With around half the world's population forced to stay at home in April, it is no surprise that property usage has been severely impacted by the coronavirus. Government closure of commercial premises has decimated high streets around the globe and seen real estate – traditionally a haven for investors during market stress – underperform global equities in the current crisis.
Compounding general fears over the impact coronavirus could have on global economic health, real estate is capital intensive and typically financed with significant debt. Investors therefore face the risk of uncertain cash flows from assets that can be difficult to refinance or sell, particularly when valuations are as unclear as they currently are.
Liquidity advantage
The crisis has also served to remind investors of the unsuitability of using open-ended fund structures that offer clients daily liquidity while investing their cash into highly illiquid property assets. At least ten such funds, managing around €15bn in assets, have been suspended as the economic impact of the pandemic has cast doubt over the value of their underlying property investments. For their investors, who are trapped and face the prospect of significant write-downs, the pill tastes even more bitter as many continue to be charged fees by the funds' managers.
It also underscores the relative benefit of SKAGEN m², which invests in listed real estate securities that provide a far more appropriate liquidity profile for investors who don't wish to lock-in their capital. Analysis at the end of April highlighted that over 60% of the fund could be sold within a day, if required, and 80% of the portfolio within five days. Thankfully, investors recognise the attractions of both the asset class and the fund structure, and m² has continued to receive significant inflows which it has been able to invest at attractive valuations.
Reflecting Covid-19's circulation, real estate markets around the world have suffered losses, with the US, Europe and Asia all around 20% lower in EUR year-to-date[1]. More striking is the polarisation between different segments as properties in some sub-sectors bear more of the burden of the virus’s economic impact while others benefit from increased home working, entertainment and e-commerce. Year-to-date there is over 70% difference in returns between the best performing segment (data centres) and the worst (regional malls), while the office, healthcare and lodging sub-sectors also performed poorly (see figure 1 below).
Like most areas of the economy, the coronavirus will have a significant impact on real estate, although it is still early to accurately predict the long-term repercussions for the overall market or individual segments. Among the winners are likely to be logistics and warehousing as supply chains become more localised and the desire to stockpile goods in short supply during the pandemic (i.e. medical equipment) creates new client segments. Further demand should come from growing e-commerce as households who have become comfortable shopping online during lockdown will continue to do so. This trend will similarly benefit data centres, as will more people choosing to work from home, even after the lockdowns have ended.
Shopping malls and centres are the obvious losers from the growth in e-commerce and their structural decline will likely accelerate. The hospitality sector may also contract as the economy turns down, particularly businesses reliant on overseas demand as people choose to reduce travel for business and leisure.
For some segments, like offices, the long-term effects are likely to be mixed. While the long-term trend of increasing densification may slow or reverse as employees are provided more space, companies may operate from smaller or cheaper offices as home-working increases. The trend for healthier working environments will likely accelerate, meanwhile, requiring additional capital expenditure on areas like air purification.
The chart below illustrates the sensitivity of different property sub-sectors to Covid-19 and the broader economy. This is useful to understand both recent performance and potential risk areas in a coronavirus-induced recession.
Active portfolio
For SKAGEN m², recently awarded the best global property fund by Lipper, many of these themes already anchor the investment approach around which its portfolio is constructed. While the economic and equity market impact of the coronavirus has been severe and risks remain, particularly in the short-term, it also creates opportunities for investors and particularly those with a long-term horizon.
The fund has been active and made several new investments in more resilient segments, such as residential real estate, self-storage, healthcare, logistics/warehousing, social and digital infrastructure. We have been investing in these areas for a long time and their relative attraction has been further increased by enticing valuations and the protection they provide against an economic downturn.
The fund has cut its exposure to pure play hospitality and retail companies, which are particularly vulnerable in a post-corona world. Also gone are companies with high levels of debt as balance sheet strength is likely to be an increasingly important driver of performance, particularly if liquidity remains stretched. More details on these portfolio changes can be found in m²'s first quarter report. The result is a portfolio of 32 companies, diversified across 12 countries and 9 sectors with favourable leverage and valuation ratios versus the benchmark.
The outlook for global real estate remains positive; return prospects are even more attractive following the correction while urbanisation and demographic shifts will continue to provide long-term support for asset values. The coronavirus will serve to accelerate many long-term trends and the widening gap between winners and losers will make stock selection increasingly important.
Reference
[1] Source: NAREIT, total return in EUR as at 30 April 2020: Americas (-22.1%), Europe (-23.0%), Asia (-18.8%).