The Q2 Four Quadrant Market Update

Covid-19 bared its teeth in Q2 as we started to see the full effect of the pandemic on global real estate, with the short-term implications of the pandemic on economic growth and business activity. General consensus estimates that a recovery would come in the latter stages of this year/early 2021, although the situations remains fluid with uncertainty.

That being said, our recovery estimates remain as we have seen governments continue to provide fiscal stimulus and liquidity measures to help kickstart companies, boost public spending, and encourage a return to work while keep the property market afloat.

The flipside of these drastic but necessary measures is that real estate companies have undergone increased financial scrutiny, with mortgage payment holidays, hiatus on serving of eviction notices, and inability of landlords to forfeit business leases due to non-payment of rent.

In Q1, we saw the early impact of lockdowns across Europe appear in capital growth: with UK property capital growth shrinking 0.9% (and 1.3% in Q4 FY19), with ERV remaining flat. Now as we pass through the first full quarter under lockdown across the vast majority of the world’s economies, it’s important to look at where the impact has been felt beyond capital growth.

But before we do that, let’s look at where there has been some progress. While direct real estate transaction activity and development projects have been temporarily stunted, several market changes have continued to emerge and make headway with no impact from the pandemic:

LIBOR discontinuation progress

SOFR adoption has continued with LIBOR quotes to be phased out by December 2021, with the SONIA rate now being used on a number of real estate-related bilateral loans (with certain syndicated loans including a conversion mechanism for the transfer). See a greater analysis here.

German rental caps

As of 18th June, Berlin has passed the act of Redrafting on Rent Limits for a period of 5 years – which has largely been introduced as result of the flows of international capital into Berlin and the construction and redevelopment of high-end apartment complexes – pushing rental prices up. Exemptions will be applied for social housing related assets, and rent freezes will apply to all existing leases (other than those excluded here).

Land registration in Scotland

Historically, the Land Registry of Scotland has not permitted scans of property deeds to be accepted for registration purposes. As a temporary measure during the pandemic, a new Scottish Act has amended existing legislation to permit submissions to the land registry in digital form – accepting signed paper deeds by electronic means.

While there has been some progress made during this time, it’s important to look at the effect on finance and investment in this asset class through the 4 quadrant model – a model created by DiPasquale-Wheaton (1992) that has been ingrained into RE5Q (the 5th quadrant of real estate).

Through the remainder of this update, we focus on providing colour to the 4 quadrants of real estate; Public Debt, Private Debt, Public Equity and Private Equity.

Public Equity

By looking at the MSCI Europe Real Estate free floated-adjusted market cap index (consisting of large and mid-cap equities across 15 developed European countries), cumulative price returns for the period are down 23% from their YTD, and down 7.96% for their 3-year returns (with a Sharpe ratio -0.38).

Diagram 1: MSCI Index
Source: MSCI

While technology stocks have largely regained their pre-COVID momentum (with some perceiving technology to be a safe haven), REITs have somewhat stabilised, albeit at a 20% – 30% decline from their YTD values. As we have shown in the past[1], REITs heavily weighted in Logistics, Data Centre and HealthCare assets have performed relatively well. Hospitality focused REITs, those with large weightings in Casinos, Hotels and Retail have notably underperformed and felt the full force of the pandemic. As we approach the path to a new normality, the future of the class remains foggy.

General share price movements have seen significant splits in asset level performance. Four of the ten best performing assets are heavily weighted in logistic and industrial sectors – benefiting from the publics move into the virtual space. Diagram 2 shows Tritax Big Box REIT making headway in share price returns – with a share price jump of 30%.

Diagram 2: Share Price Performance Data
Source: Bloomberg, Marten & Co

Long-term, a bearish outlook for the student housing and hospitality sector is expected as the full force of the pandemic comes into play. With negotiations continuing around which countries can have land bridges with the UK (so that tourists can have free movement and visit regions that structurally rely on tourism), mass uncertainty lies ahead. Even with successful agreements for land bridges, we expect ever-volatile fluctuations in demand as a significant knock in confidence for tourists is anticipated, further, to be exacerbated with the looming of a second wave and regional lockdowns coming into play.

Private Equity

Private Equity Real Estate (PERE) investors seem to be concentrating capital commitments with fewer managers, with Preqin research showing a reduction in the number of global real estate funds closed in Q2, dropping from 78 in Q1 to 53 in Q2 – despite increases in capital raised (from $28Bn to $39Bn in Q2). Real estate private equity deal volume plunged in Q2 – deal transactions dropped from 1,904 (Q1 20) to 988 (Q2 20), a 48% decline. Similarly, deal value fell to $30Bn, a decline of 62% from Q1.

Diagram 3: Real Estate Fund Raising, European Focused Funds
Source: Preqin, Q2 2020

At a high-level, Preqin illustrates that North American and European markets fell the most in Q2 2020, declining 50% and 45% respectively. On a sector basis, deals for the quarter in residential and industrial markets appeared to sustain the most, albeit experiencing a 23% decline.

Diagram 4: Global Quarterly PERE Deals (Type)
Source: Preqin, Q2 2020
Diagram 5: Quarterly PERE Deals (by Region)
Source: Preqin, Q2 2020

Public Debt

In Q2 it was assumed most European Commercial Mortgage Backed Security (CMBS) transactions would be able to deal with the liquidity stress in the short-run, although did conclude that the impact on CMBS would differ by sector – where lodging, hotels without fixed leases and co-working office spaces would have the greatest exposure and feel the pandemic most acutely.

CBRE research showed that since April, CMBS spreads on AAA have declined 75bps from 275 bps to 200bps – although their February peak. Moreover, A and BBB spreads are at 270bps and 370bps respectively, above their ending February levels. In hotel and retail markets where owners are poorly capitalised on highly leveraged assets, owners may see intervention and a rebalancing of capital as lenders look to recover control of borrowing against assets. For loans backed by lodging related assets, servicers have initiated forbearance plans where debt service is not payable for 3 months. S&P Global note that with the likelihood of the pandemic continuing into early 2021, it’s reasonable to assume that sponsors may relinquish equity in an effort to stabilise assets to cope with the headwinds of the pandemic.

In terms of corporate bonds, Unibail-Rodamco-Westfield (URW) issued 2 offerings of senior tranches at €800MM of 10-year debt and €600MM of 5-year (in aggregate €1.4Bn) at a coupon of 2.625% and 2.125% respectively – noticeably smaller than the spread of the €750MM raised in October. URW also noted that there was strong demand, with an order book in excess of €3Bn for the placement. With the US New Issuance market reopening (halted since mid-March), S&P Global assume a relatively slow Q3 for 2020 – with full-year expectations in the $40-$50Bn range, totalling $28Bn of that issued in the first half of 2020. S&P Global Ratings research also showed that downgrades continued to outpace upgrades, with a total of 107 in the first half of 2020.

Source: S&P Global Research

Private Debt

A recent report from CBRE on Private Debt highlighted that there have been several noticeable improvements in lending and valuations.

Rent collection data has shown that lender sentiment has improved in predicting short and medium term cashflows, inferring that new lending business is up over its Q1 results. CBRE research further showed that there are drawbacks in uncertainty around lender funding costs – volume in CDS spreads and corporate bonds have reduced, with levels greater but more stable than before. Sentiment around valuations has also began to deviate from Q1, with uncertainty clauses being removed in some areas of the UK market. CBRE also noted that there has been an increase in lender variety, making a slow but clear effort to initiate new business activity. See the original CBRE paper here.

A view towards recovery – concluding remarks

While the picture of recovery is mixed, what has been encouraging is to see some new shoots of growth and recovery start to appear as markets reopen, at least for some of the 4 quadrants. Q2 was critical from the perspective of it being the first quarter to feel the full force of COVID-19 – where would activity taper off, who would survive.

Q3 2020 will be all about resurgence – and us like many other analysts will be keeping a close eye on the sector as we look to spot where this growth will emerge and what normal starts to look like for a sector that has been severely impacted to date. 

[1] See previous RE5Q Capital Market updates