Coronavirus – considering the real estate implications
18 March 2020
The evolving Covid-19 outbreak could have profound effects on the real estate space. Implications could be far reaching, but quantifying these is highly speculative at present. We share our thoughts on what this may mean for the sector and where the risks may lie. In times of uncertainty, and with share prices materially lower, we look to quality companies with strong fundamentals and long-term prospects.
Implications for real estate.
The considerable fall in share prices that the sector (and the wider market) has experienced over the past two weeks reinforces the risks that the Covid-19 crisis poses. Rental growth is ultimately linked to economic growth, and while we weren’t forecasting much of the former we must now think about the downside risks to income. With regard to yields, with the recent falls to risk free rates across the globe, real assets are likely to be remain well bid. As a result, yields at present look underpinned, but what we need to be alert to is any squeeze on the availability of credit in the wider sector.
Rent interruption is the key risk now.
The potential implications of the strategies used to fight the Covid-19 pandemic are far-reaching. In almost every case they will mean a temporary change to daily life: how and where we go, and what we can and can’t do. As this has implications for tenants’ business models, it also has impacts for landlords too. The upcoming quarterly rent day (25 March) will be a test case for rent arrears and the ability or willingness of tenants to meet their obligations. We believe it is prudent to anticipate disruption, and to think about how this may manifest itself.
Considering sector risks.
We undertake a holistic view of the sector in the context of the likely disruption. With the exception of primary care assets, it is difficult to see any sub-sectors being immune from the fallout. Supported by recent anecdotal evidence, we look at possible scenarios and highlight potential risks. We pay close attention to counterparty risk (that may not be able to meet their obligations) as well as behavioural change as these are the biggest risks we foresee. Identifying the risks is easier than quantifying them at the moment.
implications for real estate
Given just how fast the coronavirus pandemic is evolving, and how fluid responses are from governments around the world, pinpointing firm implications for the UK real estate sector feels like an impossible task at this moment in time.As we expect this to persist, rather than pinning our colours to the mast, over the following pages we have put down our current thinking on where issues may arise – and indeed where opportunities could present themselves.
To begin, we present below our own SWOT analysis for the wider real estate sector with regard to the outbreak
1. Contractual income stream
2. Diverse customer base
3. Asset-backed businesses
1. Covenant risk
2. Capital intensive
3. Sensitive to economic growth
1. M&A opportunities
2. Access to capital
3. Global capital flow
1. Behavioural change
2. Government intervention
3. Safe haven status
Economic growth = rental growth
Broadly speaking, rental growth goes hand-in-hand with economic growth over longer periods of time. Therefore, with an as yet unquantified impact on economic growth in the UK and beyond, there is a risk that our rental growth expectations will need to be re-assessed over the coming weeks and months. We must remember that the physical real estate market is slower to respond to such changes than the equity market.
Yields look underpinned at present...
We anticipated yield tranquillity over the coming years, consistent with our view on the real estate cycle. For the time being, this still looks like being the case, but again the real estate market moves more slowly than other markets.
What we do know is that we have witnessed a reduction in risk free rates in the UK, with the 10-year gilt dropping to less than 0.3% and a 5-year swap closing in on just 0.5%. A year ago these were both around 1%.
Ordinarily such a reduction would be deemed supportive of real estate yields, but with many question marks now hanging over real estate income streams (as we explore below), the equation looks less clear. That said, parts of the market are likely to retain their safe haven status (trophy London assets, for example) and the UK is expected to remain an attractive destination for foreign capital.
Restrictions on movement may also have consequences for the real estate investment market – and therefore asset pricing. Due diligence is likely to be very difficult to complete – physical viewings may become impossible for a period of time – and therefore transactions may not proceed. For potential buyers who can afford to wait, this won’t be a problem, but for motivated vendors it could become a real issue; either they can’t sell or they have to accept a lower price to compensate buyers for the additional risk they take on.
... but watch for a credit squeeze
If we learnt anything from the GFC it should be that access to capital, or the lack of it, can have dire consequences for real estate. A credit squeeze could once again have profound negative implications for the operation of real estate markets, and the pricing of assets. Although such an event could prove terminal for those who need the capital most, the drop in prices as a result of a restriction of capital would hit the balance sheet of almost every asset owner.
In recent days we have seen reports of Blackstone and Carlyle portfolio companies drawing down on available credit lines. We hope that such actions are not a precursor to more serious issues ahead, but we must be aware of them nonetheless.
Rent interruption is the key risk
We have already heard anecdotes of tenants asking for rent holidays, but it should be stressed that these are isolated cases. However, we would expect this to increase, especially if the cash flows of the tenant base are interrupted. We provide more insights on where we see the risks at present below.
The next quarterly rent day is Lady Day on 25th March. This commemorates the visit of the archangel Gabriel to the Virgin Mary and perhaps landlords will be hoping for a guardian angel this coming Lady Day too. With events moving at such a fast pace, it is probably now prudent to assume disruption and rent arrears post the rent day. How widespread these are, and what action is taken or proposed, remains unknown at present.
Much will also depend on what government action is taken (forcing the closure of shopping centres, for example?) and what compensation it offers. It may also depend on the level of insurance cover taken by both tenants and landlords, and of course the stance taken by insurers in dealing with claims.
However you look at it, the risks to cash flows – however secure they seem –have risen over the past few weeks.
We are not contract lawyers!
One thing to note here is that we are not contract lawyers, and we aren’t privy to the tens of thousands of lease contracts that our coverage universe have entered into. So we don’t know under what circumstances – if any – lease obligations can be annulled, but we wouldn’t be surprised to see more attention paid to this area over the coming weeks as the financial impacts of any restrictions become clearer.
We have recently seen the concept of ‘frustration’ tested by the European Medicines Agency (EMA) with regard to their lease on an office in Canary Wharf, arguing that Brexit was an unforeseen event that made its lease obligations impossible to honour. Although the EMA ultimately lost its case in the high court (and sublet its space to WeWork), it is not inconceivable that such an approach will be taken with regard to Covid-19. Force majeure clauses may also be something that we hear more about.