The Covid-19 pandemic is expected to result in a further widening of the spread between prime and secondary assets, much as has been seen in the equity and fixed income markets. This may initially result in relatively indiscriminate re-pricing of assets in line with traditional definitions of prime, i.e. focused on location and building quality.
This flight to perceived quality could drive prime yields even lower, reflecting the greater liquidity of prime assets in a period of low transaction volumes. However, at such low yields, these assets will need to generate significant income growth in the medium term to deliver outperformance, and the potential for mispricing of this risk increases markedly. Even a small shift in sentiment or a small increase in yields could harm capital growth for such ‘old prime’ assets. In a low growth market, it will be difficult to offset these effects with rental growth.
It will equally be important to ensure that there is appropriate differentiation of risk, especially when it comes to policy. During the Covid-19 pandemic, European governments have displayed varying abilities to deploy ’whatever it takes’ measures to get through this period of economic upheaval. There has also been a differing response in the willingness of governments to uphold the legal relationship between landlord and tenants, which could have significant long-term implications for those markets.
The German government, for example, has been clear on the importance of upholding lease contracts, while the French and UK governments have been far less supportive of landlords in favour of tenants. This suggests that German real estate will continue to be seen as a safe haven for investors as income has been better protected.
Finally, traditionally-defined prime buildings tend to command the highest rents. This provides another area of vulnerability/risk to cashflow in the current downturn. In periods of recession or weak economic growth, tenants become more cost sensitive, opting for cheaper, more affordable space, or find themselves able to drive down rents on their current space, thus reducing cashflow for the asset. Investors may therefore unwittingly be exposing themselves to more risk by “going defensive” and focusing on a narrowly defined concept of ‘prime’ based on the quality and location of an asset.
Managing cashflows in the age of Covid-19
The non-payment of rents as a result of Covid-19 disruption has challenged a fundamental attraction of real estate as an asset that provides a stable, long-term income. In the UK, second-quarter rents became payable a week after lockdown and data revealed that overall collection rates had only reached 70 per cent (vs. 99 per cent normally) a month after payment was due, and varied significantly between sectors.
In the retail sector, collection rates were only 55 per cent four weeks after the end of the quarter. Many discretionary retailers and leisure operators are highly dependent on store networks for their interactions with consumers, and so were hardest hit by the lockdown and opted to withhold rent payments in order to survive. In contrast, 81 per cent of office occupiers and 72 per cent of industrial/logistics occupiers had paid their rent at the same point.
The slightly lower level of payment for the industrial/logistics sector is a good example of the importance of understanding a tenant’s business and how it can impact their ability to pay the rent: some industrial/logistics occupiers which work with manufacturers saw significant disruption both from lockdown and damaged supply chains. Others, particularly those focused on consumer staples or e-commerce, performed well.
Valuations must be more responsive
Traditional real estate metrics measuring market characteristics and asset/fund level performance have been slow to signal structural changes in the marketplace (see Chart 3). Too many measures are backward looking and valuation processes lag market movements, in part due to the nature of legacy lease obligations. This lag creates opportunities for investors who can identify and navigate these disruptive changes in the market.
 Remit Consulting, May 2020