For most managers, tenant defaults during the covid-19 pandemic have been a reason to worry.
This includes firms that have not faced significant challenges with collecting rent to date. Canadian manager Fiera Real Estate is one. Alex Price, its UK chief executive, says the firm has been “relatively successful” on rent collection in the country, having received 85 percent of its second-quarter rents – representing a quarterly rent roll of about £7 million ($8.75 million; €8.05 million) as of April 1.
But with the due date for second-quarter rents coming just two days after the UK went into full-scale coronavirus lockdown on March 23, Price expects the next quarterly collection to be more challenging.
“I think it will be much worse in June,” he says. Tenants “will have had two-thirds – January and February – of normal trading time in Q1 from which to accumulate the cash to pay us our rent for Q2. I don’t know when we’ll be reopened, but the most likely is they’ll have at least two-thirds of Q2 closed.”
Price adds: “I think if we reopen or ease the lockdown, we’re not going straight back to 100 percent capacity economically… It will be tougher in June for those guys to pay their rent than it was in March.”
Meanwhile, in the US, Stanley Iezman, chairman of American Realty Advisors, says the Los Angeles-based manager “surprisingly” received 80-90 percent of its multifamily rents for the month of April. But he worries about the impact of record-breaking US unemployment numbers – jobless claims stateside have topped 30 million since the start of coronavirus shutdowns, according to the US Department of Labor – on his multifamily tenants’ ability to pay rent going forward. “It remains to be seen whether significant layoffs over time will result in more defaults next month,” he says.
Price does not anticipate rent collection will necessarily return to normal during the third quarter either. “Our base assumption is that most of our tenants will have resumed trading by the end of the summer. But some, especially retailers, may not make it through to this point,” he says. For example, one Fiera tenant, the UK department store Debenhams, entered into administration in early April, with other retailers, hospitality, leisure and transport companies expected to follow.
Too soon to tell
Despite this tenant default backdrop, some in the industry think it is premature to discuss real estate performance.
“It’s very early and hard to know what the marks are really going to look like,” says Meagan Nichols, global head of real assets at Boston-based consultant Cambridge Associates. “I think it’s going to take a few quarters before we see marks wash through in a more material way. There’s not a lot trading right now. Depending on how long it takes for the market to get itself back into action, I think it’s going to be hard to get comps in order to truly understand the value of what’s in real estate portfolios.”
Nearly 90 percent of respondents saw real estate deals fall through because of financial market volatility, or the inability to travel or meet because of covid-19, according to an April survey conducted by the Pension Real Estate Association, a private real estate trade association.
It is also difficult to know when most businesses would reopen and when asset sales will start up again, Nichols adds. Multiple US states, for example, have extended their shelter-in-place orders that were originally due to expire at the end of April, while others have allowed businesses to reopen but with social distancing restrictions in place. “You have to imagine that we’re not going to just all go back to life as usual immediately, so how long that re-ramp up takes will have an impact on how long it will take for assets to trade,” she says.
“Because of the overall environment, we are factoring a reduction in the cashflows we’ll receive from some of our funds for 2020,” says Jerome Berenz, head of indirect investments at Allianz Real Estate, the real estate investment arm of Munich-based insurer Allianz Group. “But with large differences across sectors.”
That said, “we think it’s too early to comment on performance.”
For Berenz, greater visibility on performance will come after the end of the quarter. “What’s going to be important are the Q2 valuations,” he says. “We’ll probably see downside in some markets and resilience in others.”
He adds: “Valuation houses did not really have the time to accurately and fully reflect on market conditions, hence Q1 valuations should be caveated with major uncertainty clauses.” Indeed, more than 69 percent of respondents in the PREA survey believed appraisals currently being conducted may contain material uncertainties.
“We will see over the summer how the valuers have formed their views as, by then, we are more likely to have sufficient transactional evidence,” Berenz continues. “For the most impacted sectors, it will be interesting not only to look at the cap rates, but also the numerator, future revenue generation, assumptions for long-term cashflow growth and structural vacancy rates. These factors will together provide a major indication for the industry.”
For others, however, rent collection numbers are among the earliest indicators of how recent vintage funds may ultimately perform in light of the covid-19 pandemic.
In a report last month, investment research firm MSCI modeled three hypothetical scenarios assuming varying levels of rent collection during the covid-19 pandemic. In the base case, cashflows are assumed to grow at 3 percent per year and are discounted with a risk-free rate of 1 percent and a risk premium of 6 percent.
In the first hypothetical scenario, where 95 percent of cashflows from the first six months are deferred, asset values fall by 13 percent. In the second hypothetical scenario, a rent holiday where 95 percent of cashflows are deferred over the first six months but where the deferred income is not paid back, asset values drop by 24 percent. Under the third hypothetical scenario, which is the same as the rent holiday scenario but with a more prolonged slowdown, asset values fall by 37 percent.
In the three hypothetical scenarios, the impact of the changes to cashflows alone could result in asset-value declines between 2 percent and 13 percent, according to MSCI. The remaining reduction in asset values comes from changes to the risk-free rate and risk premiums, which on their own implied a reduction of 12 percent to 28 percent, the report stated.
Price notes that with the current crisis, “the rent will either be the same or go down, whereas in a normal market environment we forecast rental growth. Tenants will default and in the short to medium term people taking up this space will not pay a premium for it.”
Price estimates that UK average capital values officially fell between 2-4 percent during the first quarter and will decline the same in June, although he suspects the “real market” will actually fall by 15-20 percent: “The valuation market is based on evidence. In the lack of absolute evidence, if we look at the listed REIT market, we can gauge the likely falls. Never before will we have had a quarter where trading of buildings has essentially stopped.”
In the medium term, numerous factors are expected to offset the drop in rent payments. Price believes government stimulus in the UK, European Union and the US will drive yields down further, offsetting the rental decline, which will lead to higher asset values over the medium to long term. “The £350 billion, the €1.5 trillion-plus, and the $2 trillion that’s been pumped in, where does it go?” he asks. “The capital will flow through the financial system and an element will come down to real estate.”
Central bank rate cuts will, likewise, boost asset values, adds Prashant Tewari, partner at Cleveland-based real assets investment management and advisory firm The Townsend Group. “Everybody was second-guessing the Federal Reserve’s rate cut earlier this year and they’re now, just a few months later, saying that was absolutely the right thing to do,” he says. “So hurdle rates required for investments are going to come down. That’s going to put a lot of pressure on cap-rate compression, which is going to offset the impact on valuations that is coming through from near-term NOI decline.”
Lack of confidence
Tenant defaults, however, have also contributed to a lack of confidence that has stalled transactions, which, in turn, is expected to impact performance.
“Anything you were planning to sell before the summer is probably not going to get sold before the summer, unless you’re prepared to take a big discount,” says one manager who declined to be named. “Probably the earliest you can start to market properties again in the hope you would get some type of normality in terms of pricing would be starting in September.”
A longer-than-anticipated hold for assets will have negative implications for returns. “If sales get pushed back, that impacts your IRR, because instead of selling something three months earlier, six months earlier, you’re selling it later,” that manager notes. “The other thing to think about is debt service. The longer you hold an asset, you pay more debt service, so by definition that also costs you money. So that also has an impact.”
In addition to an extended hold period, performance – particularly on the equity multiple side – would also be hurt by lower pricing, adds Price, whose firm has put all but two asset sales on hold. “Everybody will find their funds will deliver lower than they thought they would in January, because whether it’s three-months or six-months, it’s a delay, and at the end of it, the price they sell for will be lower than they thought.”
Prior to the crisis, Fiera’s value-add funds were on track to perform at the upper end of its 12-15 percent net return target range. But now he expects to be at the lower end of the range by the time the firm’s most recent funds in the series are wound down. “Funds with higher risk and earlier life cycle assets will be hit harder than those midway through divesting and returning,” Price says. “But the returns in the near term will come down for everybody, as the time to exit will push out and sale prices will be lower.”
Tewari expects private real estate, which had been generating outsized returns since the global financial crisis – to now normalize in performance. He projects core real estate – which most recently had been delivering 8 to 12 percent net returns – to moderate to the 6.6 to 9 percent range, while non-core real estate – which had been in the 12 to 20 percent range – to come down to 9 to 15 percent.
No perfect proxy
Predictably, industry executives have drawn parallels between expected real estate performance during the coronavirus crisis and that of prior downturns.
Tewari notes that since the global financial crisis, the majority of institutional capital in private real estate has focused on investing in good quality assets and has consequently given tenant credit quality much greater scrutiny. For this reason, “two to six months of challenges on a portion of rent collection is not that big of a problem,” he asserts.
“The prior downturns have shown very little impact on the income generation potential in good quality assets,” he explains. “In this current downturn, we may experience at least a similar level of income loss as we experienced in the last one, and it could be a little bit more, only because this level of unemployment is just completely unprecedented.”
Meanwhile, Nichols expects private real estate pricing to follow the trajectory of the public real estate markets as it had during previous crises. “During the GFC, it took three quarters for those public valuations to finally make their make way into the private space in a meaningful way,” she says.
The public real estate market began to show declines in values during Q4 of 2007, “but it isn’t really until Q3 of 2008 where you start to see negative numbers in privates.”
She also notes that real estate returns remained fairly strong between September 2001 and March 2004 – a period spanning the 9/11 terrorist attacks, the dotcom bust and the 2003 SARS pandemic.
“But people weren’t grounded, businesses weren’t shut globally to the same degree,” she acknowledges. “There’s no perfect proxy for what we’re going through.”
Indeed, the unprecedented nature of the current crisis has compelled the industry to assume a high level of uncertainty indefinitely, Nichols says: “Almost everyone I’m talking to is appropriately open-minded about the fact that there’s a lot of unknowns right now. It’s not a case of hiding behind unknowns but rather an acceptance there’s just a lot we don’t know right now.”