COVID-19 to test the resilience of long income

Real estate long income strategies are known for their defensive qualities. Tim Perry explores how the impact of COVID-19 on the asset class will vary across businesses and sectors.

8 minute read

COVID-19 to test the resilience of long income

The disruption as governments around the world moved to implement social distancing measures to contain the spread of COVID-19 has sown fears in almost every corner of the financial markets. As economies entered lockdown, investor confidence appeared to do the same.

The full global impact of COVID-19 will depend on its duration and how far it spreads. Another key factor will be how nations, companies and individuals respond. Governments face the twin challenges of managing a ferocious viral outbreak while trying to protect economic growth. While there will undoubtedly be a significant short-term hit to activity, many governments have announced an unprecedented array of fiscal measures to boost their economies as and when the health crisis eases. Major central banks have also moved quickly with new asset purchase programmes and further reductions in benchmark interest rates.

We expect assets let on long leases to high quality tenants to be relatively shielded from the current disruption 

In UK commercial real estate, many tenants are either unable to pay their rent or have requested payment holidays, which in turn means landlords are facing a loss of income. In addition, a deterioration in the economic outlook is also likely to result in significant reductions in capital value. However, we expect assets let on long leases to high quality tenants to be relatively shielded from the current disruption and, therefore, should offer more investor protection.

Impact on long income

The majority of long-income funds have launched since the global financial crisis (GFC). In the UK, specialist long-income funds’ assets under management had grown to almost £12 billion by December 2019 from £500 million in December 2006, according to MSCI (see Figure 1.) Of the few funds in existence at the time, most fared better than traditional real estate funds during the GFC, offering greater resilience of income and smaller decline in capital value.

As COVID-19 is expected to bring the global economy into a recession, their resilience will be seriously tested for the first time.

In the years since, the sector has attracted institutional investors for its ability to provide long-term, predictable and (often) inflation-linked cash flows in a low interest-rate environment. Long-income strategies have helped many defined benefit pension schemes to hedge pension liabilities while achieving higher returns than gilts. As COVID-19 is expected to bring the global economy into a recession, however, their resilience will be seriously tested for the first time.

Figure 1: Asset growth of MSCI Long Income Property Fund Index
Asset growth of MSCI Long Income Property Fund Index
Source: MSCI, data from MSCI UK Quarterly Property Funds Digest, December 31, 2019

Compared to traditional commercial real estate, long-income strategies benefit from rents tied to inflation or with fixed uplifts over long-term contracts, usually in excess of 15 years. As a result, where tenants remain solvent, cashflows derived from long-income assets should be relatively unaffected by short-term economic and business disruption.

The COVID-19 crisis will still affect many long-income occupiers’ businesses

Nonetheless, the COVID-19 crisis will still affect many long-income occupiers’ businesses. Credit rating downgrades are already happening, with more companies at risk of default. Many corporates will emerge from this crisis with lower cash reserves, higher debt burdens and weaker balance sheets, increasing the risk they will be unable to meet their long-term rental obligations. Tenants with defensive business models or those with larger, stronger balance sheets should have more capacity to weather economic shocks.

Those that have focussed on high quality tenants should fare well

Over the last few years, companies of varying scale and credit strength have taken advantage of the high demand for long-income assets to raise capital through sale-and-leaseback transactions. While assets let to tenants with lower credit quality may offer higher potential returns, the additional risk may result in larger losses during volatile periods, such as we are experiencing now. In previous recessions, the default rate of sub-investment grade companies was around 20 times that of their investment-grade counterparts (see Figure 2.) The disruption from COVID-19 could also result in a period of high dispersion in performance for long-income investors; those that have focussed on high quality tenants should fare well, whereas those that have been less selective may experience higher defaults.

Figure 2: Peak annual defaults during prior crises, by credit rating
Peak annual defaults during prior crises, by credit rating
Source: Moody’s, 2019

The impact of leverage is also exaggerated in a downturn. Investors using high amounts of leverage or with upcoming debt maturities are likely to be worst affected. Conversely unlevered investors should experience less of a decline in value and are more likely to have liquidity to pursue mispriced opportunities.   

Sector-specific ramifications

Social distancing measures are 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. Figure 3 summarises the impact of Covid-19 on various sectors.

The wide range of tenant types will face different challenges depending on the nature of their business

Within the office and industrial sectors, the wide range of tenant types will face different challenges depending on the nature of their business. Those focussed on hospitality or with complex international supply chains are likely to be worst affected, whilst some businesses, such as those in the ecommerce or consumer staples sectors, may be less affected.

Figure 3: Impact of COVID-19 on long income sectors
Impact of COVID-19 on long income sectors
Source: Aviva Investors, April 2020

Public sector:  In general, we expect assets let to public-sector counterparties to be most resilient. Despite the recent downgrade of the UK by Fitch Ratings to AA- from AA with a negative outlook, public-sector organisations supported by government funding are less likely to default.

Student accommodation: If social distancing measures persist until September and affect the 2020-2021 university academic year, the occupancy rate of student accommodation will likely decline. Investors have a range of exposures in the sector, including assets with rental guarantees from universities, those let to student accommodation operators and direct lets to students. The first is most common within long income and provides landlords with some protection against short-term drops in occupancy.

Despite temporary closures, the risk of default for universities remains low

Despite temporary closures, the risk of default for universities remains low, with government support likely to be provided if necessary. However, it remains to be seen whether the increased use of online tuition will be a lasting phenomenon beyond this crisis, which could impact demand for student accommodation and where students want to be located.

Social housing: A large proportion of social housing rent in the UK is backed by the government through welfare payments. When combined with the significant shortage of supply in many regions, the risk from COVID-19 should be relatively limited.

Supermarkets: The ‘stay at home’ orders have increased demand for supermarket goods as more consumers cook at home. In the UK, supermarket sales have reached a record high, increasing by 20.6 per cent in the four weeks ended March 22 compared to the previous four weeks.1 The crisis has also encouraged many to use food delivery services, which may accelerate the structural shift towards online food ordering at the expense of physical store sales. Investors in long-lease supermarkets should consider the medium- to long-term implications of this trend when underwriting the terminal value of supermarkets at the end of their leases.

Hotels: Hotel operators often have thin profit margins and high fixed costs, which will make their ability to withstand a prolonged period without cashflows more challenging relative to other pockets of real estate. Long-income investors have predominantly gained exposure to the sector through two structures: long-lease hotels and hotel-related commercial ground rents. In the case of commercial ground rents, the value of the hotel is usually a multiple of the value of the ground rent. This helps mitigate overall risks, given ground rent owners have a claim on the asset in the case of leaseholder default. For long-lease hotels, more creditworthy operators with access to funding should be more resilient. In contrast, the coming months will likely prove very challenging for many small or highly leveraged operators.

Care homes: The care home sector is highly fragmented with many small operators. Similar to social housing, a portion of care homes’ revenues may be covered by the government, which adds an extra level of stability during short-term disruptions. However, care homes are currently facing unprecedented operational challenges, which may result in rising costs. In addition, social distancing measures make it a difficult time to attract new residents. Whilst long-term demographic tailwinds should support operators that survive, some sadly will face rising vacancies as a direct result of higher mortality among residents. Investors need to carefully gauge the impact of COVID-19 on care home finances. 

Retail: Given the structural challenges facing retail before the COVID-19 outbreak, the sector will be one of the hardest hit from social distancing measures as many outlets were either forced or encouraged to close. The economic impact may also be more lasting and reduce discretionary consumer spending for some time. Retailers with a strong online presence will likely have an advantage over those more reliant on revenues generated from physical stores.

Transaction activity and valuations

Market activity has slowed as investors assess the damage from COVID-19. However, some deals are still progressing, particularly in less-impacted areas such as public sector and supermarkets, albeit often with price reductions. 

Long-income transactions are often priced relative to liquid alternatives such as long-dated government and corporate bonds

Due to their liability-hedging characteristics, long-income transactions are often priced relative to liquid alternatives such as long-dated government and corporate bonds. Gilt yields have been highly volatile since the spread of COVID-19 worldwide, with the 20-year yield declining by more than 60bps since the start of the year. While this is supportive for long-income pricing, it has been offset by the widening of corporate bond spreads (see Figure 4) to reflect the higher default risk. The required returns to invest in long-income real estate therefore should increase, but only marginally.

Figure 4: UK ten-year gilt yield vs. credit spread of A-rated bonds
UK ten-year gilt yield vs. credit spread of A-rated bonds
Source: Thomson Reuters, data as of April 8, 2020

As in previous crises, there will inevitably be investment opportunities. Forced sellers may appear due to market dislocations or fund redemptions. Companies have a greater need for liquidity than ever, with early evidence that some are already attempting to raise more cash through sale-and-leaseback transactions.

Thorough credit analysis of potential new tenants must be central to investment decisions at this time, in order to understand their ability to withstand the crisis, whatever its length. An assessment of the potential structural impacts of the crisis is also required.

Its effect on financial markets is harder to ascertain and cannot be understood merely through economic theory

COVID-19 is unlike any other crisis in recent history, in large part this is because it is a global health crisis rather than a financial crisis. Its effect on financial markets, including the real estate sector, is therefore harder to ascertain and cannot be understood merely through economic theory.

Long-income real estate can appear conservative during risk-on periods. However, it can offer much-needed portfolio protection when volatility spikes. Of course, not all long-income strategies will offer the same level of resilience. Those with high-quality tenants and more diversification by sector and tenant should offer substantially more cushion. Just as every crisis is different, so is every tenant.

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