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  • Covid-19

Defaults, disruption and development: Real assets adjust to the new normal

While lockdown measures gradually start to ease, it is still far from business as usual in the real assets sector. Mark Versey explains the impact for investors.

Defaults, disruption and development: Real assets adjust to the new normal

In a recent blog, Facebook CEO Mark Zuckerberg predicted that over the next five to ten years, half of the tech giant’s 48,000 employees may be working from home – permanently.1 On top of the obvious cost savings for the company by reducing office space, Zuckerberg also pointed to other benefits, such as access to “talent pools outside of traditional tech hubs in big cities” and environmental benefits from a reduction in commuting.

“Since many people feel more productive outside the office, it should help us better serve our community,” he wrote.

Many companies have proved they can operate effectively with staff working from home

Such statements, as well as a realisation that many companies, including in financial services, have proved they can operate effectively with staff working from home en masse, has fuelled speculation that the office market as we know it will be changed permanently by COVID-19. Clearly that has major consequences for investors in the sector, but are such predictions premature?

There are, after all, downsides to being away from the office, especially for parents juggling between work and looking after children, or those living on their own. Finding a balance between work and home life has proved difficult for many. That’s before factoring in the advantages of bringing people together and good, old fashioned face-to-face interaction.

Even Zuckerberg conceded: “I'm concerned about weaker social bonds between colleagues, especially new hires, and there’s an open question about whether groups of people are less creative when they’re not together.”

In this Q&A, Mark Versey – CIO of Aviva Investors Real Assets – discusses the offices sector, along with other implications for real assets as a result of the pandemic.

COVID-19 is a game changer for real assets. As lockdown measures begin to ease, how do you see things playing out from here?

A lot of the questions we’ve received have been about the future of offices. We’re applying three lenses to this. First, as an occupier, the short-term focus is on making the workplace safe for people to go back to work, enabling social distancing and adhering to government guidelines.

A lot of businesses have continued to operate through this crisis

Second, as a landlord, we are partnering with occupiers to prepare locations to re-open safely. A lot of businesses have continued to operate through this crisis. One of our tenants in a Cambridge science park, for example, has been designing COVID-19 testing kits, which are being rolled out in hospitals globally. We worked with them to solve some of the safety problems to protect employees. This has helped our understanding of how to make buildings safer, and we can apply what we’ve learned to help other tenants as economic activity picks up.

Third, as an investor, we were fortunate in going into the crisis with low vacancy rates in offices generally, particularly in our core cities, and long lease exposure.  So, we're in a relatively strong position. We don’t expect businesses to cancel their office space in the short term as more office space is required to accommodate staff under social distance requirements. However, in the medium term, occupiers will certainly rethink their office requirements. We think our strategy of investing in core cities with flexible, modern, office space will continue to be the right one.

Are you concerned about developments currently under construction?

Our first concern has been the safety of working practices as construction projects resume. Immediate delays arising from site closures, supply chain disruptions and staff shortages have begun to ease, although there will continue to be reduced productivity in certain projects depending on the stage of construction. Overall, we have been impressed by the industry’s speed and decisiveness to mitigate project delays.

Locations that offer variety and a mixture of experiences should be more attractive to talent

Our development strategy is aligned to our core cities investment strategy. Locations that offer variety and a mixture of experiences should be more attractive to talent and therefore more resilient against the economic impact of COVID-19. As a long-term investor, we are alert to market triggers and tailor risk appetite accordingly. As opportunities emerge, we will look to increase supply into these markets.

Most of our projects under construction are pre-let, or significantly pre-let. The low level of speculative development, where space is built with the hope tenants will come, has translated to relatively low vacancy rates for high quality office accommodation in core locations. Had we entered the post-COVID-19 phase of the property cycle with high levels of existing vacancies or speculative development, the short-term behaviours of occupiers to manage their cost base would have a significantly greater destabilising effect on the market. Constraints on supply should help mitigate downward pressure on rental growth.

Occupiers will continue to demand higher quality buildings

When the short-term impact of COVID-19 has passed, occupiers will continue to demand higher quality buildings. Employees are expected to want more choice and flexibility over their location of work, so office space will be required to deliver a higher quality experience and facilitate the human interactions and collaborations that cannot be gained from working remotely. In many instances, this will require office buildings capable of being more intensely used at peak times.  

How about the long-term impact?

It depends on whether a lot more people will want to work remotely, which would see a change in demand for offices. I still believe offices have value – for collaboration, relationships, motivation and a sense of community – but perhaps there will be less occupancy, so less space is needed.

City hubs such as London where all the talent clusters today should be fine

We are thinking about how to redesign some buildings to allow for more flexible working, and we continue to have more of a focus on core locations. In that sense, city hubs such as London where all the talent clusters today should be fine. Some secondary office locations, however, may struggle in the short term. However, if employees opt to work nearer to their homes in suburban areas, that could just as likely increase demand for localised offices in town centres. As local authorities seek more regeneration opportunities to breathe life into areas impacted by the virus, new opportunities that we hadn’t foreseen could also emerge.

The concern would be that if the crisis is prolonged or turns out a lot worse than expected, default rates will rise. In some cases, you might lose the competitive tension. In prime locations, businesses up until recently have competed for office space. That tension obviously benefits investors. If that competitive tension drops significantly, the level of risk rises.

What signals would give us an indication that the market has hit the bottom?

If everything returns to normal in 2021, there should be a rebound in property – perhaps not a full recovery, but not far off it. And we would expect prices to come back to par in 2022. But if we have a deep recession that starts causing businesses to close, real estate will face a worse scenario. In market dislocations such as this, the first impact is usually to equities, then corporate bonds, and eventually real estate. 

We suspect the impact will be felt on capital values, followed by a more severe impact on the occupancy

Real estate lags the corporate impact caused by a contraction in GDP because it takes time to quantify the impact on occupiers and cash flows. Initially, we suspect the impact will be felt on capital values, followed by a more severe impact on the occupancy. Only when the full extent of that has been identified and quantified, will we have a clearer view on whether markets are reaching the bottom.

Which areas of the market still offer opportunities? Conversely, where are the pain points?

We’re continuing to review how the pandemic affects individual businesses and sectors. Some have been hit hard, but others, such as the Cambridge pharmaceutical company I mentioned, have benefited.  We have also seen good long-lease investment opportunities throughout the crisis. A long lease with a strong covenant offers great protection from market volatility. More corporates may look to sale-and-leaseback opportunities as a route to raise cash to further support their businesses.

In real estate debt, as with real estate equity, there are already opportunities in high-quality assets. In the short to medium term, there will be more opportunities for non-bank investors to lend, as we typically see banks needing to focus on capital preservation and loan impairments before they start writing new business. This may especially be true in larger deals where one of the debt suppliers is a bank.

Government-provided debt will eventually need refinancing

In corporate lending, there has been a wave of government support to businesses, so there are limited opportunities at the moment for institutional investors. But this will eventually stop, and government-provided debt will eventually need refinancing. We would need evidence revenues are on their way back up though and we look at sectors that can recover the quickest.

Across real assets, a focus on portfolio construction is more important than ever. We will look to increase investment in areas that command sustainable cash flows, such as renewable energy which has been relatively unaffected by the crisis and data/telecommunications as more people work from home. Meanwhile, we will avoid sectors that will be hit for longer periods, such as travel.

What about infrastructure?

Infrastructure has fared reasonably well, other than the acute pain felt by certain transport assets such as toll roads and airports where usage is materially down. Airports are a combination of transport, retail, food and beverage, and hotels – all the sectors hit the hardest in one place. Demand for air travel, including business travel, is likely to be subdued for longer as the recession hits and international routes take longer to open.

Other infrastructure sectors are performing well, particularly renewable energy. I think fibre, especially fibre to the home, is now really established as the fourth utility company. Everyone wants strong broadband, so it is a key utility for society. That trend was already in place but has been accelerated as more people work from home, so there are good opportunities to invest in that sector.


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