Retail on the brink as social distancing bites
Covid-19 will impact sectors in different ways. Retail and hospitality are dependent on state aid for survival, while the logistics sector faces supply chain reconfigurations. James Wallace examines the emerging sector-specific picture ➠
It remains unknowable how exactly
the impact of the coronavirus will play out. Its impact across societies, economies and sectors is practically impossible to forecast. Models which produce probabilities disguise uncertainty and often, like now, are based on shifting sands, assumptions in constant state of flux. However, beyond the scenario forecasting, we can envisage how, where and why the coronavirus will hit real estate sectors in different ways. In this article, we look at the impact on key sectors.
Retail, leisure and hospitality
Retailers have faced unprecedented disruption in the last decade, as structural and cyclical drivers have imposed a Darwinian environment of ‘survival of the fittest’ on the sector. In the wake of the Covid-19 pandemic, many stores and restaurants have shut indefinitely. More brands will permanently close this year. Net operating income (NOI) will fall drastically over the next month across the retail sector, with short-term rental concessions only granted by cash-stable landlords and reinforced by government protective measures.
The strain across the sectors is uneven: occupiers forced to shut – such as shopping centres, restaurants, pubs, gyms and cinemas – are most severely affected, while essential retailers providing critical products and services – such as supermarkets, pharmaceutical stores,
and food delivery services – are thriving. Consequently, retail parks, anchored by large supermarkets, are comparatively less impacted. ‘Vulture investment will become focused on grocery-led assets and retail parks,’ predicts Alice Breheny, global head of research at Nuveen Real Estate. ‘Retailers that are able to mobilise strong online supply chains will have a much-needed lifeline to their business model and profitability. Companies without an online channel like Primark, for example, are in a more compromised position.’
However, evidence of the impact on valuations will likely be delayed as asset valuations will not take place over the next month and open-ended funds in markets such as the UK have already suspended redemptions. ‘Many retail businesses will be dependent on government support to survive,’ says Chris Urwin, director of research - real assets, at Aviva Investors.
However, the same is true for some landlords, who were vulnerable prior to the Covid-19 pandemic, such as Intu. ‘While non-discretionary retailers such as grocers and pharmacies may be less affected by the severe drop in demand, most retailers are likely to experience a decline in footfall, supply-chain disruptions and difficulties in staffing stores in the months ahead,’ adds Urwin. ‘Many retailers are unlikely to make their rent payments in a timely manner and, absent government support, some could go out of business.’
In the UK, chancellor Rishi Sunak addressed the sector’s vulnerability with a one-year business rates holiday for all retail, leisure and hospitality businesses with a rateable value under £51,000, in addition to up to £330 billion in loans and guarantees, including business interruption loans and cash grants of up to £25,000 (see page 6). ‘This provides a much-needed lifeline in the near term, but the consensus in the market appears to be that more, much more, needs to be done to return the sector back to sustained health over the medium-term,’ says Hemant Kotak, head of UK research at CBRE. ‘Retailers may welcome the chancellor’s financial support as a step in the right direction, but the stock market’s reaction implied it lacked any real potency, given the background of a dramatic fall in footfall, tourism numbers and, since last week, store closures.’
In the Netherlands, footfall in the main central shopping streets of the largest Dutch cities has fallen by around 45-65 per cent since the onset of the crisis. ‘Retailers are depending on support measures from the Dutch government, which can’t head off the impending heavy blow to the retail sector, but it can certainly help mitigate it,’ says Marleen Bosma, head of research and strategic advisory at Bouwinvest. ‘The coronavirus crisis will result in more vacancy and falling rents, but demand may recover quickly provided a deep recession does not take hold.’
However, amid the crisis many brands
are mobilising to address immediate healthcare needs. ‘Luxury brands, brewers, and distillers are converting factories to make hand sanitiser. Designers, like Christian Siriano, are making masks and hospital gowns instead of ball gowns,’ according to Barrie Scardina, Americas leader, retail services, at Cushman & Wakefield.
The hotel sector was hit immediately and severely by the pandemic with room occupancy rates collapsing to unprecedented levels and many operators shutting their doors. ‘Hotel chains with low levels of capital reserves are being particularly hard hit, especially if they are spread over several European markets under lockdown and as alternative sources of income, such as hosting events and restaurants, also dries up,’ says Bosma.
Hotel operators can expect occupancy rates to drop for at least two quarters. ’Risks to staff availability may put a further strain on operators’ capacity to provide a service,’ says Carol Hodgson, senior director, global research, at JLL. Fergus Hicks, real estate strategist at UBS Asset Management, says hotel operators on leases may put pressure on rental payments. Post crisis, further consolidation within the hotel sector is likely, he says.
Most hotels are now closed across Europe, except for some airport locations, while some have converted into hospitals, quarantine facilities, shelters, temporary logistic spaces and work locations, while hotel restaurants are being used to produce food for delivery and staff are being redeployed with delivery companies or in other sectors.
Covid-19 will accelerate structural changes across the retail sector this year, prompting a sharp fall in prime retail rents and increases in yields. ‘An improvement in sentiment and economic conditions in 2021 would reverse some of the decline. That said, the retail sector will still significantly underperform over the next five years,’ says Amy Wood, property economist at Capital Economics.
Hotels are likely to suffer the same fate, as travellers become more selective about travel plans and reconsider non-essential leisure-related trips. This could lead to a resurgence in ‘staycations’, says JLL, as the return to normalcy is protracted. Destinations considered epicentres of the outbreak, such as New York, Italy and Spain, are likely to experience a prolonged downturn both in domestic and international tourism demand.
Global supply chain disruption is the pre-eminent concern within the systemically important industrial and logistics sector. Reduced activity at major gateway ports and airports is resulting in falling utilisation rates and idle resources. In the near term, the coronavirus outbreak may accelerate the use of automation and robots in operations and reduce the sector’s reliance on labour. Longer term, the outbreak is likely to prompt a rethink of supply chains across manufacturing companies globally, as companies seek to establish greater supply chain resilience through re-shoring, or near-shoring, as well as through diversifying suppliers and increased local inventory levels to mitigate disruption and risk.
‘This could result in additional regional demand for industrial facilities and associated logistics, but also potentially lead to reduced container flows at major gateway ports and lower warehouse demand in these locations,’ says JLL’s Carol Hodgson. ‘Technology will be key to securing greater supply chain visibility to achieve this.’ Longer term, the reacceleration in online shopping, particularly for groceries, could become permanent, which would also boost logistics space demand.
Nuveen’s Breheny adds: ‘All these measures are likely to come with a price tag, but logistics real estate is set to benefit from increasing demand as a result, apart from big seaports handling long distance global trade. Around Europe, low-cost locations in Eastern Europe, Portugal, Turkey and even North Africa could be possible beneficiaries. This long-term upside has to be balanced with severe short-term risks around factory closures, staff shortages and supply chain disruptions, which are set to lead to bankruptcies of the weakest retailers, 3PLs and manufacturers.’
Prologis says two new structural demand drivers have emerged during this crisis: the need for more inventories as supply chains emphasise resilience over efficiency; and the reacceleration of e-commerce adoption. Logistics operators, and supply chain businesses, have seen incredible volatility – first a slowdown and now the push of product – which underscores the need for flexibility and business continuity planning, says Prologis in its Covid-19 special report.
The outbreak also appears to be a catalyst for changing consumer behaviours that will both accelerate the pace of adoption and raise the ceiling of what can be transacted online. But the volatility signals – such as record US unemployment levels and European business activity surveys, such as purchasing managers’ index (PMI) fell to all-time lows – suggest a recession and that logistics demand could pause or reverse in H2, if not sooner, posing a risk to vacancy rates and rent growth, according to Prologis. ‘We expect that the short-term will be dominated by depressed economic activity and limited capital availability, especially for small- and medium-sized businesses. Fiscal stimulus will help. Logistics real estate demand, occupancies and rent growth all face headwinds.’
In Germany, Realogis-RLI Group, the logistics and industrial property group, claims significant growth in enquiries from food retailers and wholesalers that intend to set up new distribution and shipping hubs, and want to purchase property at short notice. There is also strong demand for rental space for home delivery services. However, global supply chains are also being put to the test, says Umut Ertan, founder of the Realogis-RLI Group.
Government-mandated homeworking for all but key workers across Europe has left offices empty. The easy decisions come first: occupiers will suspend all lease decisions; landlords will suspend new developments and capital expenditure projects. Even if the sector rebounds in H2, office job losses are inevitable as stalled economic activity will prompt corporates to retrench.
Landlords’ rental cash flows will be protected if their tenants are in long-term leases, and if occupiers’ businesses have similarly resilient cash flows. However, landlords with exposure to short-term leases, which includes the stress untested coworking sector, and companies themselves come under cash flow strain, could see rental shortfalls.
Indeed, a shakeout in the coworking market could well emerge. SoftBank has revoked its offer of $3 billion worth of shares in sector behemoth WeWork, although the Japanese bank remains committed to its $5 billion bailout. In an interview with Forbes magazine, SoftBank founder Masayoshi Son admitted: “We paid too much valuation for WeWork, and we did too much believe in the entrepreneur.” In the London coworking market, Workspace Group reported it had received around 50 per cent of rents due at the end of March. Customer discussions on rent deferrals continuing on a case-by-case basis, the company said.
Many professionals will have a very difficult time working from home, including bankers, traders, medical professionals and those working for public agencies or institutions. While for others, such as lawyers, accountants and consultants, the transition will be relatively frictionless. ‘We are in the middle of the largest test of homeworking in history and corporates are adopting, refining and testing policies, processes and infrastructure to make it work,’ says Marie Puybaraud, global head of research, corporate solutions, at JLL.
In the aftermath of the crisis, companies will need to tightly control fixed costs, thus greater homeworking and lower office space would align some employer and employee interests. ‘Over the medium term, forced working from home may break down cultural resistance in some markets and reduce floorspace per
worker ratios,’ according to UBS’s Fergus Hicks. ‘Serviced office models may be properly tested for first time as their flexibility enables the self-employed and corporates to quickly vacate space they no longer need.’
Much depends, of course, on the severity and duration of the quarantine which may vary widely between European office markets. Rising office vacancies and rental reductions, to varying degrees, are inevitable in the short to medium term. ‘Investors may reassess their underwritings, in particular on future rental growth expectations,’ says Hicks. ‘But even lower interest rates may negate weaker rental growth once the market returns. Valuation levels depend on how valuers factor in lower liquidity (in the short term). We expect a “wait-and-see” approach in the short term but don’t expect vendors to offer discounts.’
While many of the residential subsectors should be more resilient due to the underlying demand strength and mismatch with supply, there are risks here too. In the student accommodation sector, many students across the UK and Europe opted to return to their family homes after governments closed universities and asked to be released from their rental obligations. If global travel and higher education remains disrupted by late summer, occupancy rates for the 2020-2021 academic year will come under pressure, warns Aviva’s Chris Urwin.
A slowdown in international applications
in the autumn academic year would have implications for purpose-built student accommodation (PBSA) assets in development across Europe. In the build-to-rent (BTR) sector, governments across Europe have promised to support renters, which should support institutional owners. Opportunistic capital will be monitoring PBSA developers and existing asset owners for signs of distress, ready to step in and acquire incomplete schemes and built assets from overleveraged owners caught out by a potential liquidity squeeze.
By contrast, effects on multi-family markets are likely to be more limited
as markets are more driven by demographic mega trend, according to Hicks, although he warns: ‘If unemployment rates rise significantly future rental growth expectations may need to be revised downward.’
Construction has also crawled to near standstill. Purchasing managers’ index (PMI) levels in the UK, Germany and France have all fallen to the 30s. In Italy, the PMI has contracted to 15.9. A possible consequence in time will be delayed, reduced, or scrapped flagship infrastructure projects. In the UK, the government will have some tough decisions to make regarding the viability of HS2, Crossrail 2, Northern Powerhouse Rail, Midlands Rail Hub and Heathrow’s third runway.