The economic and credit implications of the coronavirus outbreak are weakening the credit quality of real estate investment companies in Europe as tenants' creditworthiness and capacity to pay contracted rents starts to weaken. What's more, most governments have announced measures to contain the virus and support corporates in difficulty, some of which are credit negative to landlords, such as stores and hotels temporary closures, and the ability for corporates to skip rental payments. Here, S&P Global Ratings takes an overall look at the sector. In the days to come, we will conduct individual rating reviews on European real estate companies. We believe the duration of the outbreak and governmental measures are key in determining the impact on this sector.

S&P Global Ratings acknowledges a high degree of uncertainty about the rate of spread and peak of the coronavirus outbreak. Some government authorities estimate the pandemic will peak about midyear, and we are using this assumption in assessing the economic and credit implications. We believe the measures adopted to contain COVID-19 have pushed the global economy into recession (see our macroeconomic and credit updates here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

Outbreak Duration And Governmental Measures Will Be Key In Determining The Impact

Most governments have adopted measures to limit social interaction, thus forcing companies to close businesses temporarily and stop development projects. The effects on real estate landlords therefore should ease only with the end to containment measures, such as personal isolation and the temporary closure of shopping centers. We believe the financial pressures on tenants to renegotiate their rents will intensify in case of a prolonged outbreak.

At the same time, several governments have announced measures to support corporates and the overall economy. One of them includes the right of corporates to suspend or cancel rent payments, which could be credit negative for landlords if they do not receive refunds for amounts in arrears. At the moment, these measures have not been adopted widely in Europe, and details are to come, in particular whether the landlord would fully book the loss of rent or there would be some government intervention to make up part of the loss.

Most real estate companies are temporarily easing payment terms, mostly shifting from quarterly payment in advance to monthly in arrears. A few have also agreed already to cancel the rents for a couple of months.

We do not expect significant insurance protection for real estate companies in the current circumstances, given common exclusions for "force majeure." If refunds take place, we do not think they would exceed the variable rent portion of landlords' revenues, which is generally very minor.

Although this event constitutes a source of rent loss, we believe most companies we rate can afford a one-month loss in rent within the tolerances of the current ratings.

A Major Hit To Retail And Hotel Landlords

Retail galleries' owners face a growing demand for rent freezes

The measures to contain COVID-19 are particularly hurting industries that rely on discretionary spending, such as the leisure and high-end or nonfood retail sectors, which are increasingly present in shopping centers worldwide.

In Europe, the exposure of shopping center landlords to variable rents remains moderate, averaging around 5% of gross rent. Still, such rents will likely suffer from retailers' depressed turnover. More importantly, we believe tenants in difficulty will ask landlords to reduce their fixed rents or temporarily discount their rent if the coronavirus outbreak persists, especially in the case of temporary closures of shopping centers, isolation requirements, and other governmental measures such as rent freeze allowances. This will be detrimental to footfall in shopping centers' galleries, as well as landlords' revenues.

For their part, we believe landlords are likely to ease their payment terms temporarily and reduce operating expenses to limit the hit to EBITDA. We also expect them to put most non-committed investments and acquisition plans on hold. So far, rated retail real estate companies are not reporting significant losses of rental income and unpaid rents, but we think the situation could deteriorate quickly. We therefore believe the rate of like-for-like rental growth is highly like to decline in 2020, possibly by 15%-20%.

A retail recovery is likely to be slow, we believe, once the pandemic is over and the economy recovers, depending on how long that will take. In addition, we may see increasing vacancies particularly for retail landlords if tenants become insolvent or bankrupt.

Hotel property investors see a squeeze on the variable portion of rent

As the hotel industry experiences a wave of cancelations due to travel bans, isolation measures, and forced closures of hotels in some areas, their landlords see the variable portion of their rents, which is directly indexed to hotel operators' performance, under similar pressure. We therefore believe companies exposed to variable rents will be affected most.

Real estate companies providing long-term fixed leases should remain more protected, although tenant credit quality will likely weaken and could force the smaller and least creditworthy operators to renegotiate. Similarly to retail, we believe landlords might ease their payment terms in the short term and possibly accept rent losses.

Office properties and the leasing market might be vulnerable to weaker corporate sentiment

We believe office landlords will see slower rental growth as corporate sentiment weakens. In the short term, we believe office landlords, especially to large multinational tenants, will be more protected than the retail or hotel sectors given their long-term leases and generally stronger creditworthiness. This is also in line with our understanding of what is happening in China. That said, the office sector and its leasing dynamics generally find support from GDP growth, which is turning down, as well as job creations and corporates' expansion plans. As for the latter, we think these may be put on hold or scaled back. Cost cutting and staff reduction are a risk, which may result from a prolonged disruption, and would reduce the need for additional office space and overall market occupancy. As for flexible-office space, which has grown in the past few years, we think the short-term nature of leases will first lead to declines in occupancy in the very short term, given work-from-home requirements and the typically weaker credit profile of their tenants.

Logistics, health care, and residential properties should face less short-term turbulence

• In our view, demand for logistics space will find support from a jump in e-commerce orders because of store closures. We expect this will offset or lessen the weaker demand from physical retail distributors with disrupted supply chains.

• The health care property segment remains supported by long-term leases, high occupancy, low supply, and lower revenue headwinds for large health care operators. This is particularly the case for short-term care hospital operators, which might be less vulnerable than nursing homes to COVID-19 outbreaks in our view, due to higher government funding. Moreover, we understand there could be some government support for temporary operating losses, such as surgical procedure cancelations, especially for hospitals requisitioned by the government.

• The residential segment will likely face weakening tenant creditworthiness if economic and employment outlooks worsen. However, tenant diversity and the structural shortage of housing in most large cities should prevent large residential players from experiencing material amounts of rent renegotiations or unpaid rents in the short term. Moreover, some governments provide rental payment guarantees or other forms of support to the least-creditworthy tenants. Germany's two largest listed landlords, Vonovia SE and Deutsche Wohnen SE, have announced their intention to give individual support to tenants in financial difficulty.

Weaker Funding Conditions Could Threaten Liquidity

The real estate sector is highly capital intensive and reliance on the debt capital markets is high. Deteriorating financing conditions and reduced access to the capital markets as a result of the coronavirus outbreak are also likely to constrain real estate companies in their liability management.

In most cases, liquidity positions and headroom on debt covenants--mostly loan-to-value (LTV) ratios, interest coverage ratios (ICRs), or debt service coverage ratios--remain comfortable at this stage. We believe that most liquidity sources by our rated European real estate companies could cover uses (including the refinancing of outstanding commercial papers) by more than 1.2x on average for the next 12 months. We understand that many real estate players have drawn under their available credit lines in the last few days to ensure enough liquidity for short-term requirements or upcoming debt repayments. Some companies have also announced dividend cuts (Unibail Rodamco Westfield, for example), as well as sharp reductions in non-committed capital expenditure (capex). On the other hand, we would not rely on potential asset disposals as a liquidity source, given that property sales are very unlikely in the current environment.

We remain cautious, however, about future refinancing and increased cost of debt as a result of widening credit spreads. Moreover, we observe slightly less headroom on LTV covenants than on ICRs, as very low interest rates boosted ICRs in recent years. The impact of the financial fallout from the pandemic on future property prices remains uncertain at this stage. Weaker cash flow and a sharp decline in investment over the next quarters may result in negative revaluations and increased LTV ratios by the end of the year.

Related Research

• COVID-19 Credit Update: The Sudden Economic Stop Will Bring Intense Credit Pressure, March 17, 2020