Commentary: COVID-19 and real estate debt – where investors should be looking

More than a year has passed since the pandemic first roiled financial markets, but though the COVID-19 crisis has impacted economies and populations globally, it has also presented selective investment opportunities. Across the investment landscape, investors continue to search for yield with a now greater focus on downside risk protection. For pension funds, private credit, including real estate debt, can offer compelling relative value. However, in a world that is still plagued by uncertainty — albeit with some light at the end of the tunnel as vaccine programs progress — focusing on bottom-up analysis is imperative as we enter an environment with increasingly heterogeneous asset performance.

When the coronavirus-related downturn hit, commercial real estate lenders significantly retrenched until they could better analyze the impact on their own existing portfolios as well as assess potential market dynamics. As markets stabilized, compelling opportunities started to materialize. More favorable pricing and lower loan-to-value levels mean investors in the U.K. and Europe are now seeing better value than in a pre-COVID-19 world in most real estate sectors, and this opportunity is expected to continue for the foreseeable future.

Due to market volatility, traditional bank lenders have been reducing lending in real estate and are focusing on specific, defensive assets in a select few core home regions. As a result, pension funds and other institutional investors have been able to take advantage of opportunities in areas where banks have become too cautious to tread. This partial dislocation in the market as a result of liquidity constraints and impending loan maturities is presenting specific situations due to timing constraints that can unlock enhanced value. The reduced liquidity is likely to be most impactful for large financings where competition could be reduced. Debt capital supply/demand dynamics will also be favorable for well-capitalized, active lenders in other areas, such as transitional and development assets. There have also been some compelling return premiums in some of the less-loved European jurisdictions, such as Spain, Italy and Portugal.

In respect to real estate sectors, those assets that are deemed to be COVID-19-resilient remain the most attractive, particularly if they benefit from strong long-term fundamentals and defensive cash flows.

Supermarket operators have fared well throughout the pandemic. Unlike non-essential retail and hospitality businesses, which have had to close or limit trading due to the numerous lockdowns, large grocers have thrived as essential retailers in a captive market. Public Health England research found that volume sales of food and drink bought for consumption at home was 11.1% higher year to date for the week ended June 21, 2020 than the same period in 2019.

Furthermore, the pandemic has accelerated the growth of e-commerce. Online retailers, including grocers, need warehouses with strong transport links, meaning that logistics and industrial warehouses have benefited from the abrupt shift in shopping habits. The logistics sector was already performing strongly given a broader structural shift toward e-commerce, and the pandemic has only served to speed up this trend. In the U.K., total online retail sales are forecast to reach more than 24% of total online retail sales in Western Europe in 2021, up from 19.4% in 2019, according to data from the Centre for Retail Research. In continental Europe, the forecast figure for 2021 is somewhat lower varying by geography — between 6% to 19%. Online sales in both the U.K. and continental Europe are anticipated to continue rising. However, demand for logistics assets continues to outweigh supply and has led some to fear a "logistics bubble." Therefore, it remains imperative that managers continue to carefully conduct due diligence and only invest where they see strong fundamentals. There is risk of the sector becoming overbid as other traditional asset classes are de-emphasized, either temporarily or more permanently.

The residential sector has continued to perform strongly throughout the pandemic with the vast majority of private rented sector tenants continuing to service rent with the help of national furlough schemes. In the U.K. context, this strong income profile is combined with chronic undersupply of housing, further enhancing its appeal for institutional investors.

Alternative real estate debt sectors are also offering some good opportunities. Biotechnology and science parks are moving to the forefront of investors' minds in the current COVID-19 climate. Similarly, data centers have become more widely sought after, given the almost overnight shift to remote, digital working.

The future of the office sector continues to be a divisive topic. Though remote working could be here to stay for some time, the office will evolve to play a key role in learning, collaboration, innovation and well-being. Good quality office buildings in global cities should continue to perform strongly and those with long-term leases to high-quality tenants will attract investor interest and mitigate against any short-term volatility caused by the pandemic.

One area that warrants a more cautious approach is the retail sector, given the falls in footfall traffic due to lockdowns/pandemic-related restrictions, tenant insolvencies and subsequent impact on rent collections and net operating income. The rent structure of retail assets is at the early stages of a re-rating. We have seen significant falls in the value of retail assets given the ongoing uncertainty as to the long-term underwritable cash flows for these properties. That does not mean that there aren't opportunities available — but investors do have to be selective. High-end "destination retail" should be less impacted on a relative basis based on the "experience" retail factor that is expected to drive footfall traffic once lockdown restrictions are eased.

The hotel sector has also experienced pandemic-related distress. Previously favored business hotels are likely to face a more tenuous recovery dependent on the strength of a general business rebound. Enthusiasm for leisure/resort assets may be a reaction to an anticipated surge in holiday travel once lockdowns are lifted, with a less clear picture on medium- or long-term outcomes. There may be meaningful ability to deploy capital at significantly better pricing.

By carefully considering these insights, it is possible to invest in assets at a higher margin and lower leverage than would have been the case six to eight months ago for a similar quality asset. Investors must choose stock carefully and look for reputable borrowers with robust business plans and strong track records. At the same time, building a strong relationship with that sponsor and working closely with them is key to structuring the loan in the right way and ensuring investor interests are protected. Investors should also look to work with reputable investment managers with the requisite restructuring expertise should it be necessary. If we have learned anything in 2020, it is that no one wants to be a forced seller in a volatile market environment.

John Barakat is head of real estate finance at M&G Investments. He is based in London. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.