Yes, but the opportunity set is currently limited. To date, the large amount of government stimulus and lax credit enforcements, the differentiated impact of COVID-19 on real estate sectors, and the challenges associated with valuing assets have worked to keep broad-based distress at bay for now. While we expect more distressed opportunities to emerge next year, we doubt it will resemble the breadth of distress during the 2007–08 Global Financial Crisis.
First, governments are paying service workers part of their wages while encouraging banks to relax loan covenants. This resulted in loan interest payment moratoriums and automatic maturity extensions. It has been particularly beneficial for hotel and retail assets because it created an interim standstill when many hotel and retail assets around the world were closed in first half 2020, and no reliable rents or turnover data exist.
Second, hotel and retail are the hardest-hit sectors by COVID-19, while logistics and data centers have benefited. However, this does not mean that investors can easily find distressed retail and hotel opportunities today because banks are not foreclosing assets yet. Office and residential sectors have been less impacted, given the significant rise in fiscal spending that has offset the drop in demand. At present, we have not witnessed a spike in delinquency rates that was typical of previous recessions. In fact, most office tenants continue to pay rent even if they are not fully using the space. Furthermore, rental prepayment arrangements are common in many European and Asian markets, meaning some asset owners have not had to worry about missed rents yet.
Third, government-imposed lockdowns have presented appraisers with formidable challenges. It is more difficult for appraisers to physically inspect the asset, which is a key requirement. Also, estimating stabilized market rent and turnovers when retail malls and hotels are not fully operational due to varying degrees of social distancing and travel restrictions is challenging. To further complicate the problem, JLL estimates that global transaction volumes dropped by 55% in second quarter 2020 from the prior year and that most of the transactions completed in first quarter 2020 were negotiated in fourth quarter 2019. The lack of transaction evidence means many appraisers are using the pre–COVID-19 discount and capitalization rates. Some appraisers have tweaked the real estate risk premium up by 10–25 basis points, but the increase in risk premiums have been mostly offset by the decline in risk-free rates. Therefore, third quarter 2020 valuations are likely to be either the same or slightly less than fourth quarter 2019 valuations. This means most assets are not currently in breach of loan-to-value (LTV) covenants, which negates the pressure for banks to foreclose on the borrowers.
We expect more distressed opportunities to emerge in 2021 when appraisers can better mark assets by assessing the new normal in rents, room rates, and turnovers. Price adjustment through the re-valuation process is likely to be slower than the sudden re-pricing from loan defaults in the 1998 global financial crisis. Therefore, distressed opportunities next year are likely to be smaller, single-asset investment opportunities instead of large nonperforming loan portfolios.
Since we do not expect broad distress to develop, small, value-oriented managers with a clear focus on purchase prices may be the best way to exploit retail and hotel opportunities. But, given the significant uncertainties associated with the pandemic, make sure your manager can adapt to rapid changes in the market.
Johnny Adji, Senior Investment Director in Cambridge Associates’ Global Investment Research Team