What Kind of Future for European CRE Sector?

As we face uncertain times, the question is perhaps not whether European commercial real estate will be affected by Covid-19 but how severely and for how long.

Risk reassessments and social impacts will speed up structural changes, although the consequences will likely diverge between locations and asset types. Differentiation between prime and secondary assets and locations will increase, and investors will focus more on assets in prime locations. Investor flight to quality will result in commercial real estate value and debt being repriced, as already indicated in the CMBS and REIT equity markets.

In the short term, differentiation will also likely occur between asset types with sectors most exposed to non-essential activities, social distancing, and international customers. Beyond 2020, structural trends will accelerate the reshaping of the commercial real estate sector. The office sector may be at an inflection point following the successful world’s biggest-ever working-from-home experience. The already gloomy retail outlook will also likely worsen, while logistics, residential and healthcare may benefit from capital reallocation. One sector heading for a top-to-toe shake up is undoubtedly the hospitality sector, which will need to adapt to the new trends to even break even. This will take some years, while student housing may also have a more prolonged recovery.

Most non-essential businesses have faced a sudden and unprecedent halt in their activities, exposing many to a liquidity crunch. Most exposed or opportunistic tenants have partially or completely stopped paying rent, in some cases advocating for a force majeure type of event. Consequently, landlords have a tough time ahead as they experience not only rent deferrals, but lost rents if they fail to show flexibility.

Government measures will likely not allow for enforcement in the short term due to missed rents. Indebted landlords immediately started cutting cash outflows by reducing operating costs (including temporary lay-offs), postponing capital expenditures and drawing on their liquidity lines to honour their debt payments.

As for CRE lenders, they’ve taken a wait-and-see approach to new transactions; currently only pre-crisis committed deals are being executed. But this should be temporary and not attributable to underlying factors affecting their ability to lend unlike during the GFC. Lenders are reviewing their books, reassessing the credit risk of the sector and their portfolios, while appraisals are also on hold.

Borrowers with debt maturing soon will therefore be exposed to lengthier refinancing processes. In fact, there are already signs, through ongoing price discovery, that (re)financing conditions will tighten. Lenders are now focusing on areas that were not at the centre of attention recently, like liquidity risk, counterparty risk and tenancy industry profiles. Fundamental cashflow-driven analysis will more than ever be the cornerstone of commercial real estate investment in the near future rather than focusing primarily on leverage metrics.

Abode2 expects that this will result in increased differentiation between prime and secondary assets and locations. This means that after some years of decrease in the gap, asset differentiation will materialise in terms of both yields and refinancing conditions. This will be accelerated with some commercial real estate appraisals likely to tumble when the dust settles. We certainly have interesting times ahead.