Positioning real estate

Opportunities in a post-COVID and post-Brexit world

25 Jun 2020

As part of the UBS Asset Management webinar series Gunnar Herm, Head of Real Estate Research & Strategy Europe, Zachary Gauge, European Real Estate Analyst and Jon Hollick, Head of Real Estate Europe ex Germany, Austria, and Switzerland presented at a webinar on the potential winners and losers in real estate post COVID-19. This session was moderated by Tim Van Duren, Head of Institutional Business Benelux & Denmark.

Key webinar takeaways

  • Major productivity increase by digitalization of "standard" tasks but also increasing use of artificial intelligence and robotics
  • New working cultures and new corporate structures support flexible working arrangements by both time and place
  • Fast growth of e-commerce also in new product areas like grocery
  • While penetration rate varies, e-trade and the internationalization of businesses is likely to grow across Europe
  • Re-location of production back to Europe (closer to the end-consumer)
  • COVID-19 increases awareness of self-reliance in European societies, in particular in areas of pharmaceuticals and agriculture
  • ­ESG likely to become an even more important driver for performance and Post COVID-19 crisis regulators to put even more attention on this area
  • European bond rates are likely to stay at record low levels with traditional bond investors focusing even more on long-leased real estate assets

We are seeing seven key trends to shape the European and global economy in the next 10 years. We expect the COVID-19 pandemic to accelerate these structural trends over the next few years.

Digitalization − Digitalization of processes is likely to affect how we use offices in the future.

Agile working − Working from home supports flexible working arrangements, impacting how we will use offices in the future.

E-commerce − E-commerce is likely to penetrate into new products like groceries and affect how we trade globally.

Nearshoring – We may witness a shift to developments in nearshoring to save travel costs and counter uncertainties in the global supply chain. Therefore, we expect to see a movement of production towards the end-consumer.

Self-reliance − European societies are becoming increasingly aware of the fact that pharmaceuticals and agriculture is likely to drive the logistics sector going forward.  

ESG − ESG is becoming an even more important driver of real estate performance and the daily challenges following the pandemic should lead investors to not ignore the overarching topic of ESG. Regulators are likely to put more pressure and attention on ESG in real estate.

Low interest rates − Low interest rates are more obvious in this current environment and it is likely to be lower for longer, attracting more investors into the real estate asset class. The economic implications are significant. Therefore, if we don’t move towards a U-shape recovery, we are likely to see increasing insolvencies in the corporate sector including a drop in tenant demand and a slow recovery of the occupier market.

With insolvencies, we could also expect increased unemployment rates across Europe which could double the effect of subdued consumer markets and failing retailers. For investment, this means income is at risk. Investors should aim to buffer these uncertain times with a relatively stable long-term income return in real estate. This may accelerate in this pandemic leading to an increased polarization off the income market with capital values and real estate being at risk. It is still too early to tell how much the market will correct itself in the short-term, however, what is clear is that the real estate security market does need some caveat.

There has been quite a divergent impact from COVID-19. We have seen a boost to e-commerce, while office buildings are still (though increasing) occupying at very low levels. Investors are starting to price in future expectations for performance. With real estate assets being backward looking evaluations, this leaves some degree of subjectivity. The listed markets are insinuating a 30% premium for industrial assets. Whereas offices are trading at about a 30% implied discount to the asset value.

Should we be worried about the future of the long-term occupier office market?

Large investment into working from home and technology, will not mean the death of the office in a post COVID world. Some companies are already implementing a new working from home structure. Post COVID, we expect to see an increase in remote working and a surge in new company policies in support of this. We expect to see occupiers from large companies maintain a core presence. In particular, where landlords can deliver the capacity for some overflow space. We think there will be a shift towards buildings that can offer flexibility, as well as a focus on quality and the type of office space.

GH

In the office sector, we expect to see an increased risk when we refer to location, particularly for functional workspace in suburban areas where we don’t see much value. There may be more value in converting these offices into other uses.

For retail, we see many uncertainties and don’t see this as a good time to get back into this market.

We are also concerned about the hospitality sector, especially in the business operating segment, though there could be opportunities in the budget segment with businesses downscaling their travel budgets.

Healthcare has come onto investors’ radar due to the pandemic, though we are still cautious on this area as the long-term fundamentals (in particular on the demographic side) look supportive of this sector. However, most operators in this area are having a low credit rating. Though, investor pricing does not reflect credit rating from the operators in this area. We are therefore cautious on the current pricing in the healthcare system despite investor and client demand looking to move into this area.

Looking at the opportunities, there are two possible strategies. The first is weathering the short-to medium-term storm of the economy whereby focusing on long income stories, to cover this period of economic uncertainty may provide more stable income return. This will be particularly relevant for government tenants. Pricing for core offices is still pretty high and doesn’t offer much of an increase in capital values going forward. The supply constraints in the big European CBDs such as London West End, Amsterdam or the German top 5 cities is so constrained that there may be some volatility. However, these assets are backed by the alternative use of land value in their respective markets.

Secondly, there is an opportunity to look at the value-add strategies in these constrained markets due to office markets entering a period of uncertainty with very low vacancy rates and hardly any development activity going forward. Once the economy picks up, these supply constrained situations could get more severe. In the short-term, we can expect a sharper valuation in the pricing of values due to the lack of financing in this market and the lower rental growth outlook.

There are also uncertainties for how technology is used in logistics. Investors should focus on the main logistics hubs closer to urban areas where residual land value of those investments is relatively high. A sub-story is cold storage with the topic of self-reliance which will increase the demand for pharmaceuticals and groceries, opening a new window in the European market.

Investors should focus on affordable segments of the multifamily sector, with a focus on ESG strategies. If investors shift away from this, the capital values are likely to be more at risk. Investors should not only chase the higher yields but also get more value out of ESG strategies moving forward.

ZG

Logistics is the obvious winner here. Shifts into e-commerce is not a new trend but more an acceleration of an existing trend and is not the only occupier of the logistics space. This sector is serving a wide part of the economy, especially where COVID-19 has hit hardest in addition to the bricks and mortar retail. We must bear in mind that when buying into a market with record low yields, that they can still build their yields up over time.

For example, warehouses are usually located in areas with low skilled unemployment. If they become automated, the requirements to be closer to them increasingly shifts. Residual land value of logistics is not as  much there as it is with office space. There needs to be caution where people are buying into this market at the current levels.

Consumer spending is also likely to take a big hit, especially on the logistics side. This may have an issue as companies try to come out of this crisis.

We are seeing a trend away from globalization with Brexit, protectionism from Trump, the trade war from China and now COVID-19. This will have a fundamental shift on the logistics market overall. We will see a massive shift towards globalization to support global trade and the global flow of goods. There will still be a demand for logistics but this will look different to the types of logistics space we have been used to seeing in the past.

Amazon for example, is focusing on efficiency and cost cutting to bring margins down. They have a fundamental impact on the type of logistics space they occupy. For example, if warehouses become increasingly automated, the requirement to be close to this location shifts. You may instead need to be closer to staff who have the skills to run the warehouses. Therefore, this could have a real effect on the way occupiers operate.

Q&A:

The world in the grasp of COVID-19

ZG

Earlier this year, there was a surge in sentiment towards the UK especially in the office sector given that Boris Johnson had just won the decisive general election. Investors saw clarity on how things were going to progress and were looking to re-enter the market in a significant way. The main reason for the attraction was that due to the political uncertainty, pricing in London was out of sync with other European markets. That positive sentiment was there, but is it still there now? From the political risk view, nothing has changed in a negative way. If anything, the risk of a no deal has diminished due to the economic challenges the UK and EU will encounter at end 2020. On this basis, we have to revisit the fundamentals of pricing. We have a positive long-term view of Central London offices and we think that attractive pricing fundamentals are still in place.

Jon Hollick (JH)

In short, yes we do expect to see more opportunities, especially over next six months as there is not a huge amount of distress in the market yet. We would expect to see more over the next 18 months as Brexit is back on the headlines. Banks are supporting landlords, landlords are supporting tenants, and this is all propped up by government. But we don’t expect it to continue for the long-term. We believe the opportunities are more likely to be value-add orientated, with core also holding up well. Assets may require repositioning, or intense asset management as and when they become more available. We’d like to focus on these assets instead, especially in the London office space.
Since Brexit began, London hasn’t seen the capital returns of the other European cities, though this gives it some scope for growth. There was significant investor interest at the start of the year, and that will come back in due course. The working environment of the office environment will ultimately change, and we expect there to be more emphasis on quality of development and refurbishment. In addition, location will also become even more important. Therefore strategies should focus on the best in class assets and to attract superior tenants. Though it is difficult to get a real feel for the occupational markets, things will become clearer over time.

ZG

For us, retail is currently off the agenda in terms of new investments. That doesn’t mean there won’t be opportunities further down the line. This sector is currently facing challenges of the structural shifts towards e-commerce, in addition to bearing the brunt of the direct impacts of COVID-19. We expect there to be significant movement on pricing before retail becomes attractive again. Retail is vast and different sectors behave differently, such as supermarkets which are almost completely separately. Though supermarkets have stayed open as an essential service throughout the crisis, they tend to have longer leases, are index linked and subsequently there’s been a lot of interest in this space. Particularly for investors looking for that long-term income security. This is distinct to the rest of retail where you’d have a lot more concerns about the income and much shorter leases.

We have concerns about both the structural shifts in shopping centers and their capital expenditure requirements. Supermarkets need a lot more capital to just maintain the level of competitiveness and keep retailers. The issue is that the retailers are likewise struggling and therefore not going to be paying higher rents. Therefore, pouring money into an asset without getting income growth out of it, has its challenges. We expect most shopping center developments to shift towards redevelopments and repurposing as opposed to traditional shopping center investments. Retail parks need to be more defensive, as they have slightly longer income streams and anchor tenants like supermarkets and DIY stores who provide income security. This can be seen as slightly defensive against e-commerce e.g., carparks which support click and collect.

JH

In the investment space, retail warehousing works well with the retailers such as the online platform Click and Collect which is very popular. The low site coverage and the locations being edge of major conurbations means they often suit alternative uses. Retail warehousing tends to also be more affordable to the occupier as there is no service charge element which is typically attached to shopping centers. In terms of opportunities, certain types of assets may be worth exploring on a risk adjusted basis and the alternative redevelopment option will be important when analyzing. Today, there is still a lot of negativity regarding occupiers together with concerns over credit which will need to flow through before we decide to move into that sector.

JH

Firstly, it’s important to note that there is still plenty of demand in the long income style of investment, particularly in the logistics space. However, if you look in terms of the asset classes we’re targeting its likely the supermarket space is where we think is more attractive. With the emergence of COVID-19, corporate bonds for food stores/supermarkets in some instances have actually compressed, whereas the asset investment yield has moved out slightly and therefore the spread between the real estate and the bond is now greater. This is an interesting angle to explore, together with the notion that foodstores/supermarkets are typically located on edge of towns and cities and thus could suit an alternative use for development. We believe this will add an additional defensive angle to the long income characteristics of an investment into this sector.

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