Pressure on rent streams, increased rent volatility and an increased need to compete for tenants, says LCI Real Estate Investments’ founding partner.
Most major economies, which account for around three-quarters of the world’s GDP, are now operating at lower levels than a year ago. Many businesses are facing low demand for their goods and services, leading to increased competition for customers. Special marketing terms are on offer like price cuts and value packages, including additional services gratis and concessionary financing packages. In the property world, this raised competition leads to falling margins for tenants and reduces their ability to pay rent.
Let’s consider the operating statements for an ‘average’ business under three state-of-the-world scenarios. First, in a stable operating environment, let’s assumes the net operating income needed to keep capital employed in the industry is 10 percent, which is approximately the US’s total corporate profits ratio for 2019. When that target is exceeded, capital is expected to flow to the industry, creating new capacity and driving returns down toward the 10 percent level. If missed, capital is expected to flow out of the industry, reducing its capacity and driving returns up toward 10 percent.
In a stressed GDP environment, the first-round impact scenario is that a business must make immediate adjustments to the decreased demand/increased competition for revenue. So, for example, marketing and sales costs, and sales concessions might increase, which will lead to NOI falling below the 10 percent target. Finally, in the second-round impact, a business will make adjustments to generate sufficient NOI to justify continued deployment of capital into the industry; cuts will be required – suppliers pressured to reduce cost of goods sold, labor and management bonuses, pay and the number of positions reduced, rent levels per square footage reduced – to achieve the 10 percent NOI target.
Implications for investors
As the deficit in aggregate demand for existing supply works itself out in the short-term, and as capital re-deploys to equilibrate the SS-DD balance in line with sustainable operating statement ratios, investors can expect:
- Declining rents – lower rent levels, lower square footage demanded;
- Higher rate of tenant turnover;
- Greater demand for rent flexibility – percentage rents vs flat rents, shorter-term leases, generous break clauses;
- Increased tenant concessions and increased brokerage fees;
- Flat or declining operating costs;
- Increased rate of obsolescence, as remaining demand flows to modern buildings with superior functionality;
- Changing relative value across locations – suburban office vs CBD office, high-street retail; leisure vs suburban malls;
- Sluggish economic recovery, as employment and wages remain depressed for an extended period, consumers remain cautious (lower propensity to consume, higher propensity to save), businesses curtail investments (equipment, IP, property).
However, real estate performance tends to lag GDP indicators, so there is time to prepare for the impacts of lower GDP by adjusting leverage levels, implementing tenant retention programs and positioning property to be competitive in changing markets.