M&G Real Estate Head of Investment Strategy Jose-Luis Pellicer says that while there is limited transactional evidence to inform valuations in real estate, stabilized income producing assets are the holy grail; relative to the US, Pellicer argues the Asia property market is best positioned to deal with the COVID-19 crisis.
By Jose-Luis Pellicer
Unlike the Global Financial Crisis (GFC) in 2007- 09, the challenge facing the global economy today is not, as yet, financial in nature; rather the pandemic is causing a crisis directly in the real economy. Government imposed containment measures are impacting businesses, which in turn are impacting occupier markets.
Indeed, operating tenants, particularly in the retail, leisure and hotel sectors, are facing the greatest short-term liquidity pressure.
For some, social distancing measures have been impacting trade. This has resulted in some tenants seeking to defer rents until a later date. Rental income collection has thus suffered.
By and large, new leases are being put on hold. In an environment like this, it is unsurprising that businesses have stopped decision making. A new lease, expansion plan, a new machine? Forget it. But it’s not all doom and gloom.
Occupiers that are not reliant on a direct consumer interface to generate revenue or whose revenue is more recurrent or subscription based, are better positioned to weather the storm.
In addition, government action will help. The ingenuity and speed with which governments and central banks have moved to support the real economy is encouraging, and will help to keep businesses afloat and people employed.
However, government intervention is unlikely to avert a global recession. Markets must adapt to the new ‘normal’ and prepare to navigate both the challenges and opportunities that turmoil may bring.
The logistics sector is likely to fare better, owing to an acceleration in ecommerce as a consequence of containment, with the potential to herald a permanent shift in shopping habits. Goods still need to be moved, produced and stored. The disruption to supply chains as well as labour shortages may affect certain tenants, although rent collection in the sector overall has fallen less than in other sectors.
Depending on the length of disruption the virus causes, the student housing sector could face an interruption to cash flows as a result of a delay to the 2020-21 academic year, alongside continued travel restrictions. Nevertheless, the sector’s long-term fundamentals remain positive.
The knock on effect of containment measures also resound within the residential sector. However, people always need somewhere to live, whatever the economic climate. Even in the GFC, rental occupation remained broadly stable. Therefore, residential property is likely to remain more defensive.
Markets seeing limited transactional evidence
With investors focusing on issues in existing portfolios or waiting for greater clarity on economic implications for occupier markets, investment activity has, unsurprisingly, fallen. It may not even be possible to take a technical team to inspect a building, albeit some managers are thought to be conducting weekend inspections.
Some deals are completing, but typically only where the majority of work had already been done. The rest are either on hold or have been withdrawn. In addition, many developments are facing delay as construction sites are closed or on-site resource is curtailed, and supply chains disrupted.
There is less market evidence than usual to inform valuations at present. This has prompted independent valuers to insert material uncertainty clauses into valuations globally.
With banks better capitalised than before the Global Financial Crisis and with regulators typically encouraging a lenient approach to loan covenant breaches, currently we see no forced sellers. Naturally, this may change if the crisis persists. Therefore, valuations are yet to reflect significant movement.
Across developed Asia Pacific markets, where the outbreak first took hold, the effect on liquidity was seen earlier. Values are flat so far, although standard risk philosophy still applies to income producing assets versus those with vacancy. Furthermore, assets and portfolios using lower levels of leverage should hold up better in a declining market.
So what does the future look like? Are there any winners or substantial losers? Stabilised income producing assets are the holy grail. If let to tenants on a long lease and in a good location, even better. On the other hand, commercial properties that are currently vacant, on a short lease or about to hit the market will likely take longer to let, with businesses delaying decision making. Accordingly, investors will need to be compensated to take vacancy risk.
Markets must adapt to the new ‘normal’
In a matter of weeks, the impact of Covid-19 has affected populations and economies worldwide, like nothing seen before in many of our lifetimes. Uncertainty remains over how the pandemic may evolve, with concern over the reintroduction of infection once lock downs are lifted.
From a global perspective, we believe Asia is best placed to deal with the crisis, having learned lessons from the SARS epidemic and with the ability to enforce containment through more ‘Confucian’ social order. The US, by comparison, is least prepared to handle the crisis since it’s healthcare system is privatised and fragmented, and therefore hard to mobilise efficiently.
In pragmatic terms, pandemics tend to last for a matter of months, not years. Nevertheless, herd immunity must be achieved one way or another, which will take some time. But we will return to normality.
There remains a high level of uncertainty and the real estate sector will not escape unscathed. The crisis will pan out through tenants, though this will be partly offset by government intervention. The shape of the recovery is difficult to gauge, but normality may return, with opportunities to take advantage of along the way.