Covid-19: short-term pain, long-term opportunities for European commercial real estate

According to our base macroeconomic scenario of a strong recession followed by a slow recovery from end 2020/early 2021, the demand for offices could be impacted adversely, at least until visibility and confidence improve. Since the level of the Eurozone GDP in 2021 could stay below its level of 2019, the employment rate will suffer, and office rental demand could be dampened – even if uncertainty remains high at this stage.

On this basis, we believe that the pre-outbreak situation in the office leasing market could smooth the effects of the crisis, even if there are divergences between real estate segments, sectors and locations. Data on unemployment and employment intentions will have to be monitored closely as they are key drivers of office space demand. Another key factor is the financial situation of tenants, i.e., their ability or not to keep on paying the previous level of rents.

The pandemic has hit two segments of the leasing market most harshly due to the lockdown measures: hospitality and retail. The hotel sector was hit the hardest, as the travel industry has been almost completely shut down. The prospects for the rental income of shopping centres are weak in the short term, except for supermarkets and discounters, where cashflows have stayed positive so far. Lockdown measures have weakened discretionary private spending, with the luxury segment under heavy pressure.

Now that lockdown measures have been lifted, the uncertainty over the speed of the economic recovery is hinging on consumer sentiment and behaviour, as well as some fears around crowded spaces such as shopping centres and hotels.

This crisis comes on top of an already challenging situation for the retail market. Many international retailers have been focusing on prime cities and areas, following a broad consensus towards multichannel strategies, with a mix of online and brick-and-mortar channels. In the end, the current crisis could downgrade the financial situation of many retailers and push rents downward, depending on the strength and speed of the economic recovery. We believe that the recovery for those sectors will be gradual and that it will take time.

Due to the weak economic environment, investors and lenders are expected to adopt risk-averse behaviour in the short term, favouring assets with high-quality tenants and locations, as well as focusing on liquidity issues, especially in a market with high capital values. Financing should be more difficult to obtain – or at a higher cost – in particular for retail assets or speculative schemes.

Given the current uncertainty, many investors have adopted a ‘wait-and-see’ approach and are exhibiting risk-averse behaviour. This applies to the quality of tenants, the quality of properties (e.g., core, core plus, value-added) and the quality of  locations. We believe that investors should remain cautious in their asset selection for the foreseeable future, and in particular for hotel and retail properties, even if they might consider some opportunities when they arise.

This situation may cause a repricing of some assets, especially the weakest ones. Consequently, we could witness a widening of the yield spreads between the different types of real estate assets, segments, sectors or locations (e.g., between big cities), whereas the past years have seen a convergence of those yields. We could also see more divergence in yields as a function of lease duration and the quality of tenants. For now, the visibility on such a scenario remains low. The upcoming transactions will have to be watched carefully and a repricing before year-end is likely. Assets linked to demographic trends such as residential, healthcare and senior housing could be relatively good performers in the context of the economic fallout of Covid-19.

For residential more specifically, the expected population growth rate in some major cities should be a driver of demand, both for leasing and buying. Therefore, some investment opportunities could emerge from the lack of residential supply observed in some big cities and also highlight that real estate investment and development might be the answer to some societal issues and needs. However, as the European residential market shows significant discrepancies between cities, and there has been a strong price surge in recent years, asset selection is key.

The Covid-19 pandemic has been shaping market trends and investor behaviour in different ways:

• Falling fundraising: the amount of capital raised by real estate funds dropped quickly over the first quarter of 2020, reverting a previously positive trend. This affected all regions, though with varying magnitude and speed. There may also be seasonal factors at work, as fundraising tends to slow down in the first quarter and recover in the second and third quarters, together with increased market competition. A large number of institutional investors are cutting the size of their commitment to real estate or redirecting their capital towards large and established fund managers, leading to a higher concentration among the largest funds of recognised brands with strong track records.

• Fewer funds closing and higher average fund sizes: the number of funds closing has dropped quickly, while the average fund size has grown at a single-digit rate. In Europe, it is more difficult to close a fund than in other regions and in the average fund size looks limited, up 3% on average against a 16% rise reported globally.
• Rising number of funds: in Europe, the number of private real estate funds in the market has spiked, with competition to attract capital at a high level. High investor demand and appealing fees are all good reasons for newcomers to enter this market. However, some of these funds may struggle to survive in a consolidating market, where the key elements for success are brand recognition, the size of both the asset manager and the fund, a proven track record, a fair fee structure and the implementation of ESG principles. The number of funds in the market and the aggregate targeted capital have grown over the past three years, both in Europe and globally. As of April 2020, there were 207 funds in Europe for an aggregate target size of €82 billion, while globally there were 901 funds for an overall target size of $269 billion. This demonstrates the strong appetite for the asset class, with high competition for deals, and suggests that investors see Covid-19 as only a short-term hurdle to their real estate commitment.
• Reduction in the number and size of deals: the ongoing pandemic and the high competition for top-quality assets are affecting the number of deals and their aggregated value, with both showing a steep drop over the first quarter of 2020. In the short term, most deals at an advanced stage should go ahead, but a reduction in the number of new deals is expected, as many fund managers are adopting a ‘wait-and-see’ approach. This will impact all regions and sectors, though at varying levels. As the economy recovers, real estate deal activity is expected to rebound sharply.

Key investor trends²

In an uncertain economic and political environment where the  coronavirus fallout  is proving deeper and longer than initially anticipated, with interest rates set to stay low for a long period of time and more than $12 trillion of negative-yielding bonds globally, we believe real estate will remain appealing to investors. This asset class offers relatively stable and predictable income cashflows, high diversification thanks to its low correlation with traditional asset classes, and is a proven hedge against a possible acceleration of inflation trends in the long run. According to a recent survey from Preqin, real estate investors are currently worried about:

• High pre-crisis valuations and the upcoming repricing;
• High competition for the limited number of high-quality assets in safe countries; and
• The impact of the current economic environment on institutional portfolios.

As equities have fallen across all markets, their share within investor portfolios has declined dramatically. This denominator effect, together with bond yields trending downwards and significant losses among emerging markets assets, is making private markets look more attractive than ever. Before the current crisis, the 2020 European investor outlook for private real estate was bright for several reasons:

• Most investors were generally satisfied with the performance, which usually met their expectations;
• A positive allocation gap of 1.6% in Europe (i.e., the difference between target and current investor allocation to real estate); and
• About 20% of those investors planned to re-invest in European real estate over the next 12 months.

The Covid-19 crisis has changed this investor outlook, which now appears more conservative in the short run, while longer-term prospects look unchanged so far. Investors are decreasing slightly or keeping unchanged their allocation plans to European real estate in the short term, but remain confident and have appetite for the asset class in the longer term. According to Preqin, investors plan to limit their investments to one single fund in the short term, but with a bigger size of commitment, rising from an average of $50 million to almost $300 million. Due to the current high level of uncertainty, they prefer large funds from recognised brands. Most investors appreciate European strategies with a low risk-return profile, as they look for ways to offset volatile market conditions. The most active investors on European real estate strategies are traditionally pension funds, foundations and insurance companies. However, over the past few years, demand from family offices and wealth managers has been picking up. Most inflows in that space are coming from Europe-based investors.

With respect to strategies, European investors favour core real estate, followed by core plus and value-added, while US-based investors tend to invest in Europe in opportunistic and value-added strategies, which both offer higher expected returns but present more risks.

2. Data throughout this section refer to the Preqin survey based on a sample of about 3,400 investors worldwide investing primarily in European real estate (Preqin Pro sample, data as of 4 May 2020).

Definitions

• Basis points: One basis point is a unit of measure equal to one one-hundredth of one percentage point (0.01%).
• Closed-end fund: In these funds, there is no internal mechanism for investors to redeem their subscriptions. Investors’ subscriptions are tied up for the lifetime of the fund unless investors can find a buyer for their shares on the secondary market.
• ‘Core plus’ real estate investment strategy: ‘Core plus’ is synonymous with ‘growth and income’ in the stock market and is associated with a low to moderate risk profile. Core plus property owners typically have the ability to increase cash flows through light property improvements, management efficiencies or by increasing the quality of tenants. Similar to core properties, these properties tend to be of high quality and well occupied.
• Core real estate investment strategy: ‘Core’ is synonymous with ‘income’ in the stock market. Core property investors are conservative investors looking to generate stable income with very low risk. Core properties require very little hand-holding by their owners and are typically acquired and held as an alternative to bonds.
• Correlation: The degree of association between two or more variables; in finance, it is the degree to which assets or asset class prices have moved in relation to each other. Correlation is expressed by a correlation coefficient that ranges from -1 (always move in the opposite direction) through 0 (absolutely independent) to 1 (always move in the same direction).
• Dry powder: This refers to cash reserves kept on hand by a company, venture capital firm or individual to cover future obligations, purchase assets or make acquisitions. Securities considered dry powder could be Treasuries or other short-term fixed income investments that can be liquidated at short notice in order to provide emergency funding or allow an investor to purchase assets.
• EU-15: Germany, Belgium, France, Italy, Luxembourg, the Netherlands, Denmark, Ireland, the United Kingdom, Greece, Spain, Portugal, Austria, Finland and Sweden.
• Office vacancy rate: Share of unoccupied office space immediately available relative to all existing office space.
• Open-ended funds: In these funds, investors have the choice of whether to partially or completely redeem their subscription on each redemption day, subject to the redemption terms specified in the fund’s offering document.
• Opportunistic real estate investment strategy: Opportunistic is the riskiest of all real estate investment strategies. It is synonymous with ‘growth’ in the stock market. Opportunistic investors take on the most complicated projects and may not see a return on their investment for three or more years. Opportunistic properties often have little to no cash flow at acquisition but have the potential to produce a large amount of cash flow once the value has been added.
• Prime rent: Rent of the most sought-after assets relative to available supply. This is the highest rent for a given asset class and geographical area.
• Prime yield: Yield provided by leasing under the market conditions of the assets – sometimes few in number – most sought-after by investors relative to available supply. This was the lowest yield for a given asset class and geographic area.
• Take-up: Spaces leased or acquired for own use. It does not include lease renewals.
• Value-added real estate investment strategy: ‘Value-added’ is synonymous with ‘growth’ in the stock market and is associated with moderate to high risk. Value-added properties often have little to no cash flow at acquisition but have the potential to produce a large cash flow once the value has been added.