Coronavirus recovery: flight to quality gives property investors a chance to add value

Covid-19 has led to a sharper flight to safety, with investors seeking reliable returns favouring the most resilient and secure properties
The flight to quality is just as important, providing an unprecedented opportunity to add value to real estate by upgrading buildings for the post-coronavirus world

Nicholas Spiro

Published: 4:30pm, 5 Apr 2021

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For an indication of the extent to which investors still harbour doubts about the ability of the commercial property industry to cope with the unprecedented disruption caused by the pandemic, look no further than the share price of an S&P 500 index of office-focused real estate investment trusts (Reit). While the broader S&P 500 index has long since surpassed its pre-pandemic peak last August, the office Reit sub-index is still trading at 20 per cent below its level in February 2020.

To be sure, there have been sharp divergences in the performance of different sectors within the property industry. Logistics assets, which benefited from lockdowns as the pandemic pushed more consumers online and prompted a rush for warehouse space, have thrived. The hotel sector, by contrast, is suffering amid the collapse in tourism and business travel.

However, the real estate industry as a whole is being convulsed by changes in the way people live, work and play, creating uncertainty over the future demand for, and use of, different types of property. While the consequences and duration of these changes are unclear, trends observable before the pandemic – the rise of e-commerce, the shift to flexible working and more emphasis on wellness and sustainability – have accelerated, forcing owners and developers to rethink the future of real estate.

The challenges thrown up by the pandemic include urgent action to protect the safety and health of staff, occupiers and other end users of real estate, investing in digitalisation and delivering better tenant and customer experiences. These are putting the design, performance and location of properties under close scrutiny.

While the requirements of occupiers changed almost overnight following the eruption of the Covid-19 pandemic, owners and operators are just beginning to respond. Even the highest-quality properties in the most established and liquid markets now require some investment or enhancement to meet new post-pandemic standards and benchmarks.

The virus-induced disruption is increasing the appeal of “value-add” investment strategies. With the market for “core” investments – low-risk, low-return properties, notably those with long leases to creditworthy tenants – having become much more competitive since the pandemic struck, and given the limited availability of premium buildings, investors are more willing to move up the risk curve.

Value-add strategies – which seek to generate higher returns by improving or repositioning properties – are well-suited to the current environment. A report published by JLL noted that in the Asia-Pacific region alone, 40 per cent of office space is in need of some form of enhancement, representing US$400 billion in unrealised value for investors pursuing a value-add approach.

Yet, even this is understating the potential for upgrading and repositioning properties. Companies are becoming much more selective in their real estate requirements, powering a “flight to quality” that was already apparent before the pandemic erupted.

Andrew Macpherson, head of Asset Development for Asia at JLL in Hong Kong, noted that the lines had become increasingly blurred between adding and preserving value. In the office sector, many older and outmoded buildings risk becoming obsolete in several years’ time when new, higher-quality properties – those with state-of-the-art provisions and post-coronavirus health, safety and sustainability credentials – enter the market.

The real question, and the one many other industries face, is which changes brought about by the virus are likely to prove permanent and which ones will be less consequential as mass vaccination programmes put an end to the pandemic.

JLL is helping property owners and investors in Asia navigate the uncertain post-pandemic landscape by developing an asset performance evaluation tool that measures the physical performance of buildings across different categories of value. The results can help determine the amount of investment required – and, crucially, in which areas – to achieve the optimum return.

Given the correlation between the physical performance of a property and its rental and capital values, discerning and well-informed investors can capitalise on the disruption caused by Covid-19. They can acquire well-located and underperforming assets, improve their cash flow through repositioning and reap the higher capital value when they decide to sell.

In a sign of the increasing popularity of value-add investments in Asia, Hong Kong – whose commercial property investment market was one of the region’s worst-performing last year – is experiencing a surge in industrial redevelopment deals. Transaction volumes are expected to increase further this year following the government’s announcement last month of a pilot scheme that allows owners of older industrial buildings to pay a standard land premium rate to modify leases to facilitate redevelopment.

According to CBRE, acquisitions of industrial assets for redevelopment already accounted for a growing share of the city’s industrial and logistics investment market before the pandemic. Preliminary data shows that in the first quarter of this year, seven deals were completed, amounting to US$530 million, 70 per cent of last year’s total investment in the sector.

Covid-19 has led to a sharper flight to safety, favouring the most resilient and secure properties. Yet, the flight to quality is just as important, providing an unprecedented opportunity to add value to real estate by upgrading buildings for the post-coronavirus world.

Nicholas Spiro is a partner at Lauressa Advisory

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