Residential freeze, Commercial squeeze.

The impact of Covid-19 on markets so far has been acute, and we have covered many aspects of it since January. Our portfolios have always been built on optimal allocations to both financial and real estate assets. So, in today’s piece we take a closer look at the impact Covid-19 has had on the property market, in particular in the UK. We discuss why we are not overly concerned about the residential market, and why we believe the commercial property market is vulnerable.

The UK property market got off to a good start in 2020. After the election in December 2019, and the subsequent confirmation of Brexit, we changed our stance on property from neutral to positive for the first time since before Brexit. We have since acquired various property assets on a principal and agency basis. By the end of February, the resurgence of UK property was clear, underlined by an increase in activity, as well as a fairly sharp uptick in prices. Then the coronavirus pandemic started to unfold.

The first few months of the year highlight a valuable lesson pertaining to the relationship between financial markets and real estate. Financial markets always react quicker as they are generally more liquid. Property markets take longer to seize up, therefore giving investors some time to react. Once the property market does respond, liquidity is disrupted for months, if not years. We have always owned positions in property market funds (at a proprietary and client level) as they offer good diversification and conservative returns. But perhaps most importantly: They act as buffers. When equity markets experience shocks, they re-price within hours; property funds on the other hand (due to the illiquid nature of their assets) take days, or in some cases weeks, to react. The lesson here is quite simple: If you own property funds going into a crisis, they should be the first thing you sell as they can be liquidated without loss (provided you react quickly enough). It makes more sense to sell a property fund at par, than it does to sell an equity that has just sustained a big loss. At the start of a crisis cash immediately becomes more valuable than a property fund. In late January, as we were advising clients to take market-risk off the table, we liquidated 3 core property funds that we had been holding for many years. 2 of these property funds were suspended 3 weeks later (including one of Legal & General’s flagship property funds). Unlike physical property, which takes time to sell and has significant transaction costs, a fund can be disposed of instantly. It makes sense to take advantage of this feature when uncertainty increases to the extent we have seen.

A few months on the impact of Covid-19 is clear: Both residential and commercial property markets are frozen. Tenants cannot be evicted and have lost mobility, valuations and surveys are being cancelled, LTV’s imposed by banks are higher, mortgages take longer to approve, and sales are simply not going ahead. This is the exact reason why property funds have no choice other than to suspend:  They own illiquid assets that can no longer be traded. The only sensible course of action is to prevent panic selling. Real property is no different. If you hadn’t concluded your planned property transactions by the time the pandemic was in full swing, you are likely to struggle for at least a few months. The commercial property market faces even bigger challenges than residential, and we discuss some of these challenges later on.

What happens to the underlying value of residential property at times like these? We have 2 recent comparables. Once again it is important to draw a distinction between 2009 and 2020. In 2009 property markets globally were in decline (apart from a few haven locations). Property prices decreased because there was a fundamental credit problem (kicked off by the subprime crisis in the US). This led to mortgage defaults, foreclosures and forced sales thus creating a downward spiral for property values. This was further exacerbated by reckless risk transfers of the poorest quality assets through various derivative instruments. 2020 is completely different. Firstly, and most importantly, owners of property CAN’T panic-sell right now – simply because the market is frozen. Most agents are shut with the majority of their staff furloughed. In 2009 sales volume didn’t seize up, and as a result price declines were possible. Right now, however, sales volumes have virtually disappeared, and as a result a fundamental re-pricing of the asset is not possible.

The second comparable is Brexit. Incidentally, post-Brexit was the first time our in-house outlook on property became negative in more than 10 years. However, Brexit was also different because Brexit was about a potential transfer of demand from the UK to various countries within Europe, along with thousands of potential job losses. Brexit created a real and quantifiable risk (some of which materialized) that there would be significantly less demand for both commercial and residential property in the UK. This coincided with various fiscal measures that had already taken the froth out of the market. In the case of Covid-19 however there are no obvious regional winners and losers in the property arena. Nobody is moving from the UK to the US or to Italy to escape Covid-19 (although New Zealand does look appealing). Some equities have shown vast performance differences (tech outperforming energy for example) as a direct result of the pandemic, but not much has changed for the UK residential market. The market is closed for all intents and purposes, but desire for the asset class fundamentally hasn’t changed. If there were a risk of 5 million deaths as a result of Covid-19, then one would expect a serious decrease in demand. But that is not the case. The same doesn’t hold true for commercial property, however. That is simply because it is possible for people to spend less time in offices, and less time in retail stores. But it is not possible for people to stop living in homes.

As it stands, the typical residential landlord is currently forced to hold onto his property asset (at least temporarily) and is typically also forced to hold onto his tenant. His tenant may be affected by the crisis, but is most likely either working from home, being furloughed or receiving some form of assistance. If the landlord is unlucky and his tenant cannot pay then there is still a possibility that the landlord is receiving assistance himself, potentially through interest holidays on his mortgage. While this cannot be labeled as a positive situation for the property market, it is certainly not diabolical. It is possible, even likely, that prices moderate (at the very least the price growth seen at the start of the year will be halted). It is however unlikely in our opinion that this leads to a serious decrease in prices, and certainly unlikely to culminate in a full-on residential property market crash. A likely outcome is that the property market begins to re-open just as the global fear related to the virus starts to subside. Does the homeowner or residential landlord rush into a panic-sale just as the crisis starts to normalize? We think not.

Another aspect to consider is financing. While financing is currently difficult to obtain, this situation is unlikely to persist. Banks will be forced to pass on liquidity to clients, and lending will continue to be a vital part of their business. The benefit is that homeowners and landlords have just been given a new lease on low interest rates. Interest rates in the UK (and to an extent globally) never properly increased after the 2008/9 crisis. In the UK, some 10 years after 2009, the base rate had still only reached a peak of 0.75%. If there is one thing that is certain, it is that UK interest rates are going to be stuck at low levels for many, many years to come. One of the textbook risks when it comes to property investing is refinancing, but there is very little risk of interest rates increasing significantly over the coming years.

So financing is not expected to be a lynchpin for the property market, and so far we do not appear to have a credit crisis resembling 2009. Banks are certainly making large provisions for loan losses, but they are far better capitalized than they were 10 years ago. What about fundamental demand for the underlying asset itself? We’ve already discussed why residential property demand should be largely unscathed. But this is where our views on residential and commercial property start to diverge. There is fundamentally still a housing shortage in the UK. There is no real rationale for decreased residential property demand. If anything, people are appreciating their homes more than they did before. Not only are they spending a lot of time at home, but it is quite likely that work patterns will be altered permanently. Decentralization and working from home are not only effective cost cutting measures, but as it turns out they are also good business-continuity practice. Having a virus breaking out in a 500-person open-plan office is not good for any company. Additionally, families wanting to upgrade in order to have more space are probably more convinced than ever that this is the right move. On the flip side, many potential first-time buyers will now put off their decision to buy as they have potentially used up some of their deposit savings or are no longer in a position to obtain financing. Their need to reside in a home however does not go away, so they will remain renters and that will likely support the letting market.

The commercial property market is far more vulnerable in our opinion. Demand for the underlying asset is clearly deteriorating due to a raft of issues, not least the fact that tenants have sustained severe business disruptions, and most are unable to pay their rent. Some will go out of business completely. There is a much larger paradigm shift in motion. Traditional retail was on the decline before the pandemic started, but now the move to online shopping has intensified. Countless UK retailers have already gone into administration. There will be fewer high street retail outlets over the coming years, just as there will be less office space required (not just due to reduced workforces overall, but also due to an increase in decentralized working). An obvious cost-cutting exercise for most companies will be to reduce the size of their offices by employing strategies such as hot-desking, virtual meetings and working from home. Most investment banks have already made it quite clear that they are never returning to a 100% office-based model. Ultimately this potential reduction in demand, which we believe will be more severe for commercial than it will be for residential, is why we are bearish commercial real estate and unlikely to put capital to work there for the foreseeable future. Clearly not all categories of commercial property will suffer the same fate (online distributors will require larger warehouses for example), but overall there will be more losers than winners.

Residential property is certainly also going to feel the effects of increased unemployment, and reduced economic activity, but at least the structural demand for the underlying asset remains intact. Residential landlords are likely to have to reduce rents in response to the economic damage, but at least the overall size of the rental market is broadly the same. In contrast, for every company that goes under there is one less commercial tenant available. An article in the economist this week refers to the new “90% economy”. Well, we think 90% is optimistic and given the effect on psychology and the physical realities of social distancing the “60-70% economy” is probably more accurate. How many restaurants, bars and gyms survive at 60% capacity?

One final aspect to discuss, in particular as we always consider property holistically as a component of overall asset allocation, is the risk of deflation. While we believe this is an outside risk, it is worth addressing. Inflation is generally good for property for 2 reasons: The value of the debt underpinning it is eroded gradually with inflation and the asset itself offers a good inflation hedge as capital values tend to increase long-term, and rental values increase with wage inflation. That means that long-term leverage can be a huge catalyst in wealth creation. Unfortunately, the opposite is true for deflation. Deflation increases the value of debt thus having a detrimental effect on your net asset value. The world is undoubtedly currently experiencing dis-inflation (a decrease in the prevailing rate of inflation, not to be confused with deflation). It is quite obvious why – demand for many goods has dropped, entire industries such as travel and leisure are on hold, and some commodity prices (most notably oil) have plummeted to record lows. But we need to remember that at the same time an unprecedented amount of money printing is going on worldwide. Quantitative easing has been ramped up to levels never seen before. Ultimately this money needs to go somewhere and is likely to yield some form of inflation. Theoretically you can’t increase the money supply indefinitely without eroding the underlying value of all goods. Bizarrely, the current situation actually moderates one of the major concerns about QE in general – it is being done at a time where increased inflation is not a concern. Overall we believe these 2 factors should just about balance each other out in the short to medium term. Longer term it is impossible to say what the effect of all this stimulus will be.

Summarizing all of the above – we believe residential property still has its place in most investment portfolios: It should retain its underlying demand, it should remain an effective long-term inflation hedge, it is a beneficiary of cheap leverage (provided we avoid a deflationary environment) and it is a great diversification tool. But perhaps most importantly, it is a real asset in a world which is becoming increasingly digital and propped up by massive amounts of synthetic liquidity that is fast becoming a permanent fixture. We believe commercial property will fare a lot worse in the post-Covid-19 world.