Income Analytics: Rising bankruptcy levels put income at risk

In recent years, investors in global real estate could rely on capital market forces driving values up, supported by a stable tenant base. Low-cost debt supported both the investors and occupiers. Recently, however, yield levels are under attack from the well-documented weaknesses in the flow of equity and debt capital into the sector and, less discussed, from rising bankruptcy rates across key occupiers.

While this article will focus on the European markets, given the available dataset at press time, the same trends apply for markets such as the US and Canada. Inflationary pressures, reciprocal rises in interest rates and the resulting higher cost of debt have created a cost-of-living crisis driving tenants into bankruptcy.

At a macro level, using data from Eurostat and the UK’s Insolvency Service, we have observed a significant increase in the number of businesses going into bankruptcy or insolvency proceedings over the past 12 months. Corporate bankruptcy rates for the Netherlands, France and Norway have increased over 40 percent during the 12 months ending Q1 2023. Poland and the UK have increased over 30 percent during the same period, while the EU-27 average and most other major European economies are averaging around 20 percent.

While Spain and Germany have seen bankruptcy rates fall slightly between Q4 2022 and Q1 2023, they both experienced an approximately 20 percent rise over the past 12 months compared with the earlier one-year period.

This indicates an increased level of risk that tenants may go into bankruptcy and default on their rental obligations. While rent payment is often the last sacrifice a failing company will make, this too will eventually disappear in the event of a business
failure.

The INCANS Tenant Score is a normalized international cross-border score that predicts the likelihood that a company will seek credit relief or go out of business within the next 12 months. A higher score indicates a lower probability of failure or default. The averages represent the Q1 2023 score of a sample of the top companies headquartered in the countries shown.

German security

Looking across the selected sectors and countries, occupiers in Germany are notably less likely to fail in comparison with the UK and Netherlands. This is particularly pronounced in the retail sector. From an investor viewpoint, this is important when considering asset allocation decisions and income at risk.

While the analysis reflects market averages, as in asset-level allocation, we must recognize there is a spread of default risk within the businesses operating in the sectors.

We can examine the spread of INCANS Tenant Scores within each UK sector, for example.

The companies reflected in the sample are the largest potential tenants a landlord could have in their UK buildings. The most risk-free sector is typically healthcare, as it has significant government support, but even here there are outliers from the narrow spread of businesses between the 25th and 75th percentiles.

The leisure sector shows the highest range of risk, which is unsurprising since this sector suffered the most pain during pandemic lockdowns and is still struggling to find its feet.

Manufacturing-focused industrial and retail occupiers have been badly impacted by the cost-of-living crisis hitting disposable incomes, the inflated cost of materials, cheaper overseas imports and the move to online shopping.

In the UK, the office sector has been hard hit from a capital market perspective. However, based on analysis of the tenant failure data, it does not have the same spread of income at risk as other sectors.

The analysis varies little from one an investor would make when deciding to allocate capital to a property sector or specific assets, ie, examining the risk and return characteristics and forecasted outcomes. Why would a landlord not want to apply the same level of analysis to the income stream and allocate to the most secure tenants?

At a time of dislocation in the capital markets, landlords should be focused on managing their income at risk by identifying those tenants that have a higher probability of default and potentially working them out of the portfolio at lease expiry, seeking a parental guarantee or perhaps a greater rental deposit. Income will be king in the coming few years.