesses (with government guarantees), but what is critical are targeted fiscal measures taken to sustain businesses for as long as the effects of this crisis endure.
In France, the government announced emergency measures, including deferring taxes and payroll charges. It is also positioned to offer loan guarantees of up to 300 billion euros. The UK government has taken similar action with support measures totalling £544 billion.5
Interest-rate cuts, quantitative easing and large fiscal packages will accelerate the recovery when it begins
With an eye to the long term, interest-rate cuts, quantitative easing and large fiscal packages will accelerate the recovery when it begins. In the meantime, however, real estate investment markets face sizable challenges. Transaction volumes are slowing and, with price discovery elusive, market activity is likely to be subdued for a long period of time. In the UK, for example, we have seen the number of assets placed on the market decrease in March after a healthy start to the year.
In public markets, pricing is pointing to downside risk to valuations (Figure 1 shows the price to gross asset value of European REITs by sector, which gives an indication of the fall in property values expected by listed market participants). In private real estate markets, adjustments tend to happen at a steadier pace – bearing in mind these are not normal times.
Figure 1: European REIT discounts to gross asset values
The impact of the crisis will vary
Long-income assets have historically displayed defensive characteristics during downturns. Funds focused on such assets outperformed on a relative basis during the global financial crisis with investors heavily favouring the secure, long duration cash flows they can offer. Property assets backed by long-dated government or government-sponsored income streams are likely to be most resilient.
Riskier, growth-focused real estate strategies look more vulnerable in the near term
At the other end of the spectrum, riskier, growth-focused real estate strategies look more vulnerable in the near term. For developments, there is heightened uncertainty about the timing and costs of projects given the disruption to supply chains and temporary reduction in labour supply. For developments that do complete in the months ahead, leasing activity is likely to be subdued. More generally, investors are likely to discriminate against assets with vacancies or leases nearing expiry.
Cyclical downturns can also accelerate structural changes. This raises concerns about discretionary retail, one of the first sectors to be hit by COVID-19, particularly in areas dependent on tourism. Alongside the hospitality sector, this is where the first signs of an inability to make rental payments and potential business failures are emerging. Investors who have attempted to get ahead of the changes in consumer behaviour by reducing exposure to weaker retail assets are likely to suffer less. Non-discretionary retailers such as grocers and pharmacies are likely to be less affected by a severe drop in demand but may still face operational challenges.
Figure 2: UK corporate BBB 10-year credit spread
In the office sector, covenant strength and the quality of occupiers’ balance sheets are critical factors. As figure 2 shows, public credit markets are pricing assets as if the risk of default among weaker covenants has increased rapidly. Assets backed by leases to the government and public bodies are likely to be among the most resilient, and businesses that play an integral role in the functioning of society and the broader economy may be more likely to receive government support. In contrast, occupiers in transportation, tourism and industrial sectors may be more fragile. Portfolios designed to deliver sustainable income by targeting strong occupiers and high-quality assets are likely to see less disruption to cash flows.
A larger percentage of the population could become dependent on e-commerce during the period of enforced social isolation
In the logistics sector, fortunes will likely vary. Occupiers will be impacted by the disruption to global supply chains and potential labour shortages, and in-store retailing may reduce demand. However, a larger percentage of the population could become dependent on e-commerce during the period of enforced social isolation, providing some support for the sector. On balance, assets in proximity to consumers and, particularly, labour are likely to be more resilient.
Student accommodation is generally a defensive sector, and rental incomes here should be less significantly impacted than in many other sectors in the short term. However, if global travel and higher education are still seeing disruption by late summer, occupancy rates for the 2020-2021 academic year will come under pressure.
Landlords will have to work closely with their occupier customers to protect incomes
During this period, landlords will have to work closely with their occupier customers to protect incomes. Those that have built strong, trusted relationships will be best placed to work through the current difficulties.
A key characteristic of real estate is that investors can position themselves to have an information advantage – for instance by focusing on specific markets where they can build strong relationships with local stakeholders. This characteristic is most valuable in periods of volatility when prices diverge from value, allowing resilient investment options to be identified. While the months ahead are going to be very challenging for all investors, those that have built the deepest market expertise and strongest local relationships should be best positioned for long-term resilience.