04th May, 2020 Commercial Real Estate

COVID-19 the Ultimate Stress Test for the Commercial Real Estate Industry

At the time of writing, over 3.44 million cases of COVID-19 have been confirmed worldwide, with 6,801 recorded in Australia. The impact on the commercial real estate industry has been immediate. The Australian Federal Government’s social distancing measures and restrictions on non-essential services and gatherings has meant that shops, restaurants, malls and offices have all closed down. So, what will the post-Corona world look like for the retail and office sectors?

Pre-COVID-19, the retail sector was suffering serious structural headwinds in the form of increasing online competition coupled with a cyclical slowdown. Retail values were arguably stretched, and some shopping centres were under stress, offering large incentives as well as capex contributions to secure tenants.

COVID-19 has increased the ferocity of the structural headwinds tormenting the retail sector. Retailers are faced with a concerning longer-term prospect, with the recovery from this crisis expected to be sluggish as consumers are unwilling to spend. JP Morgan estimates that earnings for Myers will fall by 62 per cent in FY 2020. Discount department stores, like Target, have suffered a plunge in sales and management have been forced to promise their shareholders that stores will be shut. The closure of stores and the flow on effects of the coronavirus has translated into an inability for many retailers to pay rent. Global shopping centre owner Unibail-Rodamco-Westfield (who took over Westfield in 2018) collected just 20 per cent of its retail rents in April 2020!

Government intervention with the introduction of the Code of Conduct for Commercial Tenancies has sparked dialogue between commercial tenants and landlords to renegotiate and restructure lease terms. Trident Real Estate Capital is now expecting the following major changes: (1) retail rents to be rebased downwards, (2) rent structures to be more turnover based going forward and therefore rental growth will be tied to sales growth, (3) annual rent increase clauses will shift away from high fixed percentage increases and will align with annual CPI increments , (4) larger incentives in the form of longer rent free periods as well as capex contributions will be granted (5) lease terms will swing away from 5-7 year leases and become considerably shorter to reduce a tenant’s risk exposure, (6) there will be a reformulation of sizes of stores as retailers move away from bricks and mortar and rely more heavily on a digital footprint, and (7) retailers will shift away from a scatter gun approach of stores and place a stronger emphasis on flagship locations to drive brand awareness.

Retailers will not only be focusing on maintaining cashflows through the pandemic, they will also be assessing their operations and supply chains. With physical stores being closed, online trading has become a vital driver of revenues during the outbreak where many retailers are only able to sell to customers through online channels. On top of the current structural shift towards online trade, Trident Real Estate Capital believes COVID-19 will accelerate this adoption of online services. This may have profound impacts on how traditional bricks and mortar stores will operate as well as significant developments in distribution channels and warehousing.

Unsurprisingly, retail property values will fall steeply as rents are rebased downwards to allow retailers the opportunity to re-establish their businesses. Valuers such as Jones Lang Lasalle are writing back values anywhere between 5% to 18% with the main adjustments in valuation variables being downtime (now assumed to be 6 months) and incentives (which in some cases have doubled) as well as reducing tenant retention rates. Adding to the worrying write downs will be the absence of offshore investors playing in the Australian market in all asset classes, arising from the delays caused by the FIRB approval process (now creating 6 month delays) and the inability of foreign investors to physically inspect real estate as a result of COVID-19 travel restrictions. These anticipated drops in retail values have translated into some analysts forecasting drastic earnings per share falls for REITs like Scentre Group (32 per cent) and Vicinity Centres (25 per cent) in FY2020.

As with retail premises, the pandemic has seen commercial office tower landlords overwhelmed with requests for rent deferrals and waivers. Large office landlords like Dexus and Charter Hall Group have been negotiating with tenants on a case-by-case basis, prioritising relief for smaller tenants tangibly impacted by COVID-19. Larger corporate tenants, who fall outside the Code of Conduct, are also placing pressure on landlords for some sort of support. In many instances, Landlords have resisted dialog and demanded 100% of the rent to be paid in full opting to kick the can down the road and hiding behind the ambiguities and confusion created by the Code of Conduct.

Although the immediate impact of COVID-19 has taken the form of rental waivers and deferrals, Trident Real Estate Capital believes there will be a more lingering impact which may incite significant changes in the office sector. As seen in previous recessionary periods like the GFC, spaces located in CBD regions are generally most susceptible to rent decreases. Often, this represents an opportunity for tenants located in the suburbs to move towards the CBD as the premium between a CBD office and fringe office decreases. In a similar fashion, following the GFC, often the price differential between prime grade and secondary grade rentals decreases. Thus, a flight to quality may be observed where tenants grasp the opportunity to lease prime grade offices at bargain rates. As such, we believe a subsequent flight to quality will follow COVID-19 where an influx of commercial tenants relocate towards the CBD with greater preference for prime grade spaces.

The COVID-19 pandemic may also trigger a correction of recent trends in annual face rental growth. Recent trends in determining rental growth rates have been based on fixed percentages. This has led to skyrocketing compounded annual average growth rates between 4.0% to 4.8%, which has also in turn forced substantial increases in leasing incentives towards 20% to secure tenants. These rental growth rates have become increasingly higher than both the current CPI and commercial tenant’s annual turnover growth, making them unsustainable for commercial businesses. Trident Real Estate Capital anticipates a significant correction in annual face rental growth to align with current CPI rates.

Longer term, the COVID-19 pandemic may be considered a major disruptor to the office market causing structural change. Working from home will never again be referred to as ‘shirking from home’ but instead will be viewed as a legitimate alternative altruistic work arrangement. A recent Colliers Investor Sentiment Survey has revealed that 50% of investors have acknowledged that the current ‘work from home’ arrangement will create a permanent change to occupation in the future. The majority of corporates have already engaged in remote working strategies during the current COVID-19 outbreak. More importantly, many firms have looked beyond this by investigating investments in remote working facilities to mitigate future risks. In addition, current social distancing measures may ultimately alter the perception of the optimal office layout plan. Where a highly dense, large and open plan office appealed to firms prior to COVID-19, tenants will recalibrate their space requirements to include more break out areas and unassigned work stations as well as supporting employee flexibility work practices and ensuring compliance with social distancing measures.

The current COVID-19 outbreak has had a devastating impact for both tenants and landlords across all industry groups. However, the COVID-19 pandemic may also spark some much-needed structural change in how we all do business in the future!