Dear Friends

In the 30 years that the Partners at Resolute have been involved in managing distressed real estate across the globe we thought we had seen just about every variation on a real estate or banking crisis. This one is different; these are extraordinary times and it’s impossible to say with any certainty what the outcome will be. It is still very much early days but there are a few observations we can make.

In the short term we are already seeing an immediate impact on transactions and financings with most either being cancelled or deferred. Asset valuation and rational pricing have become almost meaningless terms, with volatility in many asset classes unmeasurable, liquidity failing, risk premia generally not measurable and any forward-looking income projection lacking a meaningful basis. In such circumstances, most capital providers will tend to focus on capital preservation and hoard capital until new market parameters (“the new normal”) start to become apparent. The old adage of catching falling knives is in force.

At the same time, we will see (are already seeing) distress across all real estate sectors as tenants hoard cash and struggle or simply refuse to pay rent on time. This is the first stage – cash crisis for real estate owners – as companies and individuals try to radically adjust their cost base to mitigate the dramatic fall in income they are experiencing. The issues and considerations deriving from this cash crisis are pertinent to both property owners and lenders exposed to property owners (so most of the banking system).

The resulting feedback loop has the potential to spiral into mass unemployment, market failure and banking crisis in turn leading to further falls in asset income and values. Fortunately, government recognition of the systemic and systematic risks has been swift and unprecedented action is being taken to forestall such a scenario; time will tell whether the tools available to governments are adequate, and what the side effects of utilisation of such tools will be.

Looking forward we know from theory and experience, including the 2008 crisis, that government liquidity actions are positive for property over the medium term; low rates are positive for valuations and risk premia will stabilise at some point. The real concern is on the income side.

A shut down of a few months, on its own, would not have a major impact on valuations, particularly if tied to government-mandated debt moratoria by the banks. However, the reality is that we do not know how long or how deep the crisis will be nor the shape or timing of recovery. We also face the potential of structural change to real estate usage given longer term health precautions and changed behavioural patterns of work, leisure and consumption following the crisis. This in turn implies uncertain real estate revenue streams over the medium term due to the economic impact on tenants and demand.

A very brief summary of the impact we are observing on individual real estate asset classes is attached at the end of this note.

In the current circumstances, property owners across real estate asset classes should be focused on the medium-term viability of existing tenants and the maintenance of occupancy, as these will be the critical drivers of recovery of asset income and value. Indeed, these may well be the crucial tests of the longer-term viability of many properties. This implies a need to work with tenants (and buyers of residential property), even at short term financial cost to owners.

We know from long experience that for assets that are underperforming or are particularly vulnerable, early decisive action is the best way to preserve long term value. Key actions to be taken should include:

• Preserving cash, including looking at what government support or moratoria are applicable to the landlord, tenants or borrowers.
• Proactively negotiating with tenants and occupiers as their long-term health is in the landlord’s best interests. Maintenance of occupancy is the key focus.
• Suspending capex where appropriate, with the focus on essential maintenance to preserve value.
• Managing working capital, with a focus on cashing receivables and on a not-business-as-usual approach to payables.
• Securing and maintaining properties that need to be closed, to maintain long term value.
• Proactively managing lenders, where appropriate.
• Identifying and retaining key, critical talent.

This picture for the owners of real estate translates to the position of real estate lenders; in fact, many such lenders are now the economic owners of their real estate collateral. As such:

• Lenders need to determine whether the existing legal owners and managers are adding value to the assets, either through quality of management or provision of capital. Where they are not, lenders need to act swiftly and decisively to ensure appropriately capable management is in place and in action.
• Lenders need to appropriately support owners and managers who are proactively adding value to the real estate by financially and contractually accommodating the financial compromises they need to make with tenants.
• Urgent triage needs to be conducted on real estate secured portfolios, particularly construction and development assets. Many such incomplete assets will have no clear prospect of providing an appropriate return on the residual spend; lenders need to segment portfolios between the still viable, the failed and the potentially viable. This exercise needs to be based on rigorous analysis of reality, not on simple mass haircuts.
• Lenders need to lobby government and regulators (as they are already doing) for dramatic systemic intervention to ensure ongoing credit availability to the real estate sector. This requires direct policy intervention, given the reasonable tendency of each individual lender to use the benefits of interventions currently being made to shore up their own liquidity and capital positions rather than in providing new credit (to be clear, this is over coming months, not today).

At this moment, we are in the midst of a storm of unknown intensity and duration, and the analogy of a ship in a storm is appropriate. Now is the time to lower the sails, put out a sea anchor, and batten down the hatches. Those steps allow a ship to ride out the fiercest storm, even though in the process it may drift away from its desired destination; once the storm has passed the time will come to plot and seek to steer a new course, but that time is not now. Prepare to ride out the storm.

To our colleagues, our clients, our friends, stay safe.

Bill Hancock

Managing Partner

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Summary Asset Class Observations

The most immediate impacts are being felt in the hospitality and retail segments, with government mandated closures and travel bans. However, no segment is immune.

Retail: Closed stores and reduced consumer spending power will create immense stress for most retailers. Many were already experiencing difficulties and with limited cash reserves a wave of bankruptcies and store closures is likely. These factors, combined with the likely acceleration of online shopping habits during the current crisis, are likely to imply structural oversupply of retail space with a resulting negative spiral of retail rents and values.

Hotel & Hospitality: Hotel assets are also facing all of the obvious short-term issues associated with lockdowns, flight groundings and termination of business travel. These issues are compounded by the issues of physical deterioration of closed hotels and the very significant uncertainties surrounding tourism demand in a future recovery: ongoing travel limitations, changed working and leisure habits and flight availability to name but a few.

Office: Office markets are likely to see a slower decline given the longer nature of leases, the lower share of occupancy costs as a proportion of total costs and the less immediate impact of lockdown actions. However, the underlying decline in occupier demand will impact deeply, accompanied by a potential shift in fundamental office demand as work-from-home behaviour patterns and technology are developed during this crisis. Again, structural oversupply will likely create a consequential negative spiral of rents and values.

Logistics: Logistics remains the greatest question mark, given the ongoing need for distribution and the potential for re-onshoring. Greater resilience is to be expected in the segment in the medium term, although in relation to individual assets tenant failure and shifting locational drivers remain of concern. Medium term relaxation of planning restrictions in light of structural changes in the economy driven by the Covid-19 pandemic may also impact.

Residential: Residential real estate will in most markets continue to be driven by fundamental underlying demand (although this analysis may not apply in those of our markets heavily driven by expatriate occupier or foreign buyer demand). However, the impact of the crisis on incomes and credit availability is already apparent, resulting in material downward pressure on valuations and liquidity. Secondary sellers under income pressure, together with primary selling from distressed developers, are likely to have significant and sustained impact.

Student Accommodation: In the student accommodation sector students are being sent home and while most of them will have paid for the current semester, the question is what will it mean for next semester. Fearful and financially stressed parents may think twice about sending their children away to study – assuming it’s even possible. As well the massive and sudden move to on-line classes may in fact having a lasting effect on demand in this sector as the education model itself is reassessed.