How badly will the real estate industry be affected by the Corona crisis? That’s what we asked our HSBA professor, Prof. Dr. Ralph W. Hofmann:
How hard will the corona crisis hit the real estate industry?
A great deal depends on how the overall economy will develop during and, above all, after Corona. Are we talking about a short "V", a long "U", or are we possibly talking about a long and deep global economic crisis? After all, the opinions and assessments of economists vary greatly in this regard. But no matter what happens, of course, Corona will have an impact on the real estate industry. But exactly how this will look like isn’t easy to predict. The reasons for the difficulty in forecasting this is that there are numerous dependencies and influencing factors to which this particular industry is subject to. In some aspects the industry lags behind the overall economic events. In addition, each asset class, i.e. type of property, must be looked at differently - a residential building cannot be compared to a hotel or a shopping centre. And finally, the various sectors of the real estate industry will also be affected differently. All this makes things complicated or does not allow for a simple answer.
What’s important to consider is that the sector was in a long-lasting boom phase, mainly due to the ECB's loose monetary policy. However, with rising real estate prices, investors also had to contend with a yield compression of historic dimensions, and it was pretty clear that the real estate market was already in a late-cycle phase anyway. This was the case even before Corona. But no one could say when exactly the boom would be over. I think that now is the time for this expected downturn. With the threat of company bankruptcies due to the effects of the Corona crisis, rental income is falling, which puts a lot of pressure on many business models in the real estate industry. The profitability calculations of real estate are based on future assumptions which include assumed value increases; otherwise it would not be possible to present them in economic terms. If these increases in value do not occur and many properties fail to perform due to high vacancy rates in the portfolio, we talk about negative returns in the real estate industry. So my forecast is that many properties and portfolios will have to be corrected. That will be painful. How big the losses are going to be depends - as I said - on the overall economic development as well as general consumer behaviour; the latter especially against the background of retail properties.
But apart from the current main problems in the industry, such as hotels or shopping centres, the market in Germany is actually pretty stable and may not be hit as hard as in other countries. Provided, as mentioned, that the recession will not hit too hard. There has been a huge amount of development and construction, and demand has been stable throughout this time. Especially for office space, demand has actually remained high and, as a result, vacancy rates have remained permanently low. This means that there may be a buffer between the excess demand and upcoming rent defaults, which may stabilise the sector. Alongside logistics properties, residential construction is certainly the most stable factor in the real estate sector, as it covers a basic need. However, even this segment could well become a problem for owners if, in the event of an economic crisis, high unemployment results in loss of rental income.
I think there are many reasons for the real estate industry to be nervous. Fortunately, real estate people generally have a very positive mind set. They are quite a crisis-proof people and seem to have internalised the stoic qualities of their product. Nevertheless, I'm sure many people do worry even if they don’t show it openly.
Will the crisis change prices? Will real estate become cheaper now?
I think that any change in value depends very much on the factors already mentioned above. However, when it comes to the question of price development there is another influencing factor, namely the location. Are we talking about central locations in popular investment target markets, or small and medium-sized towns?
Put simply, the value of commercial real estate is determined by the annual net rental income that can be generated plus assumed value growth. As already described in the first question, most calculations are already "on edge". If the buffer described above is used up and the economy does not recover quickly from the corona shock, one must assume a higher vacancy rate. This would automatically cause the prices of commercial property to fall and yields to rise accordingly.
But, on the contrary, in times of economic uncertainty or economic crises, investors are generally quite happy to put their capital into supposedly stable properties, i.e. primarily in sought-after locations. Investors are very opportune; they always invest where the risk/return ratio seems best for them. At this point, therefore, it will depend exclusively on how the financial market develops, which in turn will be influenced by the real economy. In the event of impending losses in value on the financial markets, investors are sometimes prepared to acquire properties with a de facto negative capitalisation. This was observed for a short time during the financial crisis in 2008, for example on the Vienna apartment building market. But at the same time, this has led to a further rise in property prices, which has compensated for the originally miserable initial yield many times over and has brought investors handsome gains in value.
In crises, however, a growing spread of market values between good locations and less good locations can be observed. While good locations continue to perform well, prices fall sharply in all other or worse locations. This behaviour is probably quite comparable to the phenomenon of flight currencies, whose value also increases because everyone seeks out the supposed safe haven. Swiss franc equals prime locations in A-cities without yield with high security, Turkish lira equals a small town in Central Hesse with a nice yield but high risk.
Current winners are logistics properties. However, logistics real estate has lost its former status of "hidden champion" for many years now and has been a very sought-after investment property since "Amazon & Co", which it is even more so in times of booming online trade. However, the risks inherent in the fragility of global value chains and, by extension, supply chains are not foreseeable in the short and medium term. In the long term, however, it can be assumed that logistics real estate will remain on the road to success, around which many investors will fight, forcing prices up and brining returns down to their knees; especially when the air is thin on other asset classes. A stable performance can also be assumed for residential construction. The price development of all other types of real estate, i.e. office, retail and hotels, is - as already mentioned - dependent on future consumer behaviour, the willingness to travel or the further development of the overall economy, whereby office space is still most likely to prove comparatively solid.
To what extent are real estate companies affected by the crisis?
That depends on the respective business segment of a real estate company. When I think of facility, property or asset management services, things certainly don't look bad even in difficult times. The buildings must continue to be managed and looked after, no matter market developments. Compared to many other industries, asset managers in particular have the great advantage that ongoing fees on their managed assets make up the bulk of their income and their expertise at strategic property level is in great demand in difficult times.
In the investment sector, the transaction volume will decline significantly due to the reasons described above, so that substantial income from transaction fees will be lost. Reasonable investment opportunities in the form of properties or projects are certainly rare to non-existent. I assume that these companies will take cover and respond with drastic cost-cutting programmes. I fear that this will also be accompanied by high numbers of redundancies. The fact is that real estate funds with greater diversification will make it better hrough the crisis than funds that build on one asset class.
In the area of project development, the extent to which an investor is affected depends very much on the asset class on which he focuses on. Hotels and shopping are likely to be on the dip for the time being, while property development and residential construction business will continue, and logistics will continue anyway. There is certainly something of a shock-induced paralysis at present. Tenants are holding back on renting new space, which is understandable in the current situation.
In the planning and construction sector we will have to await the development of the overall economy. It may well be that the government will be running investment programmes that will further drive the real estate and construction sector. At present, however, construction companies are having to contend with supply bottlenecks and personnel problems, since a considerable proportion of the products used and the workers are from abroad. All this leads to delays and additional costs, which can cause considerable difficulties for construction companies and investors in the short term.
On the plus side, there is the low interest rate phase, which will certainly continue for a long time to come, and the large amounts of money being pumped into the market. However, the banks are currently presenting themselves as bottlenecks, not passing on liquidity to companies for risk considerations, and if they do, then with corresponding risk surcharges and higher requirements for the collateralisation of loans.
Do you expect any sustainable developments for the property market? Will the Corona crisis have long-term effects?
As previously mentioned, even without Corona, sooner or later a downturn had to be expected. Corona is therefore only the trigger. However, what is currently happening in the hotel, restaurant and retail sectors is beyond good and evil and has little or nothing in common with a "normal" downturn. In my opinion, these sectors will take a long time to recover. It is also possible that structural changes of a long-term nature will accompany them.
I have to go a bit farther at this point as you are asking about long-term developments. I hope that, in fact, the current crisis is used to seriously reflect on whether we are doing the right thing in terms of a sustainable economic and social system. In the economic context, the rethinking from a pure shareholder value orientation to the stakeholder principle, i.e. the consideration of all stakeholder groups, has long since begun; however, in my opinion, these processes have so far been taking place under incomplete conditions. For one thing, the impact on the global ecosystem is relatively insignificant if a - let's say - German real estate investment company trims its portfolio for energy neutrality, while around 1,400 coal-fired power plants with new capacities of some 670 gigawatts are added worldwide, which is equivalent to a third of the currently installed capacities. Secondly, it is the condition of a neo-liberal understanding of the market and geopolitical factors that always lead to players in international competition gaining considerable competitive advantages by disregarding or even denying sustainability principles. As long as not everyone plays by the same rules, i.e. as long as, in particular, external effects are internalised in the costs of products or services, there is a market failure or at least a market distortion.
My response to this question is therefore more like a plea that is based on the idea that Europe, as a large internal market, should be a model for other economic areas in the world when it comes to transforming a resource-guzzling economic system into a sustainable form of economic activity with the greatest possible prosperity. The real estate industry and regional planning play a very central role in this process. Against the background of the “Green Deal”, I also see great growth potential and new business areas in this transformation process.
The alternative is that we return to the old normality in the post-Corona period, at the same time as overall economic recovery takes place.
So the crisis does seem to offer some opportunities for new developments especially in regards to sustainability and digitalisation, doesn’t it?
Of course, every crisis always offers the chance for new developments and growth opportunities in itself. I am currently working on a paper that looks at regional planning in a new light. The aim would be to gear real estate activities towards real sustainability, including so-called cluster strategies, organic farming and smaller-scale structures. This would entail substantial investment, which would open up new fields of activity for the real estate industry. It is obvious that digitalisation plays a central role in this process. Principles of the "Smart City" and "Smart Buildings" will continue to drive digitalisation in the real estate sector in connection with life cycle optimisation, energy consumption, building automation, communications and the technical design of working environments. Autonomous mobility in close connection with our built environment will also play a key role.
I also believe that work and construction will be more decentralised in the future. This means working more flexibility, i.e. moving away from being present at all times and fixed processes to goal-oriented forms of work. This is less about philanthropy and more about cutting costs.