Covid-19 - Investment markets: What we know, what we expect, what we question
Victoria Ormond explores what we know, expect, and question about the future of investment markets in the wake of Covid-19.
7 minutes to read
What we know
Covid-19 disruption is yet to feed into overall UK volumes. Provisional Q1 2020 commercial volumes marginally exceeded those recorded in Q1 2019, at almost £12bn, albeit over 30% down on Q4 2019. This quarterly fall is not unusual, with the first quarter of the previous two years also being down 27-35% on Q4 the year prior.
Investment activity has not entirely ground to a halt. One aspect of recent weeks has been that a significant number of UK investment transactions have progressed despite the increased difficulties of doing business. Agents continue to report strong interest (and bids) for the right assets brought to market. Inevitably, however, there have also been numerous deals postponed and assets taken off the market.
Finding stock remains a challenge. The availability of stock was already acting as a brake on market activity. The crisis has done little to change this and has presented few forced sellers so far. Some have suggested that the fall in equity values will cause some balanced funds to need to reweight, potentially selling some real estate to do so, although this is a process that can take many months or even years, and multi-asset portfolios may be reluctant to do so whilst volatility remains in others markets. Meanwhile, with some retail funds gating, the flow of assets from this part of the market is also reduced.
Addressing the practicalities. With one third of the global population now under some form of lockdown, there remains a short-term practical challenge for real estate investors. This comes both in the form of income collection (where some landlords have come to agreements with tenants to postpone or waive this quarter’s payment), but also the practicality of visiting buildings for inspections. This is particularly relevant given the historically high proportion of overseas investment. International investors with local hubs and a cultural ability for multi-locational decision making may have greater ability to continue to transact once the strictest measures are relaxed, even if borders don’t return to normal for some time.
Listed company updates offer an early insight. Recent statements from listed property companies point to several trends. The ability to collect rent has been heavily sector dependent, with the retail-focused companies typically receiving the lowest percentages, although not universally. Like many companies, a focus on cash raising and preservation has been common. Given these two factors, it is unsurprising that some dividend payments are now in question. Positively, LTVs are dramatically lower than in the run up to the GFC.
What we expect
Volumes to moderate in the coming quarters. Given that Q1 overall volumes are virtually identical to those seen in the first quarter of 2019 we would expect a moderation of volumes into Q2 2020 and potentially beyond. We do expect some level of frictions to travel to continue. The longer this persists, the more likely we could see technological workarounds to some of the practicalities of transacting.
Regardless of these practicalities, finding suitable stock has been a constraint on investment volumes for some time and we expect this to continue over the coming quarters. In an uncertain, volatile environment, the UK remains a safe haven given relative liquidity, market transparency, property rights and relative ease of transacting and there should be demand for the right stock in the right locations.
Core income to remain in favour. With risk-free rates near historic lows, real estate’s comparative yield advantage is even more compelling, and the recent fall in sterling is significant enough to materially enhance the attraction of UK real estate for overseas purchasers. It is likely there will be some bifurcation in performance between these sorts of core assets capable of providing a relatively assured income, and those of a quality or in a sector where income cannot be relied upon
Meanwhile, a pause in construction and likely reduction in future construction finance will magnify the overall lack of new stock in the UK for some time. As impacts of the pandemic take hold, we may see an increase in real estate coming to the market, some of which (particularly the core, still-income producing, long income), will likely continue to enjoy a weight of demand.
Local market dynamics will remain key. Last year in our Momentum Cities research, we identified those cities across the UK and Europe which have strong education sectors which are integrating with the local economy to drive and monetise innovation. In light of the current situation, these cities are likely to gain even more importance over the longer term. As Joe Zidle of Blackstone noted in his recent podcast “history shows that our economy is sometimes the most innovative when faced with the greatest dislocations”.
What we question
How will transactions take place? What locations and asset types will be in long term demand? What will happen to transaction volumes? The answers to many of these questions will be largely dependent on the new normal behaviour for businesses and individuals alike. Caveating that there are fundamental differences across countries, a look towards locations in Asia, provides an element of a crystal ball as to potential nearer term futures for the UK.
Normality may be returning, in some of these locations but that normality is different to before and also fragile; resurgences of Covid-19 and further lockdown measures are being seen in Singapore and Japan at the time of writing. How will different societal norms play into the experience for the UK?
APAC, the epicentre of Covid-19, saw commercial volumes decline by 50% in the first eight weeks of 2020, compared to the first eight weeks of 2019 (source Real Capital Analytics). European volumes reduced by 18% over the same period. To the extent that the UK’s economic pause is coinciding with one third of the global population also being under some form of lockdown across a broad spectrum of countries, there is scope for UK volumes to see even deeper moderation in activity.
What will be the impact on the lending market and how will this impact volumes? The Lending environment is more supportive than during the GFC, but credit risks remain. Banks are better capitalised than in the run up to the GFC and the Prudential Regulation Authority (PRA) has written to UK bank lenders encouraging them to be lenient regarding loan covenant breaches due to general market conditions, rather than specific liquidity or solvency issues in relation to specific businesses.
The banks themselves have also had their counter cyclical buffers relating to capital requirements reduced, increasing lending capacity significantly. All of this contributes to a more favourable credit environment than at the time of the GFC – which was ultimately credit led.
Nevertheless, there is a question around banks decision making regarding borrowers facing liquidity or solvency issues, which could still see control being transferred to banks through covenant breaches. There are also questions around the magnitude of non-performing loans and whether these could reach levels which create stresses on lenders. This is relevant for bank and non-bank lenders alike, as are the questions around how credit committees could alter their lending criteria, as well as appetite and ability to lend.
These questions are particularly key due to the post-GFC growth of non-bank lenders in the real estate sector, which are relatively untested in terms of their resilience, ability to work-out non-performing loans and through-cycle lending appetite.
How will demand for different investor groups and nationalities change? Near term, transaction activity will favour those domestic, equity rich investors, themselves less affected by the economic impacts of the pandemic. We could also similarly see equity-backed international investors, who are able to draw on local hubs, able to culturally adapt to multi-location decision making, or otherwise innovate to overcome travel and other restrictions, enter the UK market.
Will reshoring drive a push for greater cross-border investment? In the longer term, commercial real estate could offer a way for investors to diversify globally in a world which is seeing a reshoring and otherwise localisation of other economic activity.
How will the sustainability agenda fare? Prior to the pandemic, there was growing traction and focus on Environmental, Social, Governance investing (ESG), particularly in the UK. Carbon reduction remains legislated for by the government and assessing the impact of different climate change outcomes on assets remains within stability reporting for the Bank of England, so we expect ESG to remain important for commercial real estate, potentially with additional weight around wellness and overall building healthiness.