The Covid-19 pandemic has put occupiers under financial pressure, which has in turn stressed property funds’ rental income.
According to a report by global investment research firm MSCI, lockdowns and social distancing have hit many tenant businesses, leading to an unprecedented number of calls for rental relief, stressing real estate rental income streams.
The pandemic has led to weaker income returns for equity investors, despite softening asset values. Recent income returns may understate the full potential force as accrual of deferred rents may mask further shortfalls.
Lower rental incomes could also stress debt covenants and increase servicing pressures on some loans. In loans that default and are foreclosed upon, falling asset values may also increase potential loss severity.
The report finds that retail and hotel rental incomes were particularly hit by Covid-19.
MCSI researchers Bryan Reid and Niel Harmse say: “Rental income is the lifeblood of real estate. Without it, property funds are not able to pay distributions to shareholders and borrowers cannot service their debt. The contractual nature of property rental income, a key feature of the asset class, underpins asset values and by extension property and fund returns.
“We analysed fund and asset-level data for 107 property funds in the UK, Europe, Australia and North America to assess the impact of slowing net-income growth on distribution yields, performance and debt-service ratios during the Covid-19 pandemic. Our analysis suggests that real estate investors may want to consider new ways of analysing income risk and benchmarking the income performance of their portfolios.”
The report shows that the pandemic affected the business operations of many real estate occupiers, putting stress on landlords’ rental income streams. MSCI compared the asset-level income return of five regional MSCI property-fund indexes for the six-month periods ended December 2019 and June 2020. All five indexes showed lower income return in June 2020 compared with December 2019.
As their cash flows were disrupted, many funds adjusted the shareholder distributions by slowing, suspending or deferring payouts. As a result, the spread between asset-level NOI (net operating income) yields and funds’ distribution yields has increased, suggesting that property-level rent collections may be lagging accruals.
Globally, MSCI saw a 20-basis-point (bp) widening in the spread between the asset NOI yield and fund distribution yield, while bigger impacts were seen in the UK (+20 bps) and Australia (+30 bps).
The report warns that the income falls caused by the pandemic could hold implications for real estate debt markets. Debt in commercial real estate became a big problem for some investors during the 2008 global financial crisis. FSCI says that as investors are now more aware of the risks associated with debt, there has been a general deleveraging trend over the course of the current cycle. For example, debt as a percentage of gross asset value (GAV) in MSCI’s core, open-ended real estate indexes increased as asset values fell during the GFC, but have generally moderated since then to levels close to or lower than where they were before the financial crisis.
It also stresses the importance of risk and performance monitoring. “While some of the income disruption currently being experienced may be temporary and reversible once the pandemic is over, considerable uncertainty remains for real estate investors, in both debt and equity real estate. With the virus continuing to impact global economies and the path to recovery still unknown, rent stress and income disruption may continue for some time. Investors may therefore want to consider new ways of analysing income risk and benchmarking the income performance of their portfolios.”
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