Each year the Oxford English Dictionary chooses a word/phrase of the year which has emerged into the public consciousness and common usage. Last year it was “Goblin mode”. The formal definition is “a type of behaviour which is unapologetically self-indulgent, lazy, slovenly, or greedy, typically in a way that rejects social norms or expectations.” The phrase gained traction due to 1) the common experience people had of emerging from the pandemic and their changed behavioural (and sartorial) norms, and 2) a reactionary movement against the alleged perfect lives posted on social media. That said it also resonated powerfully with anyone who has teenage children…

There isn’t a separate category for word/phrase of the year for real estate, but if there was, at this early stage of the year, based on topicality, relevance and occurrence in recent conversations, I would propose “Stranded asset”.

My definition would be:

“A real estate asset, owned for investment purposes by an institution, which is no longer deemed fit for purpose. As it now falls outside traditional long term institutional investment criteria, it therefore appeals only to a reduced number of buyers, and commands a discount to previous valuation over and above any adjustments for general market movements.”

This may be due to one, or combination of, the following factors:

1. Environmental obsolescence – it no longer meets the required criteria (e.g. EPCs) and the cost/ability to retrofit the asset to meet the required standards is uneconomic.
   
   
2. Refinancing – The debt secured against the asset was fixed at an historically low level and now has to be refinanced at a significantly higher level which would mean breaching the interest rate covenant agreed with the lender(s).
   
   
3. Changing use class/covenant risk – The existing use class (typically retail but increasingly offices) no longer has sufficient demand to re-let upon expiry of the existing lease and a change of use is required.
   
   
4. Ownership structure 1 – An asset which is owned by a REIT, with a 90% pay-out ratio so little in the way of retained earnings, and at current valuations little access to capital markets. If income is declining the asset is less suitable to help pay the dividend, and if there is (unplanned) capital expenditure this will prove hard to finance, so the asset is best sold.
   
   
5. Ownership structure 2 – An asset which is owned by a Defined Benefit pension scheme, which as a result of the rise in interest rates, decline in lease length, and lack of covenant quality, no longer meets the required criteria to meet the liabilities of the fund and therefore has to be transferred to an insurer or sold.

The question therefore is how do we rescue these stranded assets. In other words what message would you put in the bottle as you send out your SOS, or in this case, sales particulars.

Prima facie, this a gloomy scenario indeed for market valuations in 2023 and beyond, but a little context paints a slightly rosier picture as to how and when the situation may be resolved. Fundamentally, a wholesale transfer of these stranded assets from unwilling holder to willing holder needs to occur before genuine market equilibrium can occur. This is not without precedent; In the 1980s and 1990s the US Savings and Loans crisis and changes to Real Estate Limited Partnerships tax advantages led to the real estate stock which created the modern US REIT explosion. Similarly, the banking crisis in Spain and Ireland during the GFC led to a transfer of ownership from unwilling holders (banks) to willing holders, Cash Shell REITs and Funds.

So how far are we down this road? In terms of market pricing there are signs that the process is underway:

1. An acceptable clearing price (trough valuation) appears to be approaching. The listed sector lost c.35% last year but troughed in October. Since then, performance has been far better and the market has absorbed the anticipated value declines in the results season.
   
   
2. Activity in the secondary trading market for unlisted funds appears to be picking up at realistic price levels. Discounts to current NAVs (after several months of write downs) have attracted buyers and suggest that the trough in certain (non-stranded) assets may not be that significantly below current valuations.

The longer-term transfer of assets is clearly going to be slower and particularly painful for those forced to accept a general market write-down coupled with specific obsolescence for any of the 5 reasons outlined. However, the sooner the “previously cherished” stranded assets are written down to realistic price and passed on to a new, willing owner, the better for all concerned.