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COVID-19 Accelerates Structural Shifts In Global Office Real Estate And REITs

Office Real Estate Occupancy And Rental Rates Are Under Pressure

S&P Global Ratings expects a global GDP contraction of 2.4% in 2020 before a rebound of 5.9% in 2021 under our base-case scenario. Layoffs and lower demand for office space will impact office lease renewals and leasing prospects into 2021.

In the U.S., over 42.6 million Americans filed for unemployment between mid-March, when lockdown measures began, and early June. While the unemployment rate peaked at 14.7% in April, we expect a recovering to 8.8% by year-end, compared to 3.7% in 2019. We think it will take several years to recover to pre-pandemic levels of unemployment of below 4%. Moreover, stagnant job growth will likely pause expansion plans for several corporations, limiting the appetite for additional office space.

In Europe, lockdown measures are eating into many companies' capacity to pay rent. We estimate GDP in the eurozone will deteriorate by 7.3% in 2020, but will recover and grow 5.6% in 2021. We also believe the unemployment rate will reach 8.6% in 2020, up from 7.6% in 2019. As a result, the pandemic and its aftermath will dampen companies' growth plans in key European markets, while cost cutting and staff reductions will pressure office occupancy rates.

We expect a sharp decline in economic growth in China with GDP up just 1.2% in 2020 versus 6.1% in 2019. Even prior to the COVID-19 outbreak, office rents in some tier-one cities, such as Beijing, Shanghai, and Shenzhen, were already suffering from oversupply, with vacancy rates as high as 12%-21% at the end of December 2019. Although Shenzhen's vacancy rate has stabilized since then, Beijing and Shanghai's vacancy rates remain on the rise. With weaker demand for office space combined with a significant amount of new supply over the next 12-24 months, we believe spot rents in those cities will continue to be under pressure.

Table 1

Global GDP Growth Forecasts
--Q1 CCC-- --New--
(%) 2019 2020 2020 2021 2022
U.S. 2.3 (1.3) (5.2) 6.2 2.5
Eurozone 1.2 (2.0) (7.3) 5.6 3.7
Germany 0.6 (1.9) (6.0) 4.3 3.3
France 1.3 (1.7) (8.0) 6.1 4.5
Spain 2.0 (2.1) (8.8) 5.1 4.3
Italy 0.2 (2.6) (9.9) 6.4 3.2
U.K. 1.4 (2.0) (6.5) 6.0 3.2
China 6.1 2.9 1.2 7.4 4.7
India* 5.3 3.6 1.8 7.5 6.5
World 2.9 0.4 (2.4) 5.9 3.9
*Fiscal year ending March. CCC--Credit Conditions Committee. Sources: S&P Global Economics and Oxford Economics.

Landlords Share Some Of The Pain

We believe office landlords will share some of their corporate tenants' pain despite the protection from their long-term leases. Rent collection for office properties within our rated office REIT portfolio has remained relatively high (average of 96% in U.S. in April 2020) despite many office buildings having sat virtually vacant (from government shelter-in-place orders) during the months of April and May. This is significantly higher compared to rent collection for retail properties (55% range in the U.S.) as retail store closures led to deferral of a large portion of rent. Although we expect tenant retention to stay high as companies avoid relocation expense during a recession, we believe the market has shifted to a renter's market, with landlords facing increasing pressure for rent concessions and growing vacancies across all markets over the next year. As a result, we expect same-property cash net operating income (NOI) declines in the low- to mid-single-digit percentage range in 2020 for the rated office REIT sector in the U.S.

Chart 1

image

In Europe, the pressure on office tenants, especially small companies, to renegotiate their rents is intensifying as the pandemic weighs on their earnings. The pandemic is also giving some large tenants a chance to reduce their real estate costs. Lease maturities in the coming quarters could also result in vacancies or lower rents. Given that European landlords within our rated perimeter are enjoying high rent collection for the second quarter (80%-90%, as of today), low exposure to small companies (less than 5% of annual rental income), and low rent at risk in 2020 (less than 10%), we estimate a decline in rental income will not exceed 5% of their annual rental income in 2020.

Aside from oversupply, office landlords in China may also suffer from lowering rental income in 2020 due to rental concessions, as the Chinese government is encouraging landlords, especially state-owned enterprises, to offer them to small and micro enterprises. In Hong Kong, at the end of March 2020, the overall vacancy rate in central locations was around 7%, up from less than 5% during the same period last year. If this trend continues, office rental reversions could weaken to a much larger scale, weakening the overall credit quality of rated landlords. Although rental reversions tend to take time to feed through to landlords' rental income, multinationals or larger tenants closing their offices in Hong Kong could pose growing risks. Meanwhile, in Singapore, we expect a marginally negative-to-flat rental reversion over the next six to 12 months as spot office rent continues to weaken from recent peak levels seen in mid-2019.

Office REITs Are In Relatively Good Shape And Could Stay That Way For The Foreseeable Future

Steady job growth and limited new supply supported healthy rent growth and steady occupancy levels for office REITs in 2019. In Tokyo, the vacancy rate stands at 2% and we expect a moderate rise in the vacancy rate and flattish rental growth over the next 12 months. In Australia, the two major office markets of Melbourne and Sydney enjoyed a vacancy rate of 3.4% and 5.8%, respectively, as of March 31, 2020. The Australian federal government's provision of financial assistance to employees via the "JobKeeper" supplement should help the private sector retain the core of its workforce while the economy goes into hibernation. Commercial landlords are banned from evicting tenants unable to meet financial commitments over the six months from April 2020. They also must offer a mix of rent waivers and deferrals for qualifying SMEs whose revenue has fallen more than 30%. Australian state governments have progressively announced land tax relief measures to partly soften the blow to landlords. Likewise, the Singapore government announced various measures in response to the COVID-19 outbreak, including property tax rebates to landlords, which are mandatorily passed on to office tenants, as well as job support schemes to relieve employers of some operating burden. There was also a bill introduced to allow a rent moratorium of up to six months for commercial tenants that are suffering from the COVID-19 fallout. We expect the deferred rentals will be collected in fiscal 2021.

In the U.S., occupancy rates for rated office REITs remained in the low-90% area and same-property NOI grew 4% in 2019. We expect the long-term nature of office leases (with an average of eight years) could mitigate downside risk amid a recession. However, while tenant retention rates will likely increase, the leasing up of any vacant space if tenants do move out will prove challenging, in our opinion. While only 5% of office REITs' annualized base rent is set to expire in 2020 (with 8% expiring in 2021), REITs could face modest declines in occupancy rates and lower rent growth given the fallout from the recession. We expect U.S. office REITs to report cash same-property NOI declines in the low- to mid-single-digit percentage area. This compares to a decrease of 2.4% in NOI in the last recession in 2010 for the rated U.S. office REITs.

In 2020 and 2021, after buoyant activity in 2019, most European office leasing markets should falter, mainly due to a weakening of long-term fundamentals. Consequently, our rated office landlords' major markets, such as Paris, Madrid, Berlin, Frankfurt, and Warsaw, should experience a slowdown in leasing activity in 2020. This is despite a healthy take-up in 2019 and ongoing decreases in vacancy rates to very low levels. We believe the scarcity of prime-quality assets, high population density, and low vacancy rates should partly mitigate the impact of a fall in demand in the major office markets this year. We expect a slow recovery in office demand in 2021 on the back of an economic recovery. Following years of positive revaluations, they may reverse to negative 5% in 2020. This reflects potentially weaker cash flow expectations by real estate appraisers (owing to lower occupancy rates, lower rental uplift, or lower indexation than anticipated), a decline in market transactions in the second quarter of 2020, and a potential rise in the capitalization rate. While these factors could result in valuation losses, we have no visibility on what the appraisers' independent decisions might be at this stage.

Chart 2

image

A Surge In Remote Working Will Result In A Gradual Reduction In Office Space Utilizations

As we emerge from the pandemic and evaluate strategies to return to offices, there is a growing uncertainty about the future need for office real estate. Shelter-in-place measures have accelerated digitization of work while maintaining productivity in many cases. As this test yields positive results, space requirements in many industries are in question and a structural contraction in office demand could happen over the medium to longer term. So far, Facebook stands out for announcing a more permanent shift to remote working for about half of its workforce over the next ten years. Other big tech companies have announced similar directives. The tech sector has been a key growth driver for office REITS over the past several years and accounts for about 25% of office REITS annualized base rent (ABR), on average.

Working from home is not new and remote working is not a new threat for landlords, but COVID-19 will likely accelerate its adoption. Many landlords took actions to address the work-from-home trend by implementing "hot desks" and allowing greater flexibility around the work space while limiting capacity to about 75% of total workforce. The work-from-home trend will likely be boosted by health-and-safety measures on top of other socio-environmental factors driving this trend. French automaker Groupe PSA recently decided to maintain remote working for a potential 80,000 employees (of 200,000 globally). This trend could ultimately erode tenants' demand for traditional office space and dampen overall occupancy and rent levels in the market. We think that high-grade, service-oriented, and centrally located offices should fare better. As an example, Societe Fonciere Lyonnaise S.A. (BBB+/Stable/--) recently signed a 12-year pre-lease to Goldman Sachs on a large (6,500 square meter) office building development in the center of Paris, despite the current market concerns.

Interestingly, a recent survey of 2,300 workers indicated that only 12% of the group would want to work from home five days a week. This is a very small increase compared to about 10% pre-pandemic. In addition, most workers expect crucial changes to the workplace before they're comfortable returning (Gensler U.S. Work from Home survey 2020). Moreover, a potential counter to the reduction of space could be the reversal of office densification. We've seen increased densification of office space since the 2008-2009 recession as employers packed more workers into smaller spaces and implemented open floor plans. Going forward, we think office guidelines for social distancing could reverse this densification trend and increase space from 150-175 square feet (sq ft) per employee to about 200 sq ft per employee. This could result in the reconfiguration of offices within the existing space, and the subsequent additional expense would largely be borne by the tenants and not landlords. We think office REITs with younger properties and developed with high-quality standards would likely be more attractive for tenants as they would require less redevelopment to comply with potential new health guidelines.

While it's too early to assess the ultimate impact of COVID-19 on office real estate, we expect tenants to look for greater flexibility in leases as they reconsider office space requirements, impacting occupancy and rent growth over the medium term. Tenants looking for shorter-term lease would likely need to pay higher rent per square foot. However, post the SARS epidemic, that severely hampered Hong Kong and Singapore's economy, we did not witness significant changes in office space utilization. Their office markets continued to have some of the highest cost per area and lowest square footage per person.

Co-Working Concepts Face Increased Pressure

Co-working concepts may be the first to feel the pressure on occupancy rates, given the short-term nature of their leases. The rapid growth of flexible space providers drove much of the demand for office real estate over the past few years and accounted for a substantial portion of new supply absorption. Notably, in 2018 WeWork Companies LLC (CCC+/CW-Neg/--) became the largest private office tenant in New York City, Washington, D.C, and central London. The company came under pressure in late 2019 following the collapse of its IPO and has since initiated a series of restructuring actions geared towards streamlining the business. Subsequent 2020 events, including disruption related to the coronavirus-fueled downturn, have placed further pressure on the company and its longer-term viability.

As flexible space providers face the prospects of sharp reduction in demand and uncertain recovery, they'd likely curtail growth plans and cut expenses and ancillary spending to preserve liquidity. Today, our rated office companies only have moderate exposure to the flexible office industry, both in terms of tenants (less than 5% of rental income, including WeWork) and as direct providers (less than 3% of rental income). Clearly, the pull-back in growth of co-working concepts could further depress growth prospects for office landlords. This could result in much slower absorption of new inventory, particularly in key gateway markets such as New York, which is facing significant new supply. While the exposure to flexible space providers remains limited, the spike of vacancy could add to rent pressure.

Negative Ratings Bias Grows But Downgrade Risks Are Tempered

We rate 46 office REITs globally, of which 15% have negative outlook currently. Across regions, the U.S. has the highest number of negative outlooks at 27%, while Asia-Pacific (APAC) has 7% and Europe, the Middle East, and Africa (EMEA) has 13% of ratings with negative outlooks. Of the 15 rated office REITs in the U.S., four issuers have negative outlooks, or a one-in-three chance of downgrade over the next 12 to 24 months. The issuers with negative outlooks generally face heightened development risks and limited cushion on credit metrics to sustain a downturn. However, we expect downgrades to be limited to one notch given our expectations for moderate and gradual pressure on cash flow in the next one to two years.

Chart 3

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Chart 4

image

Of the 16 European office landlords we rate, two have negative outlooks. The other 14 enjoy long lease maturity profiles, creditworthy tenants, and comfortable credit metrics headroom that should enable them to withstand this decline without affecting the ratings. Even a 5% decline in asset valuations in the same year is unlikely to affect most ratings.

Compared to other property types, office REITs have elevated development risks, as pipelines have outsized funding needs, with this risk only somewhat mitigated by relatively healthy pre-leasing levels. We expect office REITs to cut back development activities and reduce capital spending needs to limit cash outflows.

Office REITs remains a largely investment-grade sector with most ratings in the 'BBB' category. Despite pressure on cash flow over the near term, most maintain good access to the debt markets. In the U.S., investment-grade issuers returned to the markets to bolster liquidity in a low-interest-rate environment. The investment-grade corporate bond market in the U.S. reached record levels of issuance so far this year and the more-resilient REITs tapped the bond markets despite wider credit spreads. However, equity prices for office REITs remain under pressure, trading at a significant discount to net asset value (NAV), and we expect access to the public equity market to be limited to property types that are priced more favorably, such as landlords owning e-commerce fulfillment assets and data centers.

Chart 5

image

Still, most of our rated office landlords have some financial buffer and adequate liquidity to weather the storm. Capital expenditure (capex) reduction, operating cost savings, and conservative shareholder returns will be essential to maintain cash flow and financial standing. We believe disciplined financial policy and cash flow allocation will be key to maintaining credit quality for the rated office REIT universe.

Table 2

Global Office REIT Ratings
Region Issuer Long-Term Rating Outlook Short-Term Rating
APAC

Japan Real Estate Investment Corp.

A+ Stable
APAC

Nippon Building Fund Inc.

A+ Stable
APAC

Hongkong Land Holdings Ltd.

A Stable
APAC

IFC Development Ltd.

A Stable
APAC

Japan Prime Realty Investment Corp.

A Stable
APAC

Nomura Real Estate Master Fund Inc.

A Stable
APAC

AMP Capital Wholesale Office Fund

A- Stable
APAC

Dexus

A- Stable
APAC

GPT Wholesale Office Fund

A- Stable
APAC

Investa Commercial Property Fund

A- Stable
APAC

Swire Pacific Ltd.

A- Stable
APAC

Hysan Development Co. Ltd.

BBB+ Stable
APAC

CapitaLand Commercial Trust

BBB+ Watch Pos
APAC

Charter Hall Prime Office Fund

BBB Stable
APAC

Yuexiu REIT MTN Co. Ltd.

BBB- Negative
EMEA

Gecina

A- Stable A-2
EMEA

Aroundtown S.A.

BBB+ Stable A-2
EMEA

Covivio

BBB+ Stable A-2
EMEA

Icade S.A.

BBB+ Stable A-2
EMEA

Inmobiliaria Colonial, Socimi, S.A.

BBB+ Stable A-2
EMEA

Societe Fonciere Lyonnaise S.A.

BBB+ Stable A-2
EMEA

Alstria Office REIT-AG

BBB Positive
EMEA

Befimmo S.A.

BBB Stable A-2
EMEA

CPI Property Group SA

BBB Negative
EMEA

Merlin Properties, Socimi, S.A.

BBB Stable
EMEA

Workspace Group PLC

BBB Negative
EMEA

Globalworth Real Estate Investments Ltd.

BBB- Stable
EMEA

Immofinanz AG

BBB- Stable
EMEA

Summit Properties Ltd.

BB+ Stable
EMEA

DEMIRE Deutsche Mittelstand Real Estate AG

BB Stable
EMEA

Diok Real Estate AG

B Stable
NA

PS Business Parks Inc.

A- Stable
NA

Boston Properties Inc.

A- Negative
NA

Alexandria Real Estate Equities, Inc.

BBB+ Stable A-2
NA

Brookfield Property Partners L.P.

BBB Negative
NA

Vornado Realty Trust

BBB Stable
NA

Highwoods Properties Inc.

BBB Stable
NA

Kilroy Realty Corp.

BBB Stable
NA

Piedmont Office Realty Trust Inc.

BBB Stable
NA

Columbia Property Trust, Inc.

BBB Negative
NA

Brandywine Realty Trust Inc.

BBB- Stable
NA

Hudson Pacific Properties Inc.

BBB- Stable
NA

Office Properties Income Trust

BBB- Stable
NA

Corporate Office Properties Trust

BBB- Stable
NA

SL Green Realty Corp.

BBB- Stable
NA

Mack-Cali Realty Corp.

B+ Negative
APAC--Asia-Pacific. EMEA--Europe, the Middle East, and Africa. NA--North America.

This report does not constitute a rating action.

Primary Credit Analyst:Ana Lai, CFA, New York (1) 212-438-6895;
ana.lai@spglobal.com
Secondary Contacts:Franck Delage, Paris (33) 1-4420-6778;
franck.delage@spglobal.com
Edward Chan, CFA, Hong Kong + 852 2533 3539;
edward.chan@spglobal.com
Fernanda Hernandez, New York (1) 212-438-1347;
fernanda.hernandez@spglobal.com
Michael H Souers, New York (1) 212-438-2508;
michael.souers@spglobal.com
Craig W Parker, Melbourne (61) 3-9631-2073;
craig.parker@spglobal.com

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