The COVID-19 Era: What Every Real Estate Investor Needs to Know
Most financial forecasts now include curtailed economic expectations and greater odds of a negative tail event. While there’s much greater than normal uncertainty on real estate pricing, commercial real estate ought to deliver unlevered total returns in the high-5% range for buy-and-hold investors. Compared to the corporate bond market, where yields have risen materially in recent weeks, this suggests that property prices could decline by double-digits in the coming year. The bond market, however, has offered plenty of false signals over time. That said, comparing expected returns on corporate bonds (investment grade and high yield) to real estate returns is far more telling than what can be gleaned from shrinking treasury yields. Corporate bonds provide a real-time gauge of how investors are pricing securities that have a similar risk profile to real estate.
For institutional investors willing and able to put capital to work during these unprecedented times, market volatility is an opportunity, not a threat. Both public and private real estate investors should keep the following crucial considerations in mind when making any decisions on capital allocation:
1. Sector Sensitivity and Cyclicality
The sensitivity of property values to changes in the economic outlook differs between sectors and is a function of the variability of 1) market rents (e.g., office rents are more volatile than apartment rents), 2) operating leverage (e.g., lodging and senior housing have lower margins), and 3) the cushion provided by in-place leases.
The broad lines of property sector economic sensitivity have been mixed in recent weeks in share price reactions. Defensive (largely niche) sectors – such as data centers and self-storage – have comfortably outperformed other real estate categories, some (e.g., apartments) have puzzlingly underperformed. Non-core sectors now comprise over 60% of REIT U.S. market capitalization. Meanwhile, sectors we would expect to react most to changes in GDP expectations – lodging, retail, and office – have in fact displayed sizable economic sensitivity (although office has fared better than expected). The fallout from what promises to be a record-breaking plunge in GDP should have somewhat predictable impacts across property sectors. For more information, access report: Heard on the Beach: The Sum of All Fears.
2. Balance Sheet Strengths and Weaknesses
Share price declines in this sudden and violent bear market have been steep (>35% in US). Equity value changes are magnified by financial leverage, but the implied change in unlevered property value is less significant (>25% in the US) and sends a bearish signal for property value trends. Credit concerns (and therefore balance sheet concerns) should not be confused with the dire 2008 situation – not yet, at least. However, balance sheet position – including liquidity – should remain a key differentiator for share price performance in the near-term.
Broadly speaking, U.S. REITs have stronger balance sheets than they’ve had historically, and that should allow most of them to weather this storm. However, that is not the case in Europe, where the reaction in the public market reflects a high level of concern about the liquidity position of some real estate owners. Moreover, with the high leverage employed by many European Propcos, the change in underlying property values that is reflected in share prices can be missed. For that reason, looking at unlevered returns is a must. For more insight on this, refer to our report: COVID-19’s Socially Distanced Pricing Behaviour.
3. Private and Public Market Interplay
Property sectors that have over/under-performed in the public market typically experience higher-/lower-than-average appreciation in private markets over the ensuing six months. Thus, for private market investors, a look at the public market will, at least, provide insight into the potential future direction of pricing across property sectors and regions.
At one extreme, the drop in REIT share prices over the last three weeks implies a decline in U.S. asset values of about 30% in lodging and >35% in senior housing. During these unprecedented times, those with a dual mandate across the private and public markets have more choices, and perhaps some arbitrage opportunities.
The COVID-19 pandemic has turned much of the world, including real estate, upside down. While there is no playbook for recessions induced by a global pandemic, Green Street has consistently produced trusted and valuable insights to help investors outperform during economic downturns by understanding individual sector and balance sheet risks and the interplay between private and public markets.
Investors armed with detailed information about how commercial real estate markets typically operate during risk-off environments are well-positioned to identify opportunities when volatility reigns. Forming judgments about absolute valuations amid great uncertainty is a fool’s game, but opportunities are likely to arise as relative valuations change by the day.
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