Outlook: lockdown losses

While there is every hope that the economy and property values recover swiftly from the trauma of containing the coronavirus, it is likely to accelerate profound change in the nature of occupier demand.

INDUCED ECONOMIC COMA 

The improving UK economic sentiment at the beginning of the year now seems a distant memory. Drastic international measures to contain the spread of COVID-19 will inevitably plunge the world into a global recession in 2020. Amid the fallout from the lockdown, the Office for Budget Responsibility (OBR) forecasts UK GDP to drop by a staggering 35% in Q2.

As also seen across the globe, the UK government has unleashed an unprecedented package of support. Wide-ranging measures, including among others the jobs retention scheme, £330bn of business loans and an additional £200bn of bond purchasing, may come at an extraordinary cost but are seen as necessary to stave off irreversible long-term damage.

Landlords are having to do their bit to keep tenants afloat, partly imposed on them through the Coronavirus Bill, which allows three months rent deferments. While this is sensible on a short‑term basis, it will not be sustainable. Despite all the government support, many previously untroubled businesses are now battling to survive the lockdown, bringing previously rock-solid covenants into question.

HOPING FOR A V-SHAPE

Debate surrounds how the recovery will play out. Unlike crises of the past, economists are beholden to epidemiologists to chart the path of the recovery. If the virus is contained and lockdown measures are lifted in the coming weeks, hopes are for a swift ‘V-shaped’ economic recovery. Experian’s V-shape scenario points to circa 6% fall in GDP in 2020 as a whole, followed by strong growth of circa 8% in 2021.

Some comfort can be drawn from the reopening of economic activity at the very source of the virus, in Wuhan, China, roughly three months after the crisis took hold. While all eyes will be looking to China for signs of a strong rebound, nationally contrasting fiscal responses, healthcare systems and economic structures challenge direct comparisons between China’s path to recovery and the UK’s.

MARKETS IN SHOCK

Understandably, the global financial markets have been extremely volatile in recent weeks, reacting daily to news of the spread of the disease and announcements of economic support, particularly from the US, the world’s largest and among the most widely affected economy from the pandemic. 

While sentiment in the property markets has turned negative across the board, this is mostly reflected in the postponement of deals and the withdrawal of stock from the market. This is likely to severely curtail volumes in Q2, potentially to a record low, with the strength of the rebound in the latter half of 2020 contingent on activity returning in the economy.

FLIGHT TO QUALITY

For the time-being, the simple practicalities of the lockdown, let alone high levels of uncertainty over the recovery, challenge an assessment of its impact on values in 2020 and beyond.  Evidence to date, from MSCI, reveals that All Property capital values fell by 2.4% in March, the sharpest month-on-month fall since the wake of the Brexit EU Referendum result in July 2016. Although this was driven by falls in the retail sector, the office and industrial sectors were not immune.

While further falls in values can be expected over the coming months, high loan to values compared with the 2008 crisis and a lack of distress in the direct market should mitigate against forced selling and protracted value declines. Values for defensive, long-income product should hold up relatively well. Historically low bond yields continue to support the investment rationale, while sterling’s latest bout of depreciation will add another layer of attraction for overseas buyers seeking safe havens.

FLATTEN THE (SUPPLY) CURVE

How the market performs over the coming 12 months ultimately depends on how the economy and occupier markets recover. Based on the previous downturn, Experian’s forecast increase in unemployment - from a 40-year low of 3.9% to a peak of 6.2% over the coming months - points to a circa 5% fall in All Property rental values. Notwithstanding the fundamental difference between the two downturns, this is less than half the fall seen at the global financial crisis in 2008.

Another fundamental difference between this cycle and the last is that supply levels are relatively tight this time around. Moreover, practical constraints to labour and supply of materials caused by the lockdown will postpone development completions across the UK business space markets, which should also mitigate against steep rental declines. 

ACCELERATING CHANGE

While there is every hope of a swift recovery, the fallout from the lockdown will have profound long-term consequences across each of the property sectors. In a cruel twist of fate, the lockdown has fallen particularly hard on the already structurally embattled retail sector. Even if the major retail landlords offer their tenants major concessions, a fresh wave of high street failures is inevitable.  But, painful as this is, the spike in failures will help to accelerate the transitioning of our high streets, offering new opportunities for investors.

The lockdown is also likely to accelerate change in the office sector. In something of a forced experiment, approximately eight million people in the UK swapped their office for home as a place of work, many for the first time. Far from signalling the ‘end of the office’, landlords should expect requirements to be guided even more by the quality of space (working environment and location) over quantity, with the office largely performing in a hub role for employee interaction and client-facing activity.