In our regular update on drivers in real assets, we assess the impacts of a possible downturn in the euro zone. We touch on cash generation, the valuation outlook and the significance of security and ranking in the capital structure.
Assessing impacts of a possible downturn in the euro zone on private assets
The European Central Bank’s decision to re-start asset purchases in September at €20 billion a month highlights more cautious sentiment in the euro zone. While our central scenario is for growth to moderate rather than decline sharply, we look at the impact of a possible downturn for holders of private assets, trying to anticipate the uneven impacts of slower economic growth.
Focus on cash flows
Long income real estate, infrastructure or corporate borrowers with contracted or regulated revenues are likely to see their cash flow generation relatively unaffected, while corporate borrowers in competitive sectors would be most exposed. Historically, corporate profits have been more volatile than rental yields. Cash flows derived from real estate vary with the economic cycle but to differing degrees. Parts of the market have short leases and tend to exhibit a strong correlation betweeen GDP growth and rental values (such as high street shops). These are exposed to a downturn. Other areas feature longer leases, with low correlation between GDP growth and rental values, and are therefore more defensive.
Figure 1. Through the cycle: tracking the cash flow of corporate and property borrowers
Valuation outlook
Secured lenders would benefit from additional protection. Infrastructure asset values are likely to be quite stable, with the exception of economic infrastructure with strong GDP linkages – e.g. ports, or those exposed to commodity prices. On the other hand, property values are more strongly correlated to economic cycles.
Figure 2. Through the cycle: change in property value
Importance of security and ranking in the capital structure
Senior secured creditors would be comparatively well placed. Institutional real estate loans extended at up to 60 per cent of property value can absorb a shock consistent with the average drop in property values experienced during the Global Financial Crisis. Unsecured lenders or second lien lenders are more exposed. The same holds true for corporate lending. Figure 3 compares average losses for various tranches of corporate debt compared to the average interest income for leveraged loans. The average spread is not substantially above the long-term average loss for unsecured creditors (in green), illustrating the value of security.
Figure 3. Margins and credit losses
Indicative spreads p.a.*
