13 March 2020
Unlike previous epidemics
European real estate emerged relatively unscathed from previous global epidemics, SARS and HSN1, as the duration and geographic spread were limited, leaving transaction volumes and valuations intact. But Covid-19 is a different beast, being so contagious in a more globally interconnected economy. The virus has the potential to disrupt the real estate market for income generation and capital growth opportunities.
Major rental price correction unlikely
Tenants drive income generation in real estate, so stress on this group could signal income pressure for landlords. So far, we are not seeing a material impact on tenants, but anecdotally, there are early indications in both the UK and Continental Europe that leasing activity is slowing.
Corporate policies restricting business travel and tight cost control are likely to soften the European lettings markets in the first half of 2020. A combination of supply chain disruption and weak demand could cause cash flow problems for occupiers, who in turn may increasingly request rent holidays to help manage cashflows.
We are unlikely to see a meaningful correction in rental prices given office and industrial property supply is limited, but weak demand and falling oil prices suggest muted price inflation in the future, capping income growth from leases linked to price indexes. Rental corrections look more likely in the retail sector where the coronavirus impact could exacerbate the headwinds the industry already faces from the threat of online sales.
Property assets face repricing
Both Continental Europe and the UK have a broad base of domestic and international investors that should sustain demand but there is a risk that property assets will be repriced to reflect weaker growth in rent, increased pressure on tenants, and increased illiquidity in the market, at least in the short term. Current record levels for capital values in real estate mean the sector is vulnerable to repricing.
There are also some practical reasons why volumes could decrease. It is more difficult for investors to visit sites given travel restrictions. Sentiment could be damaged by the volatility in other asset classes and the general economic disruption we are seeing. We expect a loss of liquidity, leaving the market less transparent.
Retail could bear the brunt of the fall out
Certain sectors in real estate are more vulnerable than others. Retail, particularly in markets heavily exposed to tourism, will be hurt. Footfall is down in locations such as London, partly due to poor weather but also because tourist numbers have fallen. Luxury brand Burberry, which is heavily exposed to the Far East, has stated that the virus has already had a bigger effect on trading than the Hong Kong protests. For real estate investors this raises concerns that store-based profitability will be affected and it will prompt more sales to move online.
The hotel sector is similarly exposed. Airlines have already cut capacity by around 25 per cent indicating we could see significant falls in hotel occupancy. Investors with exposure to hybrid hotel leases, which provide for a base rent plus a performance-based top up, could be left disappointed.
The leisure sector across Europe is facing a drop in demand. France and Italy have cancelled major events, and there is anecdotal evidence that restaurants and cinemas are seeing falls in demand.
Build in resilience to portfolios
As real estate asset managers we are reviewing our portfolios continually to identify any tenants that may be impacted from the fallout of coronavirus or may not be able to manage in an economic downturn scenario over an extended period of time. In preparation for such as scenario, we can put alternative provisions in place to support tenants while also protecting the value of properties. However, the news cycle and the policy responses are highly fluid complicating the task.
We believe that work already done on portfolios prior to the outbreak of coronavirus should position us well. Picking a diversified and high quality tenant base helps reduce the risk of rental defaults and enables cash flows to be high and stable. Investments in liquid sectors with deep pools of demand builds in portfolio resilience and low leverage with high debt coverage ratios reduces risk. The majority of portfolios are also invested in income generating assets which means little exposure to capital risk.
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