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“This town is coming like a ghost town…”: Property use and economic collapse combo could leave commercial properties empty

22 May 2020 Gareth Stokes

The evolution of property use combined with economic contraction could contribute to a severe decline in commercial property occupancy worldwide. In some sense this future has been forecast by the West over the 36-months prior to the COVID-19 pandemic. Large malls in the United States (US) were already struggling to attract and retain tenants as foot traffic plummeted. A similar trend exhibits in the United Kingdom (UK), where the centuries-old High Street is under threat.

A quarter of US malls under threat

The US is so afflicted by emptying malls that a new term for the phenomenon has emerged. Ghost malls are described by as “shopping malls with high vacancy rates or low consumer traffic”. In 2017 Credit Suisse estimated that a quarter of US malls would shutter their entrances between 2017 and 2022 as consumers abandoned them for online shopping and e-commerce platforms. The struggling High Street issue has dominated UK headlines for years too. Late 2019, Guardian News and Media placed the spotlight on the struggle in an article: “UK retail footfall dips further as shoppers shun high street”. They said that traditional shopping zones faced an existential threat due to digital alternatives. COVID-19 will accelerate these trends. 

South Africa can expect huge shifts in property use as we emerge from the pandemic. We expect firms, especially small and medium enterprises (SMEs), to either abandon or greatly reduce their property footprints across the industrial, office, and retail categories. The office and retail segments will adjust due to widespread acceptance that South Africans can shop and work from the comfort of their homes. And demand for office and retail lets will decrease due to rising insolvencies and the huge impact on consumer spending due to job losses. 

Economic fundamentals demand a toll

The South African Reserve Bank estimates at least 1 600 company insolvencies through 2020, while National Treasury has warned of up to 1,7 million full time equivalent job losses. In the industrial sector we will see an acceleration of the slowdown in demand that was already taking place pre-pandemic. A forecast economic contraction of 16% in GDP through 2020 is not conducive to industrial and manufacturing activities. 

We can turn to the restaurant industry for a chilling illustration of the consequence of lockdown on tried-and-tested business models. Pre-lockdown you could walk into any of thousands of restaurants, country wide, and observe near-deserted seating areas. Apart from one or two hours in each day, these restaurants operate at a fraction of their capacity – serving only five or 10 of their 150+ seats. How sad that the entrepreneurs taking all the risks in these ventures are frequently drawing less from the business than their landlords, who refuse to budge on rentals and annual escalations as renewal dates draw near. 

Lockdown will teach these food entrepreneurs that a combination of bizarrely-named ‘dark kitchens’ and delivery services like Uber Eats and Mr. Delivery can redefine their business models and move more of the revenue back into their hands. Dark kitchens? Google says the phrase describes an emerging trend where food is prepared at separate takeaway premises rather than in a restaurant. And that means restaurants can operate without costly front-of-house overheads such as rent and regulated waiter / waitress wages. 

Quality critical to navigate uncertainty

Against this backdrop we were surprised to encounter an upbeat CEO team during the 20 May 2020 webcast of the Investec Property Fund annual results. The fund’s joint CEOs reported a solid performance for the year ending March 2020; but seemed hesitant to consider worst case scenarios for the property sector going forward. They did, however, observe that commercial property returns through pandemic would hinge on the quality of a fund’s underlying property portfolio. Joint CEO, Darryl Mayers, pointed out that landlord-tenant relationships were crucial if fund managers hoped to navigate the lockdown in place in South Africa since 26 March, and still in place at the time of writing. 

What can landlords and property fund managers expect form the next couple of years? The consensus is that lets in the retail sector will be severely affected. There are also early indications that office tenants will need up to 30% less floor space as they realise the cost-cutting potential in work-from-home and accompanying digital initiatives. “Many SMEs and non-essential traders will be hit hard,” said Mayer, adding that the shift to online retail and e-commerce was likely to accelerate. 

The Investec Property Fund should be fairly insulated from the worst of the retail space fallout due to its high quality tenant base. Approximately 83% of their retail space is let to national retailers with the remaining 17% let to SMEs, representing a nominal proportion of the balance sheet. The fund boasted extremely low vacancies in the retail segment going into the pandemic. 

But future rental negotiations in the domestic office segment are likely to focus on keeping bums on seats. “We expect greater flexibility in demand for office rentals and we will make sure that we respond to our tenants’ needs,” said joint CEO, Andrew Wooler. Over the near term the market is likely to see office rental ‘resets’ at lower rates, for shorter terms, and flexible utilisation of shared space inside multi-tenanted building. 

Logistics seen as defensive play

The Investec Property Fund has made a strategic commitment to a 65:35 split between domestic and offshore properties. It believes that its recent strategic acquisition of logistics-focused properties in Europe came at the perfect time – and into a well-positioned segment of the market. “We will get banged up; but we will emerge on the other side,” said Mayers. “Our European portfolio, post-pandemic, is more defensive and resilient”. He expected the South African portfolio to benefit from its sectoral and geographic spread and the fund’s extensive in-country expertise. 

There will be a decline in property fund income due to short term discounts given to national retailers and suppliers of non-essential goods. Mayer also expects the costs associated with managing large properties to increase as landlords implement regulations relating to access and PPEs. And these costs will have a slightly higher impact due to the inevitable rise in mall vacancies and voids. 

The ability to provide accurate guidance to the market is limited. “There is great uncertainty about rentals,” explained joint CEO Andrew Wooler. And local property fund managers will have to adapt to the heightened risk of tenant failures in the SME and retail sector. From an Investec Property Fund perspective, he concluded: “We have sound property fundamentals and robust tenant growth, a diverse earnings base, and limited exposure to under-capitalised businesses”. 

Adjustments cannot occur overnight

We appreciate the difficulty faced by landlords and property fund managers as the world emerges from the COVID-19 pandemic. As Wooler explained, it will take time for the fund to repurpose its portfolios to maximise returns as property use evolves. An appropriate conclusion from the Investec Property Fund presentation is that you cannot reset a portfolio of ‘brick and mortar assets’ that have been carefully chosen to achieve a fund’s long term investment mandate overnight. This is sound advice for investors in other long term asset classes too.

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