Curlow's convictions: Roadmap to Recovery
Varying vaccine progress leading to possible herd immunity but an uneven road map to recovery: Timing of vaccine availability, combined with willingness (or not) of populations to take it will vary the timing of recovery across markets. The US and UK were swift out of the gates to order vaccines, but their populations are in stark contrast as it relates to their willingness to take them – the British population far more willing than their American counterparts. Continental Europe is similarly seeing some stark variations by geography with southern Europe more closely aligned with the UK while the French and German populations are more reticent.
Renewed inflation risks are leading to a consequential rise in interest rates: Unprecedented and coordinated government and central bank response to the pandemic is leading to transitory inflationary pressures and a consequential rise in interest rates. However, it is important to emphasise that rising rates do not equal high rates. This is the biggest change to the macro outlook as the US stimulus package is larger, and therefore the recovery expected to be stronger and swifter therefore raising the risk of inflation. We think this inflation will be transitory and short-lived as pandemics have historically shown to be disinflationary shocks to economies. As a result, we think countries struggling with disinflationary forces before Covid (Japan, Eurozone) will continue to see a subdued inflation outlook.
Central banks likely to remain cautious and accommodative: The strong fiscal support governments have provided to ensure those industries most negatively impacted by the pandemic pull through, has led to a notable increase in debt levels. While alarming at a headline level, the current low interest rate environment means these higher debt levels still come at an affordable and sustainable servicing cost. Central banks will be acutely aware of the risk that raising rates too fast increases insolvency risk of not only sovereigns but also corporates and households which are still trying to recover from the pandemic. As a result, we think that central banks will remain accommodative and keep interest rates at or near historic lows even if we see some modest rises in inflation which are temporarily above target. This should continue to support real asset pricing which currently enjoys historically wide spreads relative to bonds (both domestic government bonds as well as corporate IG benchmarks).
Divergent ‘K’ shaped real asset sector prospects during COVID are now coming full circle to a ‘V’: The acute revenue disruption the COVID pandemic brought to those real asset sectors reliant on physical interaction (airports, hotels, retail) versus those benefitting from lockdown measures and remote working (notably residential, data centres and logistics) led to a ‘K’ shaped sector divergence during the pandemic. As we now transition from a pandemic disruption focus on rent collections rates towards one where all sector prospects become a bit clearer, we expect the ‘K’ to come full circle to a ‘V’ as underlying property fundamentals across the board normalise and recover. Current lockdown restrictions continue to hamper leasing and sales activity but new searches and project sale launches suggest a strong rebound in the second half of the year may materialise.
Defensive thematics underpinned by megatrends to be a long term, through cycle, focus as underlying demand fundamentals remain attractive and supply insufficient: These trends support the real estate sectors of residential, healthcare and logistics along with the communication infrastructure of fibre networks and data centres. The chronic undersupply of provision which is common amongst these sectors is expected to continue to support above inflationary rent growth for the foreseeable future. We think this will be sufficient to compensate for more modest yield compression going forward amidst the modest rise in interest rates. Development strategies continue to offer an attractive entry point and relative value trade within these segments as standing assets are hotly contested in the open market given the amount of capital targeting these strategies.
Offensive recovery plays become more under writable but distress limited: Reopening of the economies allows for a swift recovery in airports and hotels (with leisure travel expected to lead the way as corporate/business travel is likely to lag) while pressure on profitability will result in retailers’ licking their wounds for years. Ultimately, the COVID pandemic may have been the catalyst to drive the much-needed conversation on rebasing retail rents to a sustainable level thereby allowing for yields and capital values to adjust to reflect this more sustainable NOI. Banks are better capitalised compared to the GFC and are still working to redeem the reputational damage from the financial crisis so have been more willing and able to waive covenant breaches and limit foreclosure activity.
Office demand and the future of working is still murky but becoming more clear as more employees gradually return to the office across the world: Deferred leasing decisions as a result of the uncertainty surrounding future office usage amidst the COVID pandemic is leading to growing pent-up demand. As occupiers deferred leasing decisions during the pandemic, they have effectively stacked a couple of years of lease events on top of one another which when unleashed will likely lead to a significant wave of take-up. The more efficient usage of office space going forward is unlikely to lead to a wave of positive net absorption but we expect the bulk of this demand to be focused on top quality assets in the well-connected established office locations. In a post COVID world we expect office occupiers to focus on two key priorities: 1) peak (and not average) demand as it relates to their ultimate space needs – akin to how transit infrastructure is planned and 2) high quality, flexible modern office stock as it relates to the types of buildings demanded. In Europe this type of product is extremely limited due to the traditional age of stock which is old in a historical context and a delayed development pipeline post GFC in line with the delayed economic recovery. The pandemic has further accelerated the ESG focus of both occupiers and investors alike and while rental premiums are yet to be clearly evidenced higher investment liquidity and stronger pricing metrics is becoming increasingly evident. Furthermore, the capital markets have acknowledged the potential change in demand patterns with a healthy reconsideration and pricing of risk, outside of prime assets where investment appetite remains sound, following an increasingly alarming number of years of risk creep whereby investors were accepting higher risk without additional reward in compensation.
Investment pricing and the need to consider capital value relative to replacement cost and implied underlying land value: The multi-decade decline in interest rates has driven property yields to record lows with the impact on capital values implying a steep rise in land values. While this dynamic varies widely by sector and geography the implicit impact on investment performance (i.e., risk) may turn out to be significant so it is critical to consider a more widespread set of parameters when investing in the current market. Properties with more limited alternative use or high conversion costs tie the majority of value to the current user as re-leasing costs could be significant. This is a particular concern for investment in non-urban locations where more limited alternative uses could severely impact property values should a key tenant vacate. In the current market context, we feel it is critical for investors to consider the wider rental situation (i.e., in place rents vs market level) and how that translates via cap rate/yield to an ultimate capital value, implied land value and comparison to replacement cost. With the COVID recovery now coming into play, the income growth story is becoming more widespread than the focused long—term secular megatrend growth stories which were at the forefront of investors preferences over the past 18 months but it is critical to keep in mind the valuations and implied land values just in case the inflation and rate risks do materialise.