'Office sector currently creates the most debate,' says Principal real estate expert
Asset News: What has been the effect of the Covid-19 crisis on the property sector and on your strategy?
Simon Hedger: The Covid-19 crisis has amplified both positive and negative trends already evident the various property segments prior to the pandemic. In the retail property sector, we were already combatting e-commerce headwinds. Because of the lockdown, people ordered goods online and worsened the trend. We were underweight that sector before and remain so now. Conversely, logistics benefitted from the positive trend due to the e-commerce frenzy therefore we are overweight in that sector. The logistics sector is very much undersupplied in terms of available space. We are invested in Segro, Prologis, Goodman and target logistics stocks that offer, based on fundamental bottom-up research, superior prospective returns. That said, stocks in that segment are trading at significant premiums already and that is an issue for us.
Individuals have come back to outlets and shops, do you consider going back on retail property stocks/REITs?
Retail spaces recorded a dramatic increase in footfall across Europe and in the US in Q3’20 as various country economies re-opened following lockdown, but they are still largely behind figures of last year. We have witnessed a sell-off especially in Europe after Unibail-Rodamco-Westfield and Hammerson announced their respective proposals for capital increases. The main issue lingering for the retail landlords is about whether they could go back to tenant occupation, consumer footfall and rent collection levels that we had before the Covid-19 crisis. Generally speaking, structurally it appears that current retail rental levels are too high. Thus rents need to be lower to enable retailers to make economic returns again, particularly in the US and in the UK.
This implies there is potential for further downside in valuations for the retail sector. Valuation yields for retail assets owned by some stocks appear to still be too firm, implying, with rents under pressure, valuations are likely to trend lower. In conclusion, despite the large discounts retail stocks currently trade at, we do not see an opportunity to meaningfully re-invest into retail at the current time. Generally speaking, there is much work to be done by listed retail asset owners to restore strength to balance sheets, including lease restructuring, asset disposals and equity issuance, before retail stock fundamentals will start to look attractive again.
What is the outlook for hotels?
In a similar fashion to retail, hotel valuations were written down at the start of the crisis. Occupancy rates dropped to 10% but that is a temporary revenue situation. If you take an iconic hotel, say the Ritz in London, it is likely the Covid-19 economic turmoil will not materially affect its longer-term value. Domestic tourism will help hotels recover in a first phase, we have already seen a bit of this during summer. The second phase will not start before early 2021 as companies will potentially look to re-start face-to-face meetings globally so they will authorise domestic and international travel to resume. Luxury travel will likely lag in terms of recovery. Towards year-end, occupancy rates in hotels could recover up to 25-40% then up to 50-60% in the first half-year 2021, depending on progress with controlling the virus. They may get back to previous from 2022. Thus, in summary, hotel revenues have experienced a big hit, but should recover slowly from here. The effect on valuation for hotel assets will vary depending on each hotel’s business/tourism mix. Hotels run by operators with stronger brands will likely fair better.
A lot of office space in its current state will thus likely be considered no longer fit for purpose and thus require a substantial upgrade or complete redevelopment.
Do you see any premia in stocks/REITs related to healthcare facilities?
Actually, healthcare facilities in various locations around the world suffered initially. Occupancy rates dropped for stocks in several countries before picking up again once government and healthcare bodies got to grips with the supply of safety equipment and other support measures for healthcare related facilities. Looking forward, demand for healthcare facilities are expected to experience steady to increasing demand. Many healthcare stocks receive at least a good proportion of income from government sources, thus underpinning asset values. Again, having a reputable operator is vital for stocks in the sector.
What is your stance on offices and the fact that the world is evolving towards a “flex office” model due to the Covid-19?
The office sector currently creates the most debate. Many articles have been published regarding Working From Home (WFH), as if this is a new trend, caused by Covid-19 lockdowns. In fact WFH is a trend that started many years ago, although it has been exacerbated by the current health-related crisis. Over time, once the Covid virus is under control, office occupancy will recover somewhat. To the extent that, going forward, companies decide they need less office space than they currently lease, any structural impact from lower demand, whether from a greater propensity to WFH, or simply due to the prevailing economic climate, will have a varying effect on the office market.
Apart from any impact from WFH, the Covid virus will in future require office accommodation to meet higher standards in terms of things like air quality & ventilation, health & safety, work and circulation space and many other aspects. A lot of office space in its current state will thus likely be considered no longer fit for purpose by some occupiers and thus require a substantial upgrade or complete redevelopment. Logically therefore, well located office buildings that meet these higher standards will likely lease up readily, while sub-standard accommodation will struggle.
In summary, demand for office space in most markets, until early this year, exceeded supply. We now face a period of uncertainty for office space. Is now a repeat of the Global Financial Crisis impact, following which the sector faced a downturn, due to a weak economy? Alternatively, is now a repeat of post UK-Referendum, where companies sat on their hands for six months, again due to economic uncertainty, but then promptly resumed near-normal activity, leading to a recovery in office demand? It is worth noting, that whatever the outcome, total net lettable office space in Central London has reduced by around one-third since the GFC, due to conversion to other uses, including residential, thus helping keep supply of space in check. This trend is likely to continue. Meanwhile, shares in office stocks are heavily discounted, relative to their underlying net asset value. Thus, arguably, through careful bottom-up stock selection, identifying those companies with office buildings still in demand, could prove quite profitable as the situation becomes clearer.
Rent collection is at a higher level and some open-ended funds have thus re-opened to redemptions.
What would Brexit affect your property strategy?
Brexit is currently causing uncertainty for the UK economy. Nevertheless, we hold selective exposure to UK listed property companies. These are predominantly specialist stocks in the logistics, self-storage and student accommodation sectors and are thus more driven by robust specific industry dynamics, rather than general economic trends.
What is your view on the wave of British property funds that have been frozen in recent months? How does that affect the sector?
Because of the relatively illiquid nature of the open ended property funds, in times of market uncertainty there may be occasions when redemption requests reach an elevated level relative to the liquid funds available to meet them. The past several months has been one such period, where certain real estate sectors have experienced low levels of rent collection, due to tenants not being in occupation during the lockdown period. Now that the economy has re-opened to a certain extent, rent collection is at a higher level and some open-ended funds have thus re-opened to redemptions. The real issue with open-ended funds is that the investment needs to be considered as long-term.