The property industry faces a ‘U’ shaped recession, which will lead to investors reshaping portfolios with liquidity in mind.
In early April, the PMI indices from IHS Markit were released for most leading economies, and they were alarming. The index convention is that a reading of under 50.0 indicates an economic contraction, and the composite UK index read at 36.0 for March 2020, the Eurozone at 29.7, and Italy at 20.2. Lockdowns to slow the spread of Covid-19 have choked off business activity, and much of the world is probably now in recession.
The UK government has indicated some degree of social distancing measures may last through the summer, a step that other nations will also have to consider. This could mean either a prolonged recession, or a slow return to growth.
Investors have not only fled from equities, but also the traditional safe haven of government bonds; so, cash is king. For real estate, the warning lights indicating a market downturn are flashing. Funds are gating, tenants are asking for rent holidays, while pricing property is guesswork. Some deals are still going through, although these transactions were probably at an advanced stage prior to the lockdowns.
So, what is the outlook?
V, U or L?
The question high on minds is whether the shape of the recession will be a ‘V’ (short and sharp), ‘U’ (sharply down, flat for a while, then recovery), or ‘L’ (a hard fall, then stagnation). In the SARS outbreak of 2003, Hong Kong saw 22% of the cases, and its economy experienced a ‘V’ shaped contraction. Yet, the Covid-19 pandemic has long since overshadowed SARS in both number of cases and global spread, leaving a ‘V’ shaped recession looking unlikely now.
The Spanish flu outbreak of 1918-19 was accompanied by a deep ‘L’ shaped recession. However, that pandemic coincided with the economic dislocation following World War One, as industries adjusted from wartime to peacetime production. Moreover, the stimulus packages announced by governments in 2020 in response to Covid-19, and central bank largesse, should help kickstart major economies once the lockdowns lift.
In March 2020, the UK government announced a £330 billion loan scheme to support businesses, and guaranteed 80% of the pay of furloughed employees. The Bank of England slashed the UK base rate to an historic low of 0.1%. Meanwhile, the US Congress has voted in favour of a $2 trillion support package for the American economy.
Consequently, the ‘U’ shaped recession feels the most likely outcome. A combination of the gradual lifting of restrictions, the release of pent-up demand from consumers, and the impact of stimulus measures, will eventually initiate an upswing further down the line.
What will this mean for real estate?
Aftershocks
For property, opportunist investors will be looking to catch the middle section of the ‘U’, in order to be negotiating while the seller is still feeling the aftershocks of the lockdown. Every recession has been accompanied by a significant fall in property prices. With alarming figures circulating – such as some retail landlords receiving less than 30% of the rent due on the March quarter day – it is hard to imagine there will not be distressed sales this time around.
Moreover, there will inevitably be a period when a lack of recent transactions leaves sellers guessing at what bids for assets to consider ‘reasonable’. In this context, someone will panic and sell too cheap. While that exceptional fire sale deal may not be generally accepted as the new pricing benchmark, it will be widely reported. This will psychologically prepare other sellers to accept offers that are below February 2020 levels. Thus, the market reprices, and consequently reopens.
Opportunities
Turning to where the opportunities will emerge, for those looking to exploit the distress, shopping centres are the logical starting point. This market was embattled even before the virus. I would suggest focussing on assets that have potential for change of use.
One should be careful though not to tar all retail assets with the brush of distress. If anything, supermarkets might emerge from the outbreak as being viewed as ‘national infrastructure’, becoming even more sought after by investors seeking safe assets.
Similarly, the crisis has hauled warehouses to the centre stage as essential infrastructure for the economy. Following the battle to obtain personal protective equipment for healthcare providers, and shortages of generic drugs, I see more nations encouraging reshoring of manufacturing of such items, buoying demand for industrial units. This could draw the attention of investors towards logistics and industrial assets.
Leisure and hotels are markets that will see distress, as a lean summer stretches ahead for hospitality firms. Investors may be more willing to take a long-term view on such assets, as tenants have run into a once-in-a-lifetime crisis that will eventually blow over. This could moderate price falls, particularly where tenants were trading well prior to the pandemic.
Offices
One sector that is tipped by some for negative consequences as a result of the lockdowns is offices, but I personally have my doubts. The argument goes that with so many people working from home, firms may decide they will need less office space in the future by encouraging more flexible working.
While there will be short-term distress for the office market, including requirements being placed on hold, sub-letting of space, and lower rents, I doubt the sector faces a structural demand shift towards home working. Offices encourage team spirit, generate creativity via human interaction, and instil corporate culture into workers. They are the forum for a raft of useful communication, from the overheard conversation to the chance encounter in the lift or kitchen. Plus, the majority of humans are social creatures, who most of the time want to interact with others.
The experience of working from home is already highlighting these benefits to senior executives in firms. There is also the sense of ‘cabin fever’ that is rising among homeworkers to consider. I suspect by the time the lockdown ends, many will be pleased to escape from home, and return to the office.
Moreover, the aftermath of the pandemic will draw investors’ attention to the relatively high level of liquidity offered by prime offices in major cities. In dark times, you will still find a buyer for the offices of a tech titan based in a downtown location in London, New York, Paris, San Francisco, etc.
Going forwards, I see more investors reshaping portfolios with liquidity in mind, which will favour offices, supermarkets, and warehouses.
James Roberts has been an economist and research analyst for 25 years. He currently runs a research consultancy, Independent Property Analysis, having previously worked as Chief Economist at Knight Frank.
