Commercial Insights - Capital Markets: Short Term Challenges, Long Term Demand
May 2020
6 minutes to read
What we know
Q1 real estate investment volumes largely shook off COVID-19 in the UK. Despite some of the UK’s Asia-Pacific investors facing lockdown very early in 2020, the UK only embarked on its own lockdown measures towards the end of Q1. As a result UK first quarter investment volumes are £15.2bn, nearly one third higher than Q1 2019 and only 12% down on Q4 2019. Office and Alternatives / Mixed use sectors fared particularly well, with volumes 54% and 140% higher than the first quarter 2019 at £4.0bn and £7.5bn, respectively. Industrial volumes were 20% lower than Q1 2019 at £1.5bn. While overall retail volumes were down over Q1 2020, Shopping Centre volumes saw £211m of volume, compared to just £63m one year ago and £180m in Q4 2019.
Addressing the practicalities. With one third of the global population now under some form of lock down, there remains a short-term practical challenge for real estate investors. This comes both in the form of income collection (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, although international investors with local hubs should more easily be able to overcome this, 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 a number of trends. The ability to collect rent has been heavily sector dependent, with the retail-focused companies typically receiving the lowest percentages, although not universally. For 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 lower than in the run up to the GFC.
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. Falls in equity values could mean that some balanced funds need to reweight, potentially selling real estate to do so. However, 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 other markets. Meanwhile, with some retail funds gating, the flow of assets from this part of the market is also reduced.
What we expect
Government spending to reduce the depth of the economic downswing. However, this is not expansionary capital spending that grows the economy. In future years, interest will need to be serviced and debt repaid, meaning potentially lower future spending and / or increases in taxation, with knock-on implications for real estate investment strategies.
Real estate activities to see a significant contraction in Q2. Commercial real estate markets were already experiencing a tight supply side, including for new development, so the forecast reduction in construction activity should constrain this further, and potentially for the coming few years. Delays in completions also mean risk of covenant breaches for developments reliant on debt, as well as additional costs, potentially reducing the NPVs and / or margins of development companies / construction firms, depending on specific contracts. Lower density of use of buildings, should there be subsequent social distancing rules similar to places such as China, could also mean squeezed margins and potentially lower profitability. This could also potentially impact capital values of some real estate assets in the future, should this be a longer-term phenomenon.
Challenges to rental and capital growth. Emerging forecasts see rental and capital values falling over this year, both at an asset class and property sector level, albeit with a recovery from 2021 for the main office and logistics sectors. Within all property sectors, the asset specifics will continue to be highly significant, with performance differing between prime, secondary and tertiary assets within the same asset classes.
Demand to persist for income-producing, safe-haven, core assets. Volatility in other financial assets is set to continue. In such an environment, core income-producing assets in safe-haven locations are likely to remain in demand, particularly against a backdrop of low interest rates. We therefore expect an increased likelihood of a bifurcation in performance between assets capable of providing a relatively assured income, and those of a quality or in a sector where income cannot be relied upon. Notwithstanding the continued practical challenges of being able to transact and short term questions over occupier demand and rental levels, London and other UK assets enjoy some of the strongest covenants globally and therefore likely remain in demand.
What we question
How will demand for different investor groups and nationalities change? Near term, transaction activity will favour those domestic, equity rich investors, themselves less impacted 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 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.
What will be the long-term impact on real estate debt? Going into the pandemic, loan-to-values are lower than at the time of the GFC but the commercial real estate market is still heavily debt dependent. Banks are better capitalised, but from a real estate investor’s perspective, not all debt is with banks. Due to changes in regulatory capital rules incentivising banks to lend more simply on senior pieces of debt, over the last decade there has been a large rise in real estate debt funds. The loan documentation and the debt funds themselves are as yet largely untested by a significant downswing.
Looking forward, we question how the impact of bank bad debts may impact the availability, loan to value and pricing of bank lending, what the current situation means for existing debt funds and what sort of actions they will take and how future lending by debt funds may change. We also question the degree to which new debt funds / equity players will step in to manage any short falls in debt provision if current lenders retrench. There are also questions related to if, when, and what debt-led asset sales could look like.