Resilience required in the real estate finance market as new term optimism fades

As we reach the end of September and the focus turns to the third COVID quarter date, real estate finance partners Debra Cooper and Mehar Patel look at how the month has passed from new term optimism to increased restrictions and a need to focus on resilience and relationships.

As September started, parents prepared the new school uniform and anticipated being able to actually work from home rather than having to teach the key facts of the Roman Empire in between Zoom calls. However, the optimism was short lived as, over the space of the month, an increasing number of local lockdowns were put in place and, by 24 September, the hospitality sector was hit hard by a 10pm curfew. There was also a renewed encouragement to work from home.

Keeping in line with regulations and the rule of 6, here are our new school year thoughts on the real estate finance market as we stand at the end of September:

1. Top and bottom of the asset class

• Beds and sheds have been widely proclaimed as the top students in the COVID class of 2020. However, it is clear that beds refer to the residential side of real estate and not hotels or student accommodation. 
• Student accommodation is a sit and wait game to see if the predicted reservations materialise and what the impact of global travel restrictions is. However, on the positive side, student numbers are higher than expected potentially due to the inability for students to take gap years and a less than buoyant jobs market – making higher education a more inviting prospect.
• The hospitality and hotel sectors are clearly struggling and will continue to do so while global travel restrictions, corporate demand and 10pm curfews remain in place.
• Residential and BTR is sitting pretty near the top of the class as lockdown has highlighted the importance of where we live and having the space and flexibility to use the home space as they need - and people being willing to pay for this. This is a regional phenomenon, not just in London.
• Logistics has generally seen an increase in demand across the board, from big sheds sitting alongside motorway distribution routes to last mile locations.
• Office has been one of the more resilient asset classes to date, despite a higher percentage of home working being anticipated in the future. We believe there will be a growing shift in how offices are used – more as a hub than as a fixed workspace and floor plates and offerings will need to adapt to this. The concern around lockdown on mental health and isolation means that we believe offices will adapt but will remain part of working lives. However, there will be a need for older stock to be reassessed in order to consider if it remains viable for office use or it needs a fundamental change, for example to residential.
• Retail is very clearly at the bottom of the class but, as has been widely discussed over the past 12 months, COVID has been the final straw in a steady decline rather than the cause of retail’s demise.
• Healthcare and later living are the new kids in the class and received a lot of attention early in the crisis. Investors are waiting to see how the operators function going forward and whether this asset class should be used to diversify portfolios.
• It is very clear that the gulf between top and bottom of the class is growing, and the year will feel very different for the top and bottom sectors. The key question is if any of the players will be able to change their position over the coming 12 months and longer. It is important to note that real estate is a long game, which means it is unfair to make a permanent judgement on the viability of any sector based on the past six-month period.

2. Change in curriculum

Whilst COVID-19 remains the most studied lesson now, there needs to be an increasing focus on BREXIT and LIBOR discontinuance. These subjects were supposed to be the focus of 2020 and, for many, these are seen to be extra-curricular activities that fall by the wayside in these unprecedented times. Our colleague Fiona Cameron has just circulated an excellent article on the current LIBOR discontinuance position.

Another much talked about topic on the current curriculum is sustainable lending and ESG. Owners of assets will be looking at value and usage and whether those assets will be fit for purpose in ten years’ time. Currently the frameworks are going in the right direction, but we are not quite there yet. Investors with larger portfolios are more unwilling to accept ESG targets on the whole portfolio. We are trying to build a sustainable framework in the absence of global regulation. Sustainable principles are very corporate driven. We need specific, measurable, transparent targets with KPIs to be reflected in margin reductions or increases in margins if these are not achieved. This is difficult, for example, for longer term FRI Leases where landlords may not have the same opportunities to improve their assets.

3. Lender lessons

As we moved through the March and June quarter dates, lenders were exceptionally busy supporting their existing customers as best they could, understanding and delivering the government backed support loans and trying to understand the future risks that their customers were facing.

In terms of ongoing appetite, the message is cautious optimism with a close eye on consumer confidence once the government schemes come to an end/change. Underwriting is being looked at carefully and lenders are challenging clients about their business plans and keeping an open dialogue to test the information being received. Real estate lending has not fundamentally changed but there are some new requirements and it is important both lenders and borrowers understand them and why they are needed.

Generally speaking, the market is working. There is a broad mix of lenders in the market between the volume lenders, international lenders, debt funds, insurance and pension funds, and between them all the market is covered. The volume lenders are very focused on supporting their existing customers and providing short term waivers and payment holidays with long-term support where needed. The debt funds and specialised lenders are filling the gap for those looking to fund opportunities coming out of the crisis.

4. Team work

Most players within the real estate eco system agree that government support for the real estate sector overall has been lacking. The government support has focused on short-term solutions instead of looking at a longer-term rent support scheme, which would have longer-term benefits for employment and taxes. Landlords would welcome a reduction in rates on empty units but, again, this is a longer-term approach that does not appear to be being considered.

However, on the whole landlords, tenants and lenders have all worked together with all parties doing what they can to help each other and acknowledging that each party has a need, but there will have to be further give and take on all parts.

It has been acknowledged that some of the larger tenants have taken advantage of the moratorium process and held the threat of a CVA process over landlords’ heads, but this is the exception and not the rule. The independent tenants and those without large cash or group reserves have widely been reported to be the first to pick up the phone to discuss issues with their landlords - always better to say you don’t understand the homework task early on than failing to hand it in after the deadline has passed.

5. Resilience

As mentioned above, it is important to remember that real estate is a long-term game by its very nature and, while the current crisis has resulted in five years’ worth of changes in five months across many sectors, it should be stressed that the period since March is a relatively short period in the grand scheme of investments.

The American Psychological Association (2014) defines ‘resilience’ as “the process of adapting well in the face of adversity, trauma, tragedy, threats or even significant sources of stress”

Given the figures reported for rent collections across the market as a whole for March and June, it demonstrates that the assets themselves are resilient and, as such, all of the players in the real estate eco system need to be resilient as well. This is a full class effort not just the top students in the class.

6. Be friendly – relationships are key

The key messages from talking to clients – borrowers, lenders, tenants and landlords – is that relationships matter. In all cases, the earlier and more frequent conversations were taking place the better the outcome for all parties.

It looks like we are all still learning but the good news is that school reports don’t come out until the end of the school year – hopefully time for improvement in all areas by then.