Few will mourn the passing of 2020. In addition to its impact on health and liberty, COVID-19 upended all economic, financial and real estate market projections for at least 2021. In this paper, we review how 2020 differed from expectations, creating opportunities and pitfalls, and enhancing the importance of aggressive active asset management and insightful stock selection.

1. European Real Estate Pre-COVID-19 – cautious optimism?

Most real estate investors started 2020 cautiously. Low real estate and government bond yields, high capital values for all financial assets and an ageing economic cycle suggested two potential paths:

• First, real estate yields would remain low and relatively flat.
• Second, a shock would trigger a correction in occupier demand.

However, there were reasons for optimism. Real estate yield spreads over bonds were attractive, while both supply and leverage were under control. These conditions suggested that real estate could offer investors both protection from a possible demand shock and a positive contribution to portfolio returns under the first path.

Under both paths, technology trends associated with e-commerce and flexible working were expected to continue, creating both risks and opportunities. At the same time, low yields were expected to push investors into emerging forms of the asset class. While Brexit cast a shadow over the UK, risks were largely priced.

2. COVID-19 – a different type of crisis?

While the odds of a shock in 2020 were clearly high, most commentators assumed a continuation of the status quo ante. Of course, identifying the trigger of economic corrections is notoriously difficult.

The recessions of the early 1980s and early ’90s were both associated with energy crises, while the correction of the early 2000s was triggered by the end of the late 1990s boom, particularly in the dot-com sector. The global financial crisis (GFC) of the late 2000s was caused by weaknesses in the financial system exposed by the bursting of the U.S. housing bubble. The European sovereign debt crisis that followed was triggered by a balance-of-payments crisis.    

Given the regularity of economic crises over the last 40 years, it was reasonable to assume that the next shock would be similar. Although there is a long history of global pandemics (e.g., the Spanish flu in 1918–20, the Hong Kong flu in 1968–70, SARS-CoV-1 in 2002–04 and the swine flu in 2009–10), recent crises have been limited in scale and geographic reach.  

Analysis of the Spanish flu crisis shows that cities that intervened earlier and more aggressively experienced a relative increase in real economic activity after the pandemic subsided (Correia, Luck, & Verner, 2020). However, while the economic correction associated with the Spanish flu (about 7% of GDP) was similar in scale to recent shocks, there are differences.

The ‘repair’ process associated with recent recessions was often complex and multiyear; in contrast, pandemics are simpler and concentrated. As such, there is a risk of overestimating the length of the correction period required after a pandemic. This appears to be reflected in the data.  

GDP growth during 2020 has been exceptional due to the scale of the correction and the speed of the bounce back (Figure 1). While the renewed shutdown during Q1 2021 suggests a partial reversal in the data, the rollout of vaccines through 2021 points to an accelerated return to economic normality.       

Figure 1 – Real GDP growth index Q1 2000–Q3 2020 

Source: J.P. Morgan Asset Management, Oxford Economics.

At the start of 2020, investors were cautious regarding the scope for additional fiscal and monetary intervention; there were also concerns regarding its efficacy. As such, economies were assumed to be particularly vulnerable to shocks. These concerns proved to be overdone.    

The effectiveness of policy interventions can be illustrated by the dramatic change in government and corporate bond yields during 2020 (Figure 2), the subdued impact of the COVID-19 crisis on unemployment levels in continental Europe and the rapid bounce back in GDP growth.  

Figure 2 – Government bond yields pre-COVID-19 vs. peak and current 

Source: J.P. Morgan Asset Management, Bloomberg.

While the scale of the monetary and fiscal response to COVID-19 has surpassed pre-crisis expectations and is likely to provide a solid basis for a robust recovery, this doesn’t mean that the decisions will be without consequence.  

A rebound in GDP growth will inevitably create pressure for reduced deficits and higher interest rates. At the same time, enhanced levels of government debt will likely lead to a preference for low interest rates, even at the cost of a rise in inflationary pressures. While inflationary pressures will likely be delayed by the output gap, the perception of a growing risk of inflation should enhance demand for real assets, including real estate.

3. 2021 – a new start?

The vaccine rollout over the first half of 2021 suggests a potential turning point in both economies and real estate markets. As such, caution may be penalised rather than rewarded. 

The potent combination of low interest rates, attractive spreads and growing concerns regarding inflation should support demand for real estate. At the same time, improving economic data combined with a return to office use should address some supply-side concerns. In the UK, Brexit headwinds are likely to be offset by pricing differences with continental European markets.    

Spreads between core and non-core real estate yields were elevated at the start of the crisis and expanded further during 2020 (Figure 3). While low interest rates during 2020 enhanced the demand for, and the supply of, core assets, they also contributed to wide bid-ask spreads in the non-core market. Bids were depressed by elevated short-term uncertainties at the same time low interest rates limited vendor distress and the number of forced sales.

Figure 3 – Core vs. non-core real estate spreads 

Source: J.P. Morgan Asset Management as at December 2020; CBRE (as at Q3 2020); Bloomberg (as at Q3 2020). Note: Prime yields are based on UK, French and German office and retail data from CBRE. Nonprime yields are based on CBRE’s secondary yield series and match the data used for the prime yield series. Corporate bond yields are the average of euro and sterling aggregate investment grade series (LECPTREU Index and LC61TRGU Index).

However, economic momentum from early 2021 should help to reset the non-core market. Although spreads should narrow, opportunities for non-core investors should remain, particularly given low interest rates.  While vendor distress should remain limited, improving market conditions are likely to encourage investors to pick up pre-crisis disposition plans. Further, where lenders have been forced to take possession, it is likely improvements in economic conditions will lead to accelerated sales. Similarly, investors might choose to move on from failed projects. 

4. COVID-19 – reshaped but more nuanced real estate markets? 

The pandemic has also impacted real estate at the sector level. Understanding these nuances will be crucial for European real estate investors in 2021.    

4.1 Retail – caution, ‘rebuilding’ are likely to continue 

COVID-19 accelerated the shift from physical to online retail, with previously reluctant consumers moving online. Some of the changes are likely to be temporary, but others will be permanent. As a result, large quantities of retail space will become obsolete. Successful retailers will likely focus on blending online and physical or on products and services likely to struggle online. 

Navigating these changes will be difficult. The blurring of online and physical activities will limit investors’ ability to assess the profitability of individual retail units. The combination of opacity and ongoing change will complicate underwriting, suggesting a clear advantage for specialist operators.

4.2 Hotels and Leisure – watch out for the business travel sector

Hotels and leisure had an exceptionally poor 2020. For large parts of the leisure sector, the end of the pandemic will trigger a return to pre-crisis levels of activity. The outlook for the business travel sector is less positive. The enhanced use of video conferencing during the pandemic is likely to lead to a permanent reduction in business travel. As such, while we are optimistic on the outlook for the leisure sector, business- focused hotels are likely to experience ongoing challenges through 2021.

4.3 Offices – ‘The report of my death was an exaggeration’ 

During 2020, the enforced shift to home working led to suggestions of a permanent change in the office sector. However, while changes were dramatic, they were not new. COVID-19 merely accelerated existing technology trends, and while the experiment endorsed the technology, it also illustrated its limitations.  

While home working can enhance efficiency and reduce commuting time, it cannot provide the economic and social benefits of innovation and collaboration. Long-term economic data support this thesis. Concentrated cities provide agglomeration economies and enhance productivity (Henderson, 2003, and Brülhart & Sbergami, 2009). More anecdotally, it is probably unwise to infer long-term changes to working practices from the success of a forced experiment.   

The crisis has illustrated the benefits of providing workers with greater agency over their own time and working environments. As such, office occupiers are likely to seek a hybrid approach to their space requirements, with home working complementing office use.    

This change is likely to have implications for both the scale and the form of office demand post-crisis. As office workers blend home and office work, ‘desk’ requirements are likely to fall while space per capita may increase along with the importance of proximity to multimodal transport hubs, amenities and connectivity. These trends should protect core buildings at the expense of more marginal assets.

4.4 Logistics/Industrial – continuing benefits from the shift to online retail

The logistics sector is benefiting from complementary trends in occupier and investment markets, both of which have been accelerated by the COVID-19 pandemic. We are optimistic regarding the sustainability of these trends (Kennedy, 2011).

The shift to online retail has enhanced occupier demand for well-located logistics. Over 2020, UK e-commerce sales increased by just over £40 billion, implying additional demand for some 40 million square feet; over the same period, logistics net absorption totalled just over 16 million square feet. While e-commerce growth is likely to slow, recent trends should continue. 

On the investment side, pressure on pricing levels has been enhanced by robust occupier demand, growing supply-side restrictions and the availability of long-duration leases offering inflation protection.

4.5 Residential – diversification, institutionalisation and robust demand

Residential demand is not expected to be impaired by the pandemic; nevertheless, home working has led many to review their housing requirements in general and city living in particular (Fitch Little, 2021).

The ability to mix office use with home working may lead some to accept longer commutes. For others, reduced demand for city centre apartments, the challenges of long-distance commuting and the attractions of city centre living post-pandemic might lead to a recommitment to city living.  

For investors, elevated concerns regarding city centre residential demand suggest a good entry point in early 2021. The sector’s attractions are enhanced by the impact of elevated capital values on rental demand, diversification benefits offered by the sector and scope for institutionalisation and consolidation.

5. Summary – resetting the European real estate market, but increasing complexity

Although the effects of COVID-19 are likely to linger, the ‘vaccine reset’ should provide opportunities in both core and non-core real estate. However, the crisis has led to a complex and nuanced investment environment.  

The narrowing definition of ‘core’ office assets creates a clear obsolescence risk. Ongoing changes to retail mean that even specialist operators are likely to face substantial difficulties. Although the logistics sector benefits from strong demand-side tailwinds, capital values are high and occupier requirements fluid. In residential, home working, changes to the sector and inherent asset management challenges create implementation complexities. Finally, the reshaping of the hotel and leisure sector to reflect reduced business travel suggests clear risks.

More than ever, navigating this environment will require superior asset management and insightful stock selection. Success will fall to investors who are able to combine an understanding of macro trends with detailed market knowledge and a willingness to pursue aggressive acquisition and asset management strategies.

References

Brülhart, M., & Sbergami, F. (2009). Agglomeration and Growth: Cross-country evidence. Journal of Urban Economics, 65 pp 48-63.
Correia, S., Luck, S., & Verner, E. (2020). Fight the Pandemic, Save the Economy: Lessons from the 1918 Flu. Federal Reserve Bank of New York.
De Santis, R., & Van der Veken, W. (2020). Economic expected losses and downside risks due to the Spanish flu. VOXEU.
Fitch Little, H. (2021). How coronavirus has shaped the home of tomorrow. Financial Times (1/1/2021).
Henderson, V. (2003). The Urbanization Process and Economic Growth: The So-What Question. Journal of Economic Growth, 8 pp 47-71.
Kennedy, P. J. (2021). European Logistics – an evolving sector. Institutional Real Estate Investor - Europe (forthcoming, February).

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