2020 > The year of the swan 22 June 2020

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Simon Vardon

Director, Product Development – Real Assets

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Towards the end of 2019 the macroeconomic landscape included a number of well documented downside risks. The US/China tariff wars continued, there was nervousness in the Gulf following an escalation in tensions following the seizure of an oil tanker in the Strait of Hormuz and not forgetting rumblings of Brexit.

With the headwinds present, 2019 had been a subdued year for investors, with many taking a ‘wait and see’ approach where they had the luxury of being able to do so.

Despite the downside risks, some of the early whisperings crossing into 2020 were consistent and perhaps could become self-fulfilling. Many within the real assets industry saw the glass ‘half full’ as the new year arrived. There was expectation that the election result in the UK would encourage investment volumes to return, given improved certainty around the direction of Brexit. Furthermore, just maybe, in a US election year, the US/China trade friction would de-escalate with expectation that attentions might be focused elsewhere. Perhaps 2020 was going to be the right time to make a positive move for real asset investors.

What followed, of course, over a matter of weeks, has shaken the global economy. The advent of the Coronavirus precipitated an acute economic shutdown, moving rapidly from country to country. The disruption has been seismic, with a global recession looming.

A ‘black swan’ event has characteristics of rarity, extreme impact and where in retrospect there exists some predictability. The term is derived from the saying that ‘black swans don’t exist [……until one arrives]’. COVID-19 appears to neatly meet the definition of a black swan event.

Initial impact on Real Assets

Liquidity

As the scale of the pandemic was realised, the overwhelming response for managers of real estate portfolios was to focus on immediate liquidity needs. Planned quarterly distributions were cancelled and capital calls were made. Cash was maintained at the asset-level to ease liquidity as many tenants were given options to defer rental payments by Governments around the world. Asset managers have also turned quickly to their debt providers to seek some breathing space as impact assessments were concluded and business plans re-drafted. Liquidity concerns are set to resurface again when deferral windows expire and rents become due.

The impact of the measures imposed by Governments to protect their citizens had differing impacts on sub-sectors of the real assets industry, principally dependent upon the extent to which the asset relied on social activity. Retail, hospitality and travel-related infrastructure have all been hit particularly hard by the restrictions imposed.

Asset managers with a diversified portfolio might fall into a ‘suffering but coping’ category. A small number of sub-sectors have actually performed very well, supermarkets and logistics being two such examples.

Adding to the challenge in the real assets sector, material valuation uncertainty is currently inherent for many assets, and open-ended real estate funds have been obliged to suspended redemptions as a result.

Flexibility

The impact experienced by asset managers will vary depending upon leverage within structures, the tenant mix, and the ability of the tenants to see-out and survive the current restrictions on their abilities to trade. The ability to be flexible is going to be important. Many sound businesses through no fault of their own, suddenly find themselves closed and in financial difficulty. Supporting these businesses and reducing administrations, redundancies and ultimately the depth of the recession to come, has been central to some of the financial packages deployed by Governments. If investors, asset managers, landlords and lenders can be flexible in their respective reactions, then a more positive outcome for tenants and by consequence, wider stakeholders should prevail.

What now is a realistic scenario for real assets in 2020?

Asset managers should be through the initial reactive stage. They will have cashflow forecasts and business plans updated for the remainder of the year and beyond. The majority of new plans will remain contingent upon the loosening of restrictions and the speed at which a degree of normality is able to return. By way of example:

  • An asset manager with a development site under construction will have concerns around supply-chain disruption and the ability for workers to return to the site and continue construction. It seems inevitable that timelines will be stretched out to new dates.
  • An asset manager holding student accommodation assets, will have concerns around when international flights are able to resume, and universities are able to reopen. Refunds may have been extended to students and there will be fluctuations on occupancy levels witnessed in the sector, depending on whether students returned home or decided to stay put.
  • Contrasting fortunes will also arise where not previously contemplated. An asset manager investing in long-income assets, could have two investments once considered alike e.g. two 10-year leases with incremental fixed uplifts, both returning the same yield. Vastly different scenarios will be presented currently if one lease is with a supermarket operator and the other with a restaurant chain.

Valuation uncertainty and movements will be present throughout the sector and many asset managers will need to review financing options to avoid covenant breaches and possible foreclosure of security by the debt providers.

For the majority of asset managers, it seems unlikely there will be a quick bounce back to normality. Those currently holding assets seem destined to play out a patient waiting game, managing what is within their control for the months ahead.

Disruption breeds opportunities

Many investors were already turning their eyes up the risk curve during 2019, seeking improved returns because yields in core markets had become increasingly compressed. Investment into real estate debt has seen rapid growth as the sector becomes more established and familiar for investors.

Opportunistic real estate strategies, including development is another way investors have been taking more risk in the expectation of improved returns.

Many fund managers are planning new funds as a result of the fall-out from the current situation. Funds targeting distressed or special situations strategies are being lined-up, buoyed by investor demand to have a stake in potential upside. Fund managers with a track record for these strategies are thus very well placed to exploit the disruption.

Looking further ahead

The current ‘black swan’ looks set to dominate the macro landscape for the immediate future. Prior to the COVID-19 outbreak, a number of significant trends were being witnessed and these are expected to continue. ESG considerations have rapidly moved up the list as managers increasingly discover the positive impact ESG measures can have on returns and risk management. Investor appetite to be associated with investments linked to responsible and sustainable ESG policies has risen in recent years.

The ability to measure and report on ESG measures is catching up, as well as the emergence of recognised standards. Momentum is very much expected to continue in this area, which is such a positive trend.

Technology advancements in recent years have rapidly changed social habits, behaviours, and the use of buildings and infrastructure requirements. Governments have pledged to improve infrastructure aimed at advancing the productivity of their economies, supporting the connectivity needs of business and citizens as they continue to become more technology advanced, and dependent. Indeed, it is noteworthy that so many businesses have been able to continue to operate, whilst invoking work-from-home plans, owing to the resilience of technology and remote working capabilities.

The next swan could be green

In January 2020, BIS published a paper entitled “Central banking and financial stability in the age of climate change”. The paper highlighted that planet earth is facing a climate emergency and without coordinated intervention, which is increasingly urgent, ‘green swan’ events will materialize. It is a sobering thought that the shape of another global crisis is already in the wings, currently without the required coordinated reactions.

One positive reflection, is to consider the way in which many businesses were able to make immediate and fundamental changes to their operations, demonstrating resilience and the ability to make significant change, which would otherwise have been much more incremental. Substantial and urgent adjustment has been proved to be achievable. It’s just possible that lessons learned from the black swan, will help us avoid, or at least diminish the green swan in the future. Those involved in the real assets industry across the globe will have a part to play in influencing the change required.

We would be delighted to speak with you to discuss SANNE’s Real Assets services. For more information please contact Simon Vardon, Global Head of Real Assets