Property: a rapid unwinding
For publicly listed real estate, the market reaction to the coronavirus pandemic has been swift. Real-estate investment trusts (REITs) have plunged: all national indices were down sharply in Q1 2020, recording an average 28-30% decline that was broadly in line with equity markets.
In a now familiar pattern, there has been meaningful variation between sectors. US retail shopping-centres were down 69% in Q1, while mortgage REITS fell by 60% and industrial real estate and data centres rose by 7%. This suggests the market has priced in a continuation of the trends in motion before the crisis: it does not yet seem to anticipate a more significant shift in demand.
Markets are volatile and liquidity is still weak. There is significant pressure on income, as a large proportion of the global real-estate market remains closed. Rent-collection rates for the most diversified asset owners were only 60% in Q1, with meaningful dispersion between sectors. Some residential REITs had collection rates of about 95%, compared to 29% for a number of retail REITs. Uncertainty about future income and dividend suspensions have bolstered negative sentiment, particularly for UK REITs where large discounts to net-asset value persist.
The policy response from the UK government will have a mixed impact on landlords. While the 12-month business-rates holiday will be positive for most tenants, the moratorium on evictions will impact room for manoeuvre. There are also signs that investor sentiment has hardened against retail assets and is likely to push values down, at least in the short term.
Within private real-estate markets, uncertainty about income means valuers have invoked material value uncertainty (MAC) clauses that were last used after the Brexit referendum. The challenges in valuing real estate are obvious: many retail and institutional funds have been suspended and will likely remain closed to redemptions. This poses a major test and there is likely to be considerable demand to redeem cash once these suspended funds seek to sell assets, which could happen in May.
Is history repeating itself?
Although the moves in public real estate are stark, they do not match those seen during the global financial crisis. In 2008, real estate was central to the crisis and REITs declined more than equities. There is less leverage in the market today, while the reduced ability to pay rent is mainly due to external factors rather than fundamental issues with the sector (although these do exist). Yet with large parts of the economy in lockdown, it remains extremely difficult to ascertain long-term value.
That said, history may help us understand the scale of what happens next. During the financial crisis, capital values for UK real estate fell by 7.3% in 2007, 25.9% in 2008 and 3.3% in 2009. Indices declined by a similar amount in the US and there was no significant difference in the fall in capital value across real-estate sectors in either country.
Meanwhile, the sell-off in the early 1990s was driven by declining rental values and a sharp rise in vacancies caused by rising unemployment and a contraction in spending. Capital values in the UK fell by 14% in 1990 and 10.4% the year after. There is a risk that the current crisis could include elements of both downturns, which could result in values falling more than during any previous cycle correction.
Shifting spaces: change on the horizon
The length of time that the lockdowns last – and the paths that exit strategies take – are crucial in determining the outcome of the crisis. There remains considerable uncertainty – particularly for the retail and hospitality sectors – which should arguably be rewarded with higher risk premia.
As for commercial property, the surprisingly seamless transition to remote working has resulted in the inevitable predictions that the nature of work will change. The chief executive officer of a US investment bank recently claimed that the firm had proved it could operate with “no footprint” and predicted that it would have “much less real estate” in the future.
This change will take place over time and is likely to produce winners and losers. One example might be residential real estate: if workers transition towards a more remote style of working, this may enhance their desire to enjoy their surroundings and could boost the value of real estate in rural areas.
Investor sentiment and (still limited) pricing suggest that there will be a short, sharp downturn, before a swift recovery as tenants return to properties and pay rent. This seems an optimistic assessment of the cash-flow challenges tenants face during lockdown and the potential that they will be burdened with higher debt in the aftermath.
Asset allocation: the role for real estate
The strident intervention from central banks suggests that policies will be looser for longer, resulting in a trifecta of lower growth, inflation and nominal and real interest rates. In this environment, assets with a higher real yield will be attractive. Like other real assets, real estate typically acts as a portfolio diversifier in the form of an inflation hedge or a source of yield.
The current crisis has – perhaps temporarily – altered these characteristics. Income and dividends seem in danger, while many real-estate assets have moved in sync with equity markets (at least in the short term). The dynamics of other real assets like infrastructure, natural resources, commodities and precious metals have also shifted in response to cash-flow concerns, while gold has fulfilled its role as a flight-to-safety asset.
Over the past few years, investors have allocated to real estate for a number of reasons: some see it as an income generator, others a source of growth. This will likely continue and there are signs that investors have responded to the asset class in different ways during this crisis. For example, those looking for longer-dated real estate with annuity characteristics appear to be more active at the moment.
We have also witnessed a surge of investors focused on environmental, social and governance (ESG) characteristics. In particular, the governance aspect has become vital as landlords take a long-term view and recognise the rewards that come from forming partnerships with tenants. We believe that the current crisis will simply reinforce the importance of these factors. As such, it presents an opportunity for the next generation of real-estate investments to be aligned with ESG principles from the very start.