Real assets

Curlow's Convictions: COVID-19 update

  • Uncertainty and volatility continue to reign, but data anecdotes begin to emerge: Following on from our initial piece on the topic (read here) we now have an updated Global CRE Outlook Deck available on request which provides some more detailed commentary on the expected COVID-19 impact on economies and more specifically the underlying property markets and rent collections. Divergence in performance by property segment continue to emerge with the PRS/multi-family and logistics/industrial segments most insulated whilst the hotel and retail markets are at the epicentre as revenues dry up. As we continue to digest and monitor the new market reality, it is now time to consider in more detail the investment implications as more evidence of the performance of the underlying fundamentals starts to emerge. 
  • Prime vs Secondary prospects diverge: It is human nature that during periods of heightened uncertainty and downside risks that we revert to safety. In property that means prime income generating assets. We are expecting the property yield convergence and risk creep witnessed over the past 18 months to disappear as property investors retrench to the familiarity of prime, stable, core assets. Supported by strong underlying property fundamentals and the large amounts of dry powder entering this pandemic, we believe the prime end of the market is likely to see limited levels of disruption and be the first to re-emerge with liquidity and transactional activity. That said, investors’ definition of what constitutes prime assets may very well narrow – and rightfully so as it was becoming a bit loose over the past few years. 
  • Listed vs Private valuations: Listed real estate pricing is currently implying an average of c5-35% decline (varying by sector) in direct property market pricing. This level of adjustment implies a protracted and lengthy recessionary period along with reduced rent collection and some technicals. Bearing in mind that the listed market tends to overshoot/exaggerate during both corrections and peaks, private market valuation adjustments may well be more modest. Changing investment underwriting rental inputs to reflect flat headline rents rather than the above-inflation rental growth previously assumed could lead to a decline in property values before considering any change in risk premium and yields. We will need to continue to monitor just how severe and long the economic disruption continues in order to know if this is enough or if the fallout is more severe. This is the issue valuers are currently grappling with as ultimately it is a known unknown. The reported rent collection rates coming from listed REITs provides some key insight as to the cash-flow disruptions being felt.
  • Debt market pricing critical to where equity lands: Given the capital-intensive nature of real estate investment it is critical to assess and monitor the functioning of the debt capital markets in order to anticipate where the equity markets are heading. Now most new bank lending activity is on hold although previously committed deals are completing – albeit with some margin flex where possible. While the cost of capital for banks is up by about 50-100bps, it remains to be seen to what extent this will be passed onto real estate borrowers as new transactional evidence on both the debt and equity side remains limited.
  • Prudent leverage use vs Financially engineered performance: The use of leverage to juice property level performance was becoming more prevalent as the cycle continued to extend, and lower property yields the income component as a proportion of overall total return prospects. However, now that the economy and property markets are likely to experience a correction those with financially geared performance may be in a more difficult position in terms of covenant breaches while those entering this correction with prudent leverage levels should continue to control their own destiny by focusing their time and effort on active asset management and tenant focused – rather than lender – engagement. The time may soon come to see who was swimming without their trunks so to speak.
  • Time to think about investment opportunities: The current economic stoppage is clearly beginning to impact some rental collections from tenants in the epicentre of the halt in demand, but the wider property markets have entered this downturn without the excess supply and widespread high levels of leverage seen in more severe property downturns. As such, we expect limited levels of ultimate distress as both government and banking sector approaches to the pandemic have been highly prudent and understanding. That said the investment market will be digesting the underlying impacts as travel restrictions and containment/isolation put a lid on transaction volumes and price discovery as the bid-ask spread widens. We think the time is right to be building an investment shopping list as there should be attractive investment opportunities arising for well-capitalised investors and managers with a solid market reputation, unlocking the first transactions that reset market liquidity and price discovery.

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All data sourced by AXA IM - Real Assets as at April 2020.

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