By Andrew Schwartz, Group Managing Director, Qualitas
Thursday 5th March 2020
As the Coronavirus fear grows its footprint, uncertainty is taking its toll on markets. As real estate investors, we see both opportunities and threats on the horizon.
There are two key themes likely to impact property assets: lower interest rates and changes in demand revenue. With those two variables in play, some types of real estate will be more volatile on the downside, while others could increase in value.
In Australia, interest rates were already looking likely to go downwards. Sluggish economic growth, anaemic wage increases, and then the bushfire disaster: all signs pointed towards the Reserve Bank of Australia cutting rates. Now, the threat of a global pandemic is another data point.
Interest rates matter for real estate because they impact the cost of debt capital. Whether you’re a mum-and-dad homebuyer or an international asset manager, the less it costs to borrow, the more attractive it is to buy as the equity return rises. This is in turn increases asset values, thereby enriching the owners.
For commercial property, rental demand sits on the other side of the equation. Even though cheap debt costs can mean higher return on equity, the income side needs to stack up through healthy tenant numbers. In a downturn, lower demand becomes a balancing force against the more attractive interest rates.
Therefore, the certainty and growth of revenue that a property can provide is a key to assessing its value and potential upside.
Some properties have less certain income streams because they aren’t tied to a lease and as such, depend on customer patronage received by an operator who makes variable payments to the landlord.
The types of properties immediately at risk from the Coronavirus could include, for example, hotels that rely heavily on Chinese guests; student accommodation providers waiting for students to arrive; or conference centres reliant on unrestricted business travel.
By contrast, properties that are well-placed to take advantage of increasing values are those with fixed and escalating revenues, so that profitability increases with certainty (unless the tenant can’t pay their rent). These properties are not directly exposed to patronage risk, and are shielded by the corporate goodwill of the tenant through their wider business activities.
Assets with leases of 12+ years, quality tenants and rent increases above inflation are ideal. They include office, convenience and non-discretionary retailing, and industrial premises tenanted by the public sector or major corporates. Owners of these assets are in a good position at this stage of the cycle.
In terms of the residential property sector, there are some potential tailwinds to consider.
Previous cycles have shown that when the equity markets become unstable, much of the capital pulled out of the listed equity markets makes it way to residential property. Investors want the security of bricks and mortar and this could be more so than ever before, coupled, as it is, with cheap credit.
In terms of housing supply, there may be significant disruption to new builds, as supply chains suffer and raw materials can’t be delivered from offshore.
This follows a period of reduced construction starts, which have seen residential inventory levels running down – particularly in Melbourne and Sydney.
As a result, we may see rents increase after a long period of sideways and sometimes downwards movements. If this occurs, then escalating rents and falling interest costs could deliver improved asset profitability. This, in turns, usually leads to increased value, so there may be good news for homeowners.
Like any economic disturbance, the Coronavirus will no doubt create both winners and losers. This is true for real estate sector, but those with patience, access to capital and an analytical approach will see a range of investment opportunities emerge.