Although history offers no magical answers, it can serve as a useful guide in times of extreme uncertainty. Vivienne Bolla and Souad Cherfouh dig into the archives to better understand the effects of recessions on real estate.
7 minute read
While COVID-19 may be unlike anything economies have experienced before, the inherent cyclicality of economies and real estate markets is nothing new. Real estate is cyclical, and downturns are part of the cycle.
During the early 1990s recession in the UK, GDP fell by 1.9 per cent over five quarters, while capital values fell steadily over that period by 36 per cent. Yet subsequently, the UK economy experienced 16 consecutive years of growth before output fell in 2008 during the global financial crisis. That economic downturn had a far greater impact; with an economic contraction of 6.2 per cent over five quarters and capital value declines of 40 per cent.
Figure 1: Change in UK real estate capital values, 1981-2019
Although this illustrates no two recessions are the same, a historical perspective can still offer valuable lessons. This is even more relevant as economies in many parts of the world are heading towards a deep recession. Within real estate, while there has been a lot of focus on the impact of the COVID-19 crisis on the retail and hospitality sectors, our analysis brings other sectors into play, including what this recession means for the office sector.
Past recessions and real estate
Analysis of historical property data over past cycles provides useful insights on the sensitivity of real estate sectors to changes in GDP and therefore to economic downturns (Figure 2 and 3).
Figure 2: Sensitivity of UK real estate total returns to GDP
Figure 3: Sensitivity of European real estate total returns to GDP
Historically, the office sector tends to be most sensitive to changes in GDP, particularly in global financial centres. Two factors specific to the office sector help explain this.
First, the office development cycle can be very pronounced and, in times of crisis, lead to oversupply. The early 1990s recession in the UK provides a striking illustration of the impact of oversupply on the sector during a recession. Net additions to office stock in UK office markets increased by 16 per cent from 1990 to 1992, while values fell by 50 per cent over the same period. In comparison, other sectors saw declines of less than half that.
Business investment tends to fall hardest in a downturn
Second, business investment, one of the key components of GDP and an indirect driver of office demand, tends to fall hardest in a downturn, resulting in a bigger hit on offices compared to other sectors.
On the other hand, certain types of retail assets have usually been less sensitive to GDP changes. One explanation for this could be that households are able to dip into savings to smooth out consumption as non-discretionary spending is by nature stable, and in the case of prime high street retail, have supply constraints. The defensive qualities of certain alternative sectors, including healthcare, residential and student housing, have also been apparent during difficult periods.
How this crisis is different and the impact on real estate
The specific nature of a crisis and the economic sectors that cause recessions determine the impact on property sectors. The current recession is not a typical one. COVID-19 is a health crisis that has triggered an economic recession. Strict containment efforts – lockdowns, transportation bans, and restrictions on public assembly – have resulted in an unprecedented and abrupt stop of economic activity in many industries, with an immediate and severe impact on businesses and workers.
Figure 4: Economic indicators: Key differences between this crisis and the GFC
One key difference between COVID-19 and previous crisis is that the services sector has been hit the most strongly. In previous crises, this sector was usually resilient compared to the manufacturing sector. As a result, the impact on real estate sectors is likely to be different in this crisis. The consumer-driven services sector will be hit hardest, with risks highest for the hotel and non-food retail sectors.
Length, depth and speed of the recovery will determine how this crisis will impact the real estate market
Another key element that will determine how this crisis will impact the real estate market is the length, depth and speed of the recovery. Given the high degree of uncertainty around the evolution of the pandemic, different economic scenarios are possible:1
- An optimistic scenario where after the first lockdown the virus can be contained whilst economy is restarted. The recovery would begin as soon as 2020 H2.
- A scenario where after the first lockdown, restarting economic activity results in new infections rising again. However, more targeted social distancing for at-risk groups, alongside improved testing, contact-tracing and health system capacity means that social distancing can keep the numbers to a level at which treatment can be provided to those in need. That would result in the depth of the downturn to be greater, but recovery would still start in 2020 H2.
- A worst-case scenario would be that after the first lockdown, restarting economic activity results in a resurgence of new infections. Further rolling lockdowns occur periodically across much of the globe. In that case, the depth is even greater, and the recovery begins later
We should expect the same knock-on effects in real estate as previous crises
The deeper and longer the crisis, the more important the consequences of a recession become relative to the immediate impacts of lockdown. In that case, we should expect the same knock-on effects in real estate as previous crises. Indeed, issues around business failures, high unemployment, solvency or disrupted financial markets are likely to lead to weaker demand across all sectors, not just retail and hospitality.
With that in mind, we have analysed the current macro-environment and the risks on real estate markets. We consider both economic sensitivity (historical approach) and COVID-19 sensitivity (specifics of this crisis).
Figure 5: UK sector risk during COVID-19
In the UK, the graph highlights the high risk attached to selected types of retail assets, which were already showing weaknesses prior to COVID-19 and are also being hit hard during the crisis. On the other hand, alternative sectors such as residential or healthcare are expected to be resilient.
Figure 6: European sector risk during COVID-19
Our analysis shows a similar story in Europe. Retail appears to be more at risk due to COVID-19, but historically has been relatively resilient. Risk for the office sector is relatively high because of its historical high sensitivity to GDP, even though the impact of COVID-19 has been limited thus far. The graph also highlights that sectors seem to matter more than geographies when it comes to COVID-19 risks.
The longer and deeper the crisis, economic sensitivity will have a higher importance
Another way to interpret the graphs and to assess the risks is related to the length, pace and depth of the crisis. In the short-term, we believe the biggest impact on real estate markets stems from specific COVID-19 factors. However, the longer and deeper the crisis, economic sensitivity (as opposed to COVID-19 sensitivity) will have a higher importance. In this case, the office sector is likely to be strongly hit; while the industrial sector would also be impacted by a further decline in demand, it should outperform on a relative basis.
Alternative markets such as healthcare and residential should also outperform as reflected by the relatively low risks attached to those sectors. We recognise that the potential for this downturn to accelerate structural changes or alter how we use real estate doesn’t feature in this discussion but remains important. The downturn is likely to further weaken demand for low quality retail assets, for example.
This time is different?
In addition to understanding the nature of this economic crisis and the sensitivity of real estate markets, the state of the real estate market before COVID-19 is also crucial when assessing risks across sectors.
Figure 7: Real estate indicators - Key differences between this crisis and the global financial crisis
The main risk to real estate markets concerns absolute pricing, and there is evidence to suggest risk appetite was increasing before this crisis. Looking back to previous recessions, risks around pricing, leverage, supply and risk appetite were all strong, indicating that real estate markets were at a more advanced stage of the cycle and therefore more vulnerable to a shock.
Many European real estate markets are at a mature stage of the cycle, albeit with some differences across geographies. Cyclical risk, for example, is lower in the UK compared to German markets, as supply risks are under control and risk appetite implied by style drift and portfolios is low.
There is an increase in risk appetite, with investors seeking growth opportunities to boost returns
The spread between prime and secondary yields in European office markets is also insightful, as illustrated by Figure 8. Historically, the spread tends to widen during a recession when secondary assets usually underperform. Although the spread is not narrow by historical standards, it has been steadily eroding in the past three years. This reflects an increase in risk appetite, with investors seeking growth opportunities to boost returns. But in a recessionary environment, risk appetite is typically lower, with investors targeting secure income strategies.
In this crisis, we should also expect a flight to quality by investors, perhaps even more so given the current context of attractive relative pricing.
Figure 8: Spread between European office prime and secondary yields, 2007-2019
Social distancing measures are causing a range of impacts unique to each sector and tenant
There is also a strong case for long-income strategies in a downturn. They are known for their defensive qualities as they benefit from rents tied to inflation or with fixed uplifts over long-term contracts. Social distancing measures are, however, causing a range of impacts unique to each sector and tenant. This serves as a reminder that every crisis is different and the best way to protect against unforeseeable downside scenarios within long-income portfolios is to diversify by tenant and sector.
While long-income real estate can appear conservative during risk-on periods, it can offer much needed portfolio protection when volatility spikes. Where tenants remain solvent, cashflows derived from long-income assets should be relatively unaffected by short-term economic disruption.
Implications for real estate investment strategies
Over the long run, real estate values have shown volatility around an upward trajectory. Following this downturn, we should expect a recovery in valuations at some point. Indeed, it is possible that the policy interventions put in place create a positive environment for European real estate once an end to economic turmoil is in sight. Any cyclical downturn provides opportunities, and this time is no different.
In summary then, here are our key insights:
- The immediate impact of the crisis on retail and hotels is clear, with these sectors expected to underperform. The longer the crisis continues, the more likely the impact will move to other sectors. As the office sector is the most economically sensitive to GDP, office values are particularly likely to be under threat.
- The industrial sector will suffer too due to the knock-on effects of the recession on demand for traditional industrial space. But as industrial displays the lowest economic and COVID-19 sensitivity, it will continue to benefit from the rise in e-commerce and potentially greater investment in supply chain resilience. As a result, it is likely to outperform retail and offices under different economic scenarios.
- The defensive qualities of alternatives sectors like student housing, healthcare and residential are evident. Indeed, we are likely to see more discrepancy in performance by sector rather than geography.
- We are entering a cyclical downturn. But cyclical downturns can provide attractive entry points in sectors where there might be a short-term dislocation in valuations but are likely to see growth the long run.
- We expect lower quality assets, differentiated by the quality of income, to underperform and higher quality assets to outperform. This reflects the reduced risk appetite of investors as they focus on secured income strategies, encompassing longer leases, stronger covenants and buildings that tenants are keen to occupy during a recessionary environment. This contrasts with recent times, when there was evidence of increased investor risk appetite to boost returns.
The best way to protect against unforeseeable downside scenarios within long-income portfolios is to diversify by tenant and sector
Long-income strategies are known for their defensive characteristics. They benefit from rents tied to inflation or with fixed uplifts over long-term contracts. As a result, where tenants remain solvent, cashflows derived from long-income assets should be relatively unaffected by a short-term economic disruption. But as every crisis is different, the best way to protect against unforeseeable downside scenarios within long-income portfolios is to diversify by tenant and sector.
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