In Brief

In this uncertain, COVID-19-dominated environment, we consider three economic scenarios, along with our understanding of the real estate market’s regional and sector dynamics, to provide an informed perspective on real estate trends and potential investment opportunities. These are some of our key expectations:

• Accelerated e-commerce trends are likely to hasten the demise of lower quality retail centers and benefit top-tier assets while having a positive impact on the demand for logistics.
  
  
• Over the short term, the COVID-19 crisis is likely to increase both working from home and space-per-employee requirements within the office sector; longer term, space-per-employee requirements could ease, suggesting lower overall demand. These trends are likely to have a disruptive impact on coworking/flex leasing firms but a more evolutionary impact on traditional offices.
  
  
• Distressed opportunities are most likely to be found in locations and businesses with the greatest exposure to the impact of the COVID crisis (e.g., Orlando rather than the San Francisco Bay Area) and in highly exposed regional markets with relatively ineffective health and fiscal policies (e.g., the UK rather than Germany, Hong Kong rather than South Korea).
  
  
• For both core and noncore investors, success will depend on their willingness and ability to seek exposure before there is absolute clarity.  

COVID-19’s arc of destruction will likely near its apex soon, and we, like other researchers, need to consider recovery paths that depend more on public health than on markets. The gap in potential outcomes, bounded by South Korea’s seeming success and Spain’s apparent tragedy, is so wide and the possibilities so divergent that we felt compelled to consider three economic scenarios to drive our real estate market projections.

While we are traveling in uncharted territory, we are not without a compass. Combining these alternative macro scenarios with what experience has taught us about global real estate market dynamics, we offer our insights on projected real estate transaction activity and the impact of the COVID-19 lockdown on trends shaping real estate markets. Most importantly, we provide our views on the regions and sectors where we believe the most promising investment opportunities may lie. 

Scenario 1: V-shaped correction

Under a V-shaped correction, in which we have an increasingly low conviction, economic effects are limited to one half year of annualized negative GDP growth of approximately -10% to -15%. This implies that fiscal and monetary intervention to date will have been successful and that lost output can be recovered in just a few quarters.

In this scenario, the effects felt by the real estate sector should be minimal, beyond temporary disruptions to net operating income (NOI) and modest price declines. Additionally, a brisk rebound in public equity markets should bring above-target real estate allocations back in line, reducing rebalancing needs.

Scenario 2: Checkmark correction (base case)

This is our highest conviction scenario, under which economic activity initially corrects by roughly -10% to -15% before surging as lockdowns are lifted. However, health concerns lead to a staggered reopening of businesses and economic activity, and lingering effects of the shutdown temper the pace and extend the length of the recovery.

We expect this delayed return to normalcy to have a larger effect on real estate fundamentals, including rent growth expectations and risk spreads, possibly causing pricing to fall by 10% or more during the crisis period, with results varying by market and sector. Once there are clear signs that the crisis is ending, a relatively rapid reversal of price impacts is likely.

Within Europe, the impact of this type of correction on Germany is likely to be small when compared with that on Spain, Italy and the UK. In the U.S., markets with a higher exposure to the finance and TAMI (tech, advertising, media and information) industries, such as New York, Boston, Seattle and the San Francisco Bay Area, should hold up well relative to the rest of the country. Tourism and energy markets, however, such as Orlando, Las Vegas and Houston, are likely to face stiffer headwinds. Within the APAC region, markets with higher volatility, such as Hong Kong and Singapore, may experience a larger average drawdown in capital values across major real estate asset classes relative to other economies within the region.

Across all three regions, implications for logistics and multifamily housing are likely to be more muted, while drawdowns in capital value for retail and hospitality could easily be double the market average.

Scenario 3: L-shaped correction

This scenario, in which we also have low conviction, implies a prolonged crisis, possibly with multiple COVID waves that overwhelm health services as well as fiscal and monetary policies. GDP could contract by more than 10% in 2020, with little improvement in 2021.

In this environment, capital value corrections could match or exceed those of the global financial crisis (GFC) in terms of both depth and duration. Sustained damage to personal, corporate and government balance sheets could severely impact NOI, and peak-to-trough value declines in excess of 30% are possible. Sector and regional differences will likely be directionally similar but more pronounced than in our base-case scenario.

Implications for global real estate markets

Transaction market

Real estate investment activity has been falling as uncertainty prevails. Data from Real Capital Analytics (RCA) show that over the first 110 days of 2020, activity was down 57% in APAC and 8.5% in EMEA (largely driven by Europe), while the Americas (largely driven by the U.S.) saw only a 2.4% decline, vs. the same period in 2019. However, APAC is at least two months ahead of both the U.S. and Europe in its fight against COVID-19. With clear evidence of transaction volumes slowing in both the U.S. and Europe, it would not be surprising if, over the next quarter, both regions followed paths similar to that of APAC (EXHIBIT 1).

It is reasonable to expect Europe and the U.S. to experience a slowdown in real estate transaction volume over the next quarter similar to that already seen in APAC this year

Summary and conclusions

We expect most of the pandemic’s impact on real estate performance will be driven by the duration of regional epidemics. For both core and noncore investors, success will depend on their willingness and ability to seek exposure before there is absolute clarity. Under our base-case “checkmark” scenario, we anticipate near-term opportunities to acquire high quality equity and debt assets at attractive pricing. Opportunities are likely to be greater in markets where the economy is hardest hit by the pandemic’s effects (e.g., the UK rather than Germany, Hong Kong rather than South Korea, Orlando rather than the Bay Area). Investors with a higher risk tolerance are likely to follow a similar regional market approach, albeit with more aggressive leverage strategies as well as a willingness to accept more complex equity and debt positions.

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