The COVID-19 epidemic has upended the global economy, resulting in multiple direct and indirect implications for the real estate market. No real estate segment is likely to be unaffected by the sharp fall in global commerce, but the impact will vary considerably between sectors and locations.
Dermot Finnegan, Global Head of Real Estate Fund Administration, BNY Mellon and Neal Armstrong, Director of Real Estate, BNY Mellon and a NCREIF Board Member, examine the impact of COVID-19 on the real estate sector and what the global policy response has been so far.
The scale and pace of change felt particularly dramatic given the comparative buoyancy of much of the world pre-COVID-19. Stock markets in many countries were close to their peaks just before COVID-19 went global, economic growth was steady if not spectacular, with high employment and strong job growth; corporate and industrial loan defaults were low. With hindsight, one important metric was the increase in corporate leverage, which may have a bearing on bankruptcies in the months to come.
Q1 real estate valuations largely reflect the pre-COVID-19 world. Most Q1 appraisals are based on data through to mid-February and reflect only limited or no change in value post-COVID-19. Some property sub-indices, such as industrial and office showed a slight increase on Q4 values; others, such as retail (-3.22%) and hotels (-4.75%) were sharply lower, according to NCREIF1. It may be necessary for advisors and appraisers to consider re-opening appraisals/valuations based on COVID-19’s impact on values. The NCREIF Valuation Committee Bulletin points out that one potential challenge to this could be gaining access for property inspections and appraisals given social distancing, though this requirement could be waived2.
The Impact of COVID-19
The severity and length of reduced economic activity resulting from the epidemic remain unknown, making reporting of fair value for properties challenging. Nevertheless, it is possible to anticipate some potential consequences: REITs fell by around 20% between February and March, with significant variation by segment. By March 20, European industrial REITs were priced at an average discount to NAV of around 10% compared to almost 25% for retail REITs3.
Some segments such as hotels and non-grocery large retail will be heavily impacted by the economic shutdown in March and April as their near-term income has dried up. KPMG anticipates that hospitality occupancy levels will be below 30% in the near future, potentially jeopardising some hotels’ viability4 . Similarly, KPMG estimates that office vacancies may rise by more than 20% in 2020 with a further additional increase in vacancies in 2021 before they then start declining. In the student housing sector, many colleges and universities have moved online; given uncertainty about when face-to-face learning will resume, pre-leasing activity has come to a halt, according to KPMG5.
Some other segments may see limited impacts or even benefit from structural changes in the economy post-COVID-19. For example, logistics has performed strongly over the last five years (including a Q1 return of 2.58% 6) and Aviva Investors believes that a larger percentage of the population could become dependent on e-commerce during the period of enforced social isolation, boosting demand for warehousing and distribution space7. Nevertheless, vacancies within the industrial segment are expected to rise in 2020 and could potentially also increase in 2021, with asking and effective rents expected to decline throughout 2021. Revenue (rather than discount rates) will likely drive valuations in Q2 and will reflect various rent relief and deferral measures undertaken by landlords and changes in rent collection rates. 85% of real estate investment managers invested in retail responding to a NAREIM survey in the US in March indicated that they had received rent requests from their tenants; two-thirds of managers are providing two to three months of relief8.
Covenant strength, the quality of occupiers’ balance sheets and therefore landlord’s ability to continue to collect rents will be critical to value. However, there is also a perceived pressure in the industry that a valuation adjustment will be necessary, and participants are watching closely to see how their peers react. In the medium term, key issues include potential covenant breaches if valuation ratios are not maintained or if rent collections fall considerably. If it is impossible to collect rent then there will be no cash for debt service payments and therefore the prospect of default will increase. Additionally, the funding of investments, partnership agreement obligations and clawback on fees and promotes may require scrutiny in the future as a result of the changing market.
Liquidity will be a critical issue. Redemption queues are growing, and some funds have been gated. Although it is too early to show up in statistics, anecdotal evidence suggests that deal creation has effectively ceased while debt facilities are being mobilised to bolster funds. While public asset markets have stabilised following the extreme volatility of March and April, the impact on real estate will undoubtedly get worse in the short term as the damage to the real economy becomes more visible.
The Government Response
Governments around the world have put in place an unprecedented range of support mechanisms to prevent economic collapse, widespread bankruptcies and soaring unemployment. Some of these measures have implications for the real estate sector. The following (from JLL)9 are a selection:
- US: At least 34 states have temporarily prohibited evictions; the Federal Government has issued a 120-day moratorium on evictions from federally-subsidised housing or a property with a federally-backed mortgage loan. Some US states have halted construction on projects unless essential (i.e. medical facilities).
- Europe: Several countries, including the UK, Germany and France, have suspended evictions. In various locations across Europe, commercial and residential tenants have been offered mortgage and rent holidays. Some countries, such as France and Italy, have suspended construction.
- Asia: Some countries, such as Singapore, are considering legislation that would protect commercial tenants which cannot pay rent for a period of six months.
As well as measures to protect tenants, a number of governments have implemented policies that could mitigate damage for institutional real estate tenants and landlords. The following are a selection:
- UK: A business rates holiday for eligible businesses for the 2020-2021 tax year, with 100% relief for the hospitality and leisure sectors; Retail and hospitality grant scheme of one-off payments; VAT deferral; case-by-case corporation and other tax deferral10. Bank rate has been reduced by 65 basis points to 0.1% on March 11th and 19th11.
- EU: France: Solidarity Fund, state aid for SMEs that does not need to be repaid. Spain: Deferral of tax payments12. Germany: Grants to small business owners and interest-free tax deferrals until year-end. Through the newly created economic stabilisation fund and the public development bank KfW, the government is expanding the volume and access to public loan guarantees for firms of different sizes, some eligible for up to 100% guarantees.
- US: The Paycheck Protection Program includes forgivable Small Business Administration loans and guarantees to help small businesses that retain workers; The Coronavirus Aid, Relief and Economy Security Act includes funds to prevent corporate bankruptcy by providing loans and guarantees. The Federal funds rate was lowered by 150 basis points in March13.
The length and depth of the economic downturn associated with COVID-19 is still unknown. In countries where economic activity has resumed, most notably China and South Korea, there are encouraging indications that while life has not returned to normal, business activity is recovering. In China, for instance, 87% of hotels in China have now reopened, although most are reporting low occupancy rates (below 30%). Interest in commercial real estate has also returned in China, with investors choosing to focus on long-term opportunities14.
Obviously, Europe and the US are some way behind China in recovering from COVID-19. Moreover, the lifting of lockdowns and other restrictive measures will necessarily be different in different countries. Activity in Q1 slowed significantly and Q2 figures are certain to be worse. But action by governments and central banks around the world has been both swift and impressive in terms of scale. The hope is that as the real economy recovers, continuing strong investor interest in real estate and newly emerging opportunities will result in 2019 and 2020 fund vintages to rival some of the best in recent memory.