A CONKERS3 FEATURE : The Analytical Surveyor

Analytical Surveyor has worked for over 40 years in the City and West End of London as a real estate investment manager, an equity analyst, a multi-manager, a fund manager and as a researcher and strategist. In his area of expertise, he is highly regarded and currently works as a consultant.

The quoted equity markets have responded very clearly to the economic threat of the coronavirus, albeit there was some volatility. As I write – at the beginning of the week commencing  2nd March, the markets took some comfort from the main central banks’ (BoJ, ECB, and Bank of England)[1] modest declarations that they would be providing support to the economy or financial markets if required, while the Federal Reserve followed the PBoC in cutting interest rates[2].  Such declarations are, however, tainted by the general limits on the central banks to lower interest rates significantly or, in the case of the ECB, at all.  Quantitative easing (QE) is about the only tool left, although that has already been worked hard, and it too is coming up against natural limits, particularly in Japan.  Moreover, QE was a reasonably effective tool in the financially-induced asset recession of 2008/9, but it is not at all clear that it will have much effect on a virus-induced recession, where different drivers exist.

Not surprisingly, there has been a general ‘flight to safety’ and to a much less extent a ‘flight to quality’ amongst investors.  The biggest beneficiary of the former has been the government bonds, the yields of which are at or around record lows.  While virtually all investors know that these yields are unsustainable in the long term, many investors’ priority is securing their capital rather than optimising returns.

We should be expecting the pricing of real estate to reflect, at least to some extent, what is happening in the quoted markets.  It might be tempting to believe that the lower bond yields are a positive signal for real estate, but that would be a mistake, for two reasons.  First, the yield gap between government bonds has been rising for some time.  Contrary to some commentators’ views, that is a negative signal, indicating that the risk for real estate is also rising, if not in absolute terms then in relative terms.  Second, there are growing concerns about corporate bond defaults, particularly the lower-rated ones, in the light of the virus, and this does not portend well for real estate yields (which, given the global slowing of rental growth, are now more corporate bond-like).

So far, the main impact on the economy can be attributed to the precautions being taken to prevent the spread of the virus.  The justification for this is that, in most countries where infections have occurred, the rate of the disease’s progress has been linear.  This is very much in accordance with the model predictions[3].  If contact tracing is successful, it is very possible that the growth rate continues to be linear.  The risk is that it becomes exponential, at which point, contact tracing becomes almost impossible.  This has probably already happened in Wuhan, Northern Italy, S Korea, and Iran.  It was starting to happen in China generally but, by aggressive management, there are now signs that the growth rate may have reverted to linear (outside the Wuhan province).  Western-world countries have undoubtedly taken notice of that.

It is (always) difficult to predict what will happen next, but the fact that aggressive defensive measures are being taken in all European countries suggests that the risk of a full-fledged epidemic is considered to be high and possibly inevitable.  Interpreting the UK government’s statements, that seems to be its view.  Putting some approximate numbers on it, we should expect the next three months to be ones of a growing number, latterly exponential, of infections.  The following three months will then be of stabilisation and subsequent decline and, I would argue, we will then need, say, three months before we are back to a more normal situation.

Even the increasing public health/hygiene measures will have a significant impact of economic activity and are likely, in themselves, to move some countries into recession.  But the epidemic scenario will almost certainly cause severe recessions.  The East Asian Institute estimates that China’s GDP, for instance, could fall by 6.3% in the first quarter and, China is about one quarter ahead of Europe (as a whole).

After Italy, the two most risky countries in terms of numbers of population contaminated are Germany and France.  These are also, by coincidence, the two largest economies in Europe which were most at risk of recession before the outbreak of the virus.  On both measures, the UK comes some way behind, while Spain is catching up with France and Germany.

In the western world, the Eurozone countries were already at risk from what might have been mild or ‘technical’ recessions, and the virus may therefore accelerate and turn these into full-fledged recessions.  As many commentators have observed in recent years, businesses and governments are ill-prepared for a recession, with levels of debt being far higher than before the 2008/9 recession.  Businesses may currently have less trouble servicing that debt because interest rates are so low, but that does not make the capital any easier to repay and earnings are still required to meet the ongoing payments.

The nature of this possible recession – people avoiding social contact through meetings, shopping, and work – would be particularly adverse for real estate.  The economic value – as opposed to the financial value – of real estate will decline and it will become much less important for businesses to retain it for operational purposes as costs come under pressure.  It is, therefore, highly likely that all commercial European real estate markets will deteriorate this year, led by Italy and then, the other Eurozone countries.  There will be tenant failures, requests for rent reduction and vacation of leased premises.  The last of these effects is really the most serious and effectively means that a proportion of properties will become obsolete.  Hotels, retail, and leisure facilities may be most at risk initially, but the economic malaise will spread to offices and distribution space. In this context, obsolete may be taken to imply that, when markets do recover, these particular properties will attract little or no tenant demand and will, therefore, not participate in the subsequent recovery.

In terms of real estate yields, these are currently at low levels compared to their historic averages and are therefore not priced for a down-turn in fundamentals.  But yields move in advance of rental values, partly because they reflect a more liquid/transparent market (investment as opposed to leases) and partly because investments are not a factor of production and therefore not an essential holding.  It is very possible that distribution and offices may be worst affected, as in many markets these sectors are ‘priced for perfection’, while retail may be affected to a lesser extent, although the de-pricing of the market is still underway from a previous state of inertia.  At least that repricing was happening in the UK, but the rest of Europe is a couple of years behind in that process.

Like all recessions or downturns, the effect on real estate will dissipate as the economies recover.  And this is where we can be relatively optimistic.  Unless central banks and governments are unable to stop the virus-induced recession morphing into something more serious, there should be a significant economic rebound when the virus is finally brought under control or it ‘burns itself out’ (as all epidemics eventually do).  The human cost of this may be high, but the time for this to happen will be relatively short in an investment context.  The cost – putting it in cold hard terms – will largely not be of the working or younger population, but of the elderly.  There will be pent-up demand to replenish consumer and business stocks and for life to return to normal.  For those in real estate able to ride out the virus, this will come as a welcome relief.

But there will be two lasting effects for real estate.  First, obsolete property will remain just that, and will either need substantial capital expenditure or redevelopment.  Second, what we learn from previous recessions is that in at least some aspect, peoples’ attitudes change[1].  This time, the largest change may well be the increased take-up of technology.  Although online shopping is becoming increasingly popular, it is still a minority of retail in all countries.  As consumers switch to it as a means of avoiding social contact, they may be reluctant to switch back afterwards.  They will recognise the advantages of home delivery at cheap prices.

Similarly, with offices, we may finally see a proper take-up of video conferencing, working from home, and more efficient operating systems (with a greater use of AI technology).  In effect, this will accelerate the adoption of ‘hot desking’.  This means a lesser demand for office space.

There will still be a need for offices and other facilities, but increasingly, these will be for high added-values users.  These users will require the best in terms of facilities.  In other words, value will increasingly concentrate in the best buildings in the best locations.

In terms of the UK listed market, this means that a substantial part of the assets in their portfolios will not recover to their previous values.  To some extent, that will merely be an acceleration of the process that has been underway for the last few years, but hidden by the positive economic environment.  As a consequence, gearing will rise, putting pressure on the banking covenants, as we have seen with Intu.  Generally, and fortunately, gearing levels are modest in the sector, but some stocks may feel some pain from this.  The high dividend yields of Land Securities and British Land will be difficult to sustain, even with the discounts to NAVs imbedded in their prices, because they will need to give concessions to some of their tenants, particularly their retail tenants, to avoid defaults.  Derwent London and Great Portland Estates, operating in niche parts of the market (London offices mainly) may prove more resilient.  But the smaller stocks and those which are more specialist, such as in hospitality and (even) student housing will suffer in the medium term.  Having said all of that, there are likely to be buying opportunities in the next few months when the markets become really scared, but I would caution against expecting real estate stocks to generally have recovered – in say a year’s time – to where they were at the beginning of 2020.

[1] Even a representative of the World Health Organisation extolled the markets not to panic, although whether the WHO is competent to comment on markets is open to question.

[2] There was a strange reaction to this in the US: ‘Does it know something about the state of the economy that we do not know?’.  Clearly, the markets understanding of what is happening is lagging badly.

[3] https://en.wikipedia.org/wiki/Compartmental_models_in_epidemiology#The_SIR_model

[4] I will just quote a couple of examples.  The early 1990s recession moved consumers in the UK into a mind-set where they were far more price-sensitive than they had been in previous decades; that signalled the start of the downturn for retailing, which was then reinforced by the availability of online sales.  The 2008/9 recession was attributed to bank risk-taking; subsequently the banking industry was severely curtailed and, for instance, mortgages and loans became more difficult to obtain.

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