In just a few short months, the Covid-19 pandemic has turned many aspects of life upside down and left investors working hard to assess what these changes will mean for different asset classes. In European real estate, Germany appears to be cementing its safe haven status, while margins may come under pressure in retail.
Structural changes accelerating in retail
The crisis has accelerated structural changes already underway in how people shop, increasing online retail spending at the expense of the high street. European consumers have been slower than their counterparts in the UK, US and China in embracing online shopping, but during the three months to the end of May 2020, online sales grew 20.6 per cent year-on-year.
Some European countries are now at a tipping point that will result in an acceleration of online sales penetration. Retailers are therefore expected increasingly to focus investment on their online offering. As an example, Inditex recently announced its intention to achieve 25 per cent of total sales from online (up from 14 per cent in 2019). It also plans to close 1,000-2,000 stores over the next two years. As part of this strategy, it is investing in stores that are ’fully-integrated, digital and eco-efficient’, and closing smaller stores reaching the end of their life cycle.
While many European high streets and shopping centres are not as over-rented as the UK or the US, and Europe generally has less retail space, retailers’ ambitions to rationalise their store portfolios are likely to result in rising vacancy rates in second tier high streets and shopping centres, putting pressure on values. This likely to discourage investment in the sector, reducing market liquidity and further weighing on pricing. Furthermore, restaurants and cafes make up a vital part of many high streets across Europe, and the European Commission has estimated revenue losses of 50 per cent for these businesses in 2020. Areas dependent on tourism, such as France, Spain and Italy, are likely to be most hit.
However, in Germany, there appears to have been a relatively steady improvement in restaurant trade as lockdown has been eased, with recent year-on year trade down only a small amount. This recovery has been possible in part because the German population has a high degree of confidence in the way that the government has handled the crisis, with an approval rating consistently around 70 per cent, in contrast with those of the UK, France and Spain, which have been below 50 per cent for the past month.
Supermarkets and DIY win as consumers remain home-bound
Supermarkets have been the clear ‘winners', both online and offline, and have added significant capacity to meet demand. Sales have rocketed as a result of stockpiling and more meals being eaten at home. Across Europe, supermarkets and larger stores saw faster revenue growth than the discounters because shoppers opted for fewer, larger shopping trips. Online food shopping is relatively underdeveloped in Europe but has seen strong growth recently. To meet demand, a number of retailers have opted for a click-and-collect model based on existing store networks rather than trying to fulfil demand from fledgling warehouse networks.
Retail warehousing focused on DIY and home furnishings has benefitted from expenditure on ‘nesting’ - investing in making homes more comfortable places to spend work and leisure time. In Germany, DIY stores continued to trade throughout the lockdown because they provided a necessary service for small tradesmen, while in the Netherlands most stores also remained open with social distancing rules in place. Out-of-town retail may prove slightly more resilient than expected as lockdowns ease because the size and configuration of stores should make it easier to accommodate changes in trading to ensure social distancing.
Physical stores in demand, but margins under pressure
While retailers with a successful omni-channel business model have probably been more protected during the crisis, strong growth in online sales has not fully offset losses of trade in store, demonstrating that physical stores are still an important part of the retail offering. A number of retailers have struggled to operate their online operational models in response to unprecedented online demand, as they are typically not as nimble as the pure play online retailers. There is a small positive for investing in the retail sector in the medium term as valuers may use the crisis as a reason to write down values for retail assets more rapidly than might otherwise have been the case. The resulting higher yields should reflect expected market rent corrections and compensate investors for the risk of shorter leases and longer void periods in the sector.
Warehouses see increased demand as supply chains move back home
The industrial and logistics sector has not been immune to the downturn. Manufacturers have had to adapt production to meet social distancing requirements; supply chains have been heavily disrupted, and the auto and aerospace industries have seen an almost complete shutdown of production. Nevertheless, sectors such as food retailing and healthcare have proved very resilient.
The crisis has highlighted the importance of understanding both tenants’ business models and capitalisation, and at a broader level, the various industrial and logistics subsectors, from last-touch urban logistics to standard warehousing to specialist storage and manufacturing facilities.
Niche players in segments hit hard by the lockdown, and that were already struggling before the crisis, have been seeking rent deferrals and may take time to recover. But looking ahead, warehouse demand from retailers is likely to increase further as they seek to address any shortcomings of their current fulfilment models exposed by the crisis. There is also likely to be an increase in demand for short-term storage as retailers seek to hold onto some unsold spring 2020 stock until spring 2021.
Online retail growth should drive demand for cross-docked warehousing and urban last-touch facilities, particularly around the largest European conurbations. There is also some evidence that companies are considering a move away from just-in-time production and will therefore require greater local, and specialist, storage to ensure they have a contingency level of supply.
Some of the trends relating to on-shoring and re-shoring production and reducing supply chains were already in evidence ahead of the crisis, triggered by Brexit and increased trade tensions with American and China. Covid-related global supply chain disruption may extend those plans.
Overall, demand for warehousing and distribution facilities is likely to increase post-crisis. This has underpinned consistently strong investor demand for industrial real estate, particularly in Germany, cementing its reputation as a safe haven. However, the crisis has confirmed that the ability to deliver income security and rental growth will be a function of understanding the tenants’ business, their location and the type of asset.
The changing functions of offices
Office workers have been the least disrupted by the lockdown. A new generation of video conferencing and file sharing tools has helped shift work from the office to the home.
In the short term, the trend towards reducing space ratios will be reversed to ensure adequate social distancing. The impact of this will vary from country to country as different standards for ‘grade A’ space exist. In Germany, occupancy ratios are high (22 sqm per employee vs 9.6 sqm in the UK), it is less common for grade A offices to be air conditioned, and proximity to windows/natural light is mandated, so it may be easier to develop policies that allow a return to work compared with the UK where space ratios are low and hot desking is common in modern air-conditioned open plan offices.
A longer-term trend may be a reduction in office needs altogether. A number of organisations including SAP have indicated that they intend to allow all employees to elect to work from home permanently. This will speed up trends already visible before the crisis, but it is not clear how it will change demand for space. Offices are likely to continue to play an important role in facilitating meetings, team working and cross-fertilisation of ideas, as well as developing and supporting the corporate culture.
Work also plays an important social function, and many workers will be happy to return to the office, even if it is for fewer days per week. Before the crisis, we were already seeing a gradual change in the balance between formal and informal meeting spaces and desk space in conventional offices, and we expect this to continue. Employers are also likely to continue, where possible, to introduce wellness facilities to attract and retain employees. Amenity-rich locations offering attractive live-work-play environments will thrive.
A fork in the road
There are two paths the office sector could take. If the office’s prime purpose becomes bringing people together for specific meetings and collaborations, there is likely to be a preference for centrally located, easily accessible locations. However, if the capacity of public transport is reduced significantly by social distancing for a prolonged period of time, we may see an increase in demand for locations that support car-based commuting or suburban locations that can be accessed easily on foot or by car. The resulting increase in carbon emissions would go against ESG goals and mark a dramatic reversal of trends seen over the past 10 years. In the longer term, locations most at risk are probably poorer quality, less accessible fringe locations within cities, particularly if alternative residential use is a possibility.
Student housing disrupted, but residential and data centres still in demand
Investor demand for residential assets is likely to remain robust, and German and Dutch markets remain well placed to meet it. The challenge for those seeking exposure to the residential sector is a shortage of suitable stock, with most investment this year taking place at the entity level rather than at asset level. A key route to exposure is therefore through development of new stock. However, it will be difficult to access funding for this in a recessionary environment.
Student housing had been seen as a relatively resilient sector. In previous recessions, students opted to remain in tertiary education given the limited employment opportunities. However, universities have become increasingly dependent on overseas students, and many student housing facilities have targeted this market. The sector is likely to be disrupted for at least the next academic year, and potentially for much longer as overseas students opt to remain in their home countries and lectures are delivered online.
Data centre demand has remained strong, and there are concerns that insufficient capacity is being added globally. In the listed sector, data centre specialists have proved to be some of the most resilient REITs globally (see chart below).
Scrutinising tenants’ ability to pay rent
Government policy will remain an important aspect driving the trajectory of the recovery. It will also determine how far landlords are protected from loss of income in the short term. In Germany and the Netherlands, the government and industry bodies were quick to establish expectations for landlords and tenants. In contrast, messaging from the French government has been unclear and a framework for landlord and tenants to reach agreement has not been laid out. These differences in governance are likely to further cement Germany’s reputation as a safe haven for real estate investors, particularly those focused on stable income returns.
The crisis has also shone a spotlight on the importance not only of covenant strength, but more broadly of understanding tenants’ business models and balance sheets. This is key to their ability to continue to be able to pay rent. We expect that real estate investors will pay more attention to tenant due diligence and the definition of prime assets will now rely more on the security of the income stream than on location and profile.
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