This article is sponsored by Macquarie Infrastructure and Real Assets
Major economic and consumer shifts, which were expected to take place over a much longer investment horizon, have been brought forward due to the global pandemic of 2020 with some segments of the property market benefiting while the medium to longer-term impact on others is less certain.
Big shifts include the acceleration in the use of technology for work purposes, entertainment, leisure, further growth in online shopping, and accompanying data consumption and storage needs. Strategies focused on industrial, data centers and affordable housing are expected to continue to benefit from these trends while cyclical opportunities in the retail, hotels and aged care sectors are likely to depend on the extent of distress and pricing discounts that become available to investors.
Solid growth in online sales and data flows were already taking place pre-covid and are unlikely to fully reverse themselves even as health risks eventually become fully contained.
Demand for affordable rental housing and office space is also likely to remain solid as jobs and people continue moving to less expensive locations and occupiers diversify their corporate footprints.
In other sectors, such as leisure, entertainment and hotels, the recovery will depend on the extent to which the virus is contained and social distancing restrictions are eased, and whether increased government regulation and cost pressures do not crowd out private sector capital (for example, in the aged care sector). Retail recovery will depend heavily on the extent to which retailers can shift to omni-channel models to boost sales and underperforming assets can be converted to other uses as online penetration rates stabilize.
Here are our seven observations on the private real estate investment market in 2020, and the medium-term outlook as we enter the post-covid period.
1 – Global equities pricing continues recovery, despite uncertainty and rolling second covid waves
The global economy had been vulnerable and asset pricing stretched in the 18 to 24 months leading up to covid-19. Leading indicators, including an inverted US yield curve, declining US cash rates and weakening global trade in 2019 were already signaling a mature cycle. But covid-19 is the black swan that put a stop to a decade-long bull run.
Following the sharp sell-off of equities and credit in Q1, aggressive central bank and government policy has supported global liquidity and the subsequent rally in both risk assets (listed equities pricing) and defensive investments such as government bonds. Direct government cash transfers and private sector wage subsidies have softened the hit to incomes, boosted retail sales and allowed households to increase their savings as insurance against future shocks.
Importantly for commercial real estate, the policy response has provided companies and investors with breathing room to pay down debt and accumulate cash reserves to tide them over until the global economy recovers. This is likely to cap the rise in corporate defaults compared to previous downswings and minimize the outward movement in property cap rates this cycle.
2 – Global economy is lifting from H1 lows, but pace of the services sector recovery remains a drag
Following a sharp decline in global GDP in the first half of 2020, economic activity has lifted across markets in recent months boosted by the easing of lockdowns and bounce in industrial production and retail trade.
However, with the services sector accounting for 70-80 percent of developed economies and 30-50 percent of emerging markets, the ongoing weakness in this critical sector is likely to act as a significant constraint on the labor market recovery and global GDP growth from here.
A V-shaped global recovery is still possible, supported by a vaccine that would allow for a more rapid return to pre-covid conditions, boosted by expansionary policy. Such a scenario, if it occurs, could trigger a sell-off in defensive assets as real bond yields rise, consistent with previous global recoveries. Property cap rate spreads would compress and total returns would accelerate as fundamentals improve.
3 – Listed markets provide some guidance on relative performance across sectors
With price clarity remaining elusive in private real estate markets, listed REITs provide an early indication of the direction of near-term values by market and sector. REITs provide a good guide for private market trends, though with considerably more volatility, tending to overshoot during downswings.
In the listed space, data centers, industrial and affordable rental housing REITs, such as manufactured homes and single-family rental operators with a focus on affordable and suburban markets, have been most resilient during covid-19. In contrast, pricing and demand have weakened sharply in sectors that are most exposed to lockdowns and social distancing restrictions, such as retail ex-essentials, hotels, healthcare, fitness centers and leisure.
Medium to longer term, a vaccine and containment of covid-19 is needed to support a recovery in the leisure, entertainment and hotels sectors.
4 – Trend accelerators underpinning property demand
For logistics and data centers, the acceleration to online spending and rising data usage linked to working from home (WFH) and home entertainment trends are likely to continue underpinning demand. The health shock has brought forward growth that normally would have occurred over the next three to five years.
The structural shift to online shopping has been taking sales away from bricks and mortar retail. Ecommerce is receiving a significant near-term boost from covid-19 disruptions. Growth rates in these shifts will moderate when health risks dissipate, but some of the shift in consumer and employee behavior is likely to be permanent.
Demand for data center space is expected to remain solid supported by strong secular tailwinds, including the ongoing shift toward cloud computing and WFH, and Asia’s rising internet and mobile phone penetration rates, particularly in the region’s emerging markets.
In the rental housing space, the shift to decentralized locations and more affordable housing and locations, have supported rental housing demand. However, expensive rental housing in global gateway markets is most exposed.
5 – Hybrid working is the most likely scenario post-covid
In the office sector, most occupiers are in a ‘wait and see’ mode when it comes to their future demand requirements. For those occupiers with imminent leasing events, the focus is on flexibility and shorter leases.
Overall, we think the move to WFH has reinforced the importance of working in the office, particularly around collaboration, discussing and generating ideas, building culture and employee training. A hybrid working model is therefore most likely, where most white-collar employees will continue spending most of their time in the office – three to four days – with the remaining days working remotely.
In this environment, more affordable cities with cheaper housing and good jobs growth are likely to perform solidly. Expensive central business district (CBD) office markets that have major alternatives for occupiers and workers appear most exposed in the post-covid environment to WFH trends and slower urbanization rates.
Displacement trends are likely to support demand for space in CBD fringe locations, suburban locations in gateway markets and regional markets with good jobs growth prospects.
6 – Global transaction volumes expected to remain subdued in H2
Global commercial real estate transaction volumes fell sharply in the first half of 2020 given elevated macro uncertainty and market volatility, and travel restrictions limiting the number of site visits and client meetings.
Sales of core assets were down -25 percent in H1 versus prior year levels and -50 percent in Q2 relative to Q2 2019. This reflects the strength of transactions in the first quarter and sharp pullback in the second quarter – the steepest pullback in activity since the 2008-09 global financial crisis.
But unlike previous downswings, there was significant variation in sales by sector and location. In fact, industrial transactions remained positive in H1, up 19 percent, and apartments were relatively resilient against other sectors, with volumes down only -18 percent in H1. These trends are likely to continue this year and into 2021.
Surprisingly, sales volumes of development sites were only down -20 percent in H1. The resilience reflects the importance of China in a global context, given this market represents almost 90 percent of total sales. Sales of land earmarked for warehousing and distribution use are also likely to have propped up the market.
More broadly, ongoing resilience of development sales also seem to reflect developer views that economic conditions will recover over the medium term, underpinning future demand for new space.
7 – European transactions held up well in H1 with China’s transactions recovering early this cycle
By region, European transactions in Q2 held up relatively well compared with other markets, with volumes down by -10 percent in H1 and -31 percent in Q2, according to Real Capital Analytics (RCA). Europe was supported by two entity and portfolio deals that completed over the quarter, including large deals in Germany’s apartments sector and a couple of shopping center transactions in Iberia and France. Germany was the stand-out market in H1 with investment volumes up 16 percent from a year ago supported by elevated levels of domestic capital and a sharp recovery in economic sentiment in recent months.
In Asia-Pacific, although China’s activity in H1 was down relative to 2019, investment volumes bounced sharply in Q2 as GDP growth rebounded following the containment of covid-19. Government monetary policy also helped, as investors took advantage of loosening credit conditions and excess cash reserves.
Overall, global investment volumes are expected to pick up in H2 and into 2021, as lockdowns and social distancing restrictions are eased further across markets and sectors. But the speed of the recovery will depend on the extent to which a second major wave can be controlled and global growth accelerates.
Certainly, China’s sharp recovery suggests that with the right policy support, global investment activity can quickly recover if the health risks are contained.
Real estate post-covid: The medium-term outlook
Aggregate pricing is expected to recover back to 2019 levels (or tighter) taking a three- to four-year view if low and negative interest rates remain in place over the medium term. In this environment, cap rate compression in the next upswing cycle is likely to be supported by low real bond rates, elevated spreads to government bonds and low borrowing costs for good-quality borrowers and assets.
Asia’s commercial markets are expected to emerge first, supported by relatively stronger growth fundamentals, assuming any further health outbreaks remain localized in nature.
Strategies focused on industrial, data centers and affordable housing, including development exposure, are likely to perform solidly over the medium term if recent shifts in online sales and WFH remain entrenched in the post-covid environment.
Office opportunities are likely to include CBD fringe locations, suburban markets with good transport linkages and regional cities with good jobs growth.
Cyclical opportunities in the leisure, hotels, aged care and retail space are likely to depend heavily on the extent of distress and the pricing discounts that become available to investors as compensation for the uncertainty around future cashflows.