“How did you go bankrupt?” “Two ways. Gradually and then suddenly” is a quote from Ernest Hemingway’s The Sun Also Rises.
It summarises how both Lehman Brothers and intu met their fates. We called the top of the shopping centre sector’s cycle five years ago and forecast a further 45% fall in prime values due to the Amazon effect and death of the department store.
To our ‘beds, meds & sheds’ REITs tag covering logistics, self-storage, student housing, PRS and GP surgeries, we have now added ‘breads’ for supermarkets and discounters. Their share prices are back to pre-Covid-19 levels, with Assura, PHP, Supermarket Income REIT and SEGRO using their shares as currency to move assets from the private to public market – which is what REITs are designed to do.
Grade-A London offices continue to perform well and supply has been constricted, with 60% of the 12m sq ft due for completion by 2023 under offer or pre-let. Prime rents are £110/sq ft in the West End and £75/sq ft in the City, with rent-free periods around 24 months for a 10-year lease. Incentives will rise and rents come under near-term pressure, but we do not think capital values will fall significantly with support from bonds.
There isn’t oversupply, so the risk to London offices is lack of demand, but we think the market is heading for equilibrium and have upgraded our forecasts. Reoccupation of offices is feasible with 1m social distancing, WeWork is heading towards profitability and IWG is buying rivals, as it did after the financial crisis. The 6% of London office space operated on this model seems stable and here to stay.
The equity market is negative on London REITs; expecting a mass exodus to the ‘burbs, but calling an end to centuries of urbanisation is probably premature. Covid-19 might slow the process but is unlikely to stop it and major Chinese cities such as Shanghai and Beijing have adjusted to serial pandemics.
Working from home has its limitations, especially in collaborative industries. There is the risk that every weekend is a long one; PwC is developing facial recognition software to check employee ‘at the keyboard’ time. The death of distance started in 2000 and with all the talk of relocating to rural idylls, it is probably a good time to sell the Georgian rectory in Somerset.
High-rise buildings face issues of access. Returning workers will need to go up in socially distanced elevators and exit down stairwells. Office seating areas, like public transport, will be contactless and require masks to be worn. The losers will be old buildings with small lifts, as their lift core cannot be expanded. Modern air conditioning in grade-A offices provides a swifter change of fresh air and higher filtration than 1980s or 1990s buildings, which will need expensive retrofitting.
Short, sharp shock
Covid-19 is a ‘short, sharp shock’ with more similarities to 9/11 than the global financial crisis. In April, we concluded that REITs were cheap at 50% discounts to NAVs; they rebounded 25%,then gave up half these gains.
Unlike 2008, REITs are now well prepared, having hoarded cash to bridge this income interruption. Rent collection reports can, however, make it tricky to separate tenants that have paid their rent and those that settled after ‘reprofiling’.
It is a timely pretext for REITs to cut dividends and alleviate earnings pressure, which had led them to invest in high-yield but high-deprecation assets. REITs are cheaper than buildings ahead of an expected rerun of £30bn of asset stripping in the early 2000s. REIT analysts are cutting earnings estimates more aggressively than during the financial crisis, leaving room for a rebound on revisions.
We have upgraded our London office forecasts and what was capitalised at 3.75% will probably trade at nearer 4%. Rents may soften 5% to 10%, with little growth and increasing appetite for value-add assets.
There is optimism that a vaccine will be ready by the end of 2020. The government is prioritising restarting the economy and has reopened lidos, hairdressers, nail bars and tattoo parlours. The economic bounce is likely to look more like a reversed square root zigzag and then a ‘corrugated’ recovery, at Ford Focus rather than Turbo RS speed.
REIT dividend yields of 3% to 4% aren’t exciting, but with bond yields near zero and equity markets paying less than half last year’s dividend, relative to other asset classes, REITs have their attractions.
Mike Prew is managing director at Jefferies