How would recession hit commercial real estate?
The office sector was an area which performed poorly when the S&P500 declined more than 1 per cent during 2019. Photo: Peter Braig Photo: Peter Braig

How would recession hit commercial real estate?

OPINION

When asked for our views on the macroeconomic environment, there are two things we can say for certain – firstly, at some point there will be a recession in the US and elsewhere, and secondly, we have very little idea when it will come.

However, when asked what a recession will mean for property markets, we can be a bit more specific.

Our research shows not all real estate sectors perform equally during recessions. Despite the current narrative in Australian real estate investment trusts (AREITs) that industrial and office are “safe havens”, history suggests otherwise.

In fact, these sectors are economically sensitive to the real estate cycle. For example, a 1 per cent increase in the unemployment rate in Australia equates to roughly 120,000 jobs. To put this in perspective, the loss of 5000 office workers is the equivalent of a large-scale office tower sitting empty.

There is a case to be made that in the next downturn, retail property may perform worse and industrial property better given the structural change occurring in both sectors. But even so, the starting point of expectations for both sectors probably already reflects these issues.

Taking this analysis one step further, we looked at real estate performance when the S&P500 declined more than 1 per cent during 2019. As in 2007 to 2009, lodging, office and industrial all performed poorly while health, student accommodation and storage held up well. On this occasion, though, malls performed poorly, too.

Another aspect that will have a meaningful impact on real estate performance is leverage. There are many ways to measure leverage. The most common is loan-to-value (LVR), although this approach has some significant shortcomings – notably the quality of the V.

Our philosophy on leverage is that it is safer to have an LVR of 50 per cent where value is half replacement cost than an LVR of 30 per cent where values are double replacement cost. In that context, investors should be wary of low LVRs across well-bid sectors such as office and industrial property in the current cycle.

Another leverage measure is net debt to earnings before interest, tax, depreciation and amortisation (EBITDA). In essence, this reflects how many years of pre-depreciation cashflow covers net debt. It measures leverage against the earnings capacity of the underlying assets, rather than the market value of those assets. Again, it’s not a perfect measure but provides a useful guide for investors.

Taking all this into account, our approach is to skew our portfolio to lower risk assets with low leverage within the real estate landscape. That may mean there are times we miss some of the upside, but as long as we protect against the downside while achieving our total return objective through the cycle, that’s a good result. Ultimately, the key to property investing is wealth preservation.

Chris Bedingfield is co-founder of Quay Global Investors

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