The business disruption from the COVID-19 pandemic will materially erode the eurozone's GDP growth, increase unemployment, and rapidly weaken the credit quality of real estate companies' tenants. Most European governments have placed mandatory restrictions on social interaction, leading companies to temporarily close their offices and implement work-from-home procedures where possible. This is affecting companies' capacity and willingness to pay the contractual rents for their offices, and we expect office landlords to feel the impact.

Nevertheless, S&P Global Ratings estimates that office landlords will not see rents decline by more than 5% in 2020. The 17 European office landlords we rate have long lease maturity profiles, creditworthy tenants, and comfortable ratio 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. At the same time, weak economies and remote working pose longer-term threats to the demand for office space.

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.

Rent Concessions--Whether Essential Or Not--Will Impair Office Landlords' Revenue Growth In 2020

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 creating an opportunity for some large tenants to try to reduce their real estate costs. As a result, on a like-for-like basis, we expect a decline in rental income of up to 5% for our rated European office landlords in 2020. This takes into account our three headline estimates below and excludes contributions from other rental segments. We then envisage a moderate rebound in rents in 2021. This compares favorably with our assumption of a 15%-20% drop in rental growth for European retail landlords in 2020 (see "COVID-19 Will Likely Ruin European Retail Property Companies' Efforts To Contain Competition From E-Commerce," published April 1, 2020).

Rent concessions to small companies: 0%-1% reduction in 2020 gross rental income

Of the many companies directly affected by the COVID-19 pandemic--such as those operating in the tourism, auto, transport, media, entertainment, and nonessential retail segments--the smallest companies are likely to suffer the most and struggle to pay their office rent, at least in the second quarter of this year. Even though office landlords have limited exposure to small companies, most of them reacted by temporarily easing these tenants' payment terms and granting a three-month rent suspension to those in financial difficulty. So far, the total rent concessions that landlords have granted to small companies do not exceed 1% of our 17 rated European office landlords' annual revenue. We therefore believe that most landlords can well accommodate the prompt support they have given small companies, and the provision of such support could also boost their reputations.

Rent concessions to larger companies: 0%-3% reduction in 2020 gross rental income

Some larger tenants that may be able, but not willing, to pay rent are also requesting rent concessions or deferrals. This brings into question landlords' bargaining power and capacity to refuse such requests, which, in our view, are stronger in the office sector than in the retail sector. This is because rent collection by office landlords is high relative to other property types, and represents 80%-90% of the rent billed for the second quarter of the year. Despite rents and late-payment penalties being due, we expect landlords to conduct one-to-one negotiations and favor rent deferrals rather than rent suspensions. We believe that landlords may try to preserve economic rents by only granting rent concessions in exchange for lease extensions. We estimate that current rent renegotiations account for between 10% and 30% of office landlords' rent invoices for the second quarter of the year, based on landlords' reporting. Where information is unavailable, we conservatively assume that such negotiations could cost office landlords the equivalent of about 50% of the rents that are under negotiation and due in the second quarter of 2020, or 50% of the uncollected quarterly rent. This represents another 0%-3% of office landlords' 2020 gross rental income overall.

Potential rent decreases on lease renewals and vacancies: 0%-1% reduction in 2020 gross rental income

We believe that office landlords with the longest leases are better protected against the risks of tenant exits and negative re-leasing spreads over the coming quarters amid the current uncertainty around market rents. We assume a 10% reduction in the portion of 2020 revenue that is still subject to a potential lease expiry or break option. We estimate this portion at between 5% and 10% for our rated European office landlords. However, the impact could be greater if a landlord was "over-rented" before the COVID-19 outbreak, meaning that its actual rents were higher than market rents. The rents of most of the office landlords we rate were relatively in line with, or even lower than, market rents before the outbreak of COVID-19.

Weaker Economies And Remote Working Could Erode Companies' Need For Traditional Office Space In The Longer Term

In 2020 and 2021, we believe that most office leasing markets should falter after buoyant activity in 2019, mainly due to a weakening of their long-term fundamentals. The polarization in demand between prime-quality and low-quality offices should intensify along with the faster penetration of work-from-home practices. We think that high-grade, service-oriented, and centrally located offices should fare better.

The office leasing market is vulnerable to weak corporate sentiment and rises in unemployment

The office leasing sector is generally supported by factors such as GDP growth, job creation, and companies' expansion plans. We estimate that GDP in the eurozone will deteriorate by 7.3% in 2020 due to a deep recession, but will recover to 5.6% in 2021. We also believe that the unemployment rate will reach 8.6% in 2020, up from 7.6% in 2019. Moreover, we anticipate that the pandemic and its aftermath will dampen companies' growth plans and need for additional office space. The cost cutting and staff reductions that may result from prolonged disruption will exert pressure on office occupancy rates. Flexible office providers may be the first to feel the pressure on occupancy rates, given the short-term nature of their leases. But flexible offices may also represent a credible alternative to long-term traditional offices for corporate tenants that are on the path to recovery. 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) and as direct providers (less than 3% of rental income).

Consequently, we think that our rated office landlords' major markets, such as Paris, Madrid, Berlin, Frankfurt, and Warsaw, should experience a steep slowdown in leasing activity in 2020. This is despite a healthy take-up in 2019 and ongoing decreases in vacancy rates. We believe that the scarcity of prime-quality assets and low vacancy rates should partly mitigate a potential 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.

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The work-from-home trend may be here to stay, boosted by health-and-safety measures but also socio-environmental factors

The restrictions on movement and social gatherings that most European governments have imposed have led companies to temporarily close their offices, limit face-to-face business interaction, and deploy remote-working processes. The success and the duration of remote working may convince companies to maintain this practice and optimize their office space and related costs.

Following reports by U.S.-based Facebook and Google that they plan to maintain remote working at least until 2021, French automaker Groupe PSA recently announced its decision 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. At the same time, the experience of the pandemic may change corporate behavior, and if social distancing becomes the norm, it may require tenants to consider granting more personal space to employees than is currently standard.

However, working from home is not new. The development of remote-working capabilities started a couple of years ago, as companies started to focus on improving their employees' work flexibility and work-life balance, while reducing their real estate costs. At the same time, more people working remotely could address other socio-environmental factors, for example, by reducing the air pollution from commuting by car and the strain on metro networks due to growing urbanization in major European capital cities.

Remote working is not a new threat for landlords either, as many took action to address this trend long ago by developing a wide range of attractive services within their offices, investing in common areas to improve employees' wellbeing, and refocusing their office portfolios on central locations with excellent transport connections. Landlords' push to obtain social and green certifications for their buildings--such as WELL, Breeam, Leeds, or HQE--also aims to address the increasing demand for offices with green and social credentials from occupiers and investors.

Office Landlords Can Comfortably Absorb Rent Declines Of Up To 5% In 2020 At The Current Ratings

Our previous base-case scenario assumed flat-to-positive growth in rents and valuations on the back of supportive macroeconomic trends and greater demand than supply. However, the effects of the pandemic have undercut our expectations.

Our revised base-case scenario now assumes:

A 0%-5% like-for-like decline in rents, made up of: 

• 0%-1% loss of annual gross rental income from rent concessions to small companies, based on these companies' announcements, or 10% of office landlords' exposure to small-to-midsize enterprises (SMEs). Exposure to SMEs is moderate for our rated landlords, ranging between 5% and 25% of their revenues.
• 0%-3% loss of annual gross rental income from other rent renegotiations, assuming losses from half of the requests received for quarterly rent discounts or deferrals, or half of the uncollected second-quarter rent, as of today. We estimate the uncollected rent and rent-deferral requests at between 10% and 30% of the landlords' rental income for the second quarter of 2020.
• 0%-1% loss of annual gross rental income from increased vacancy rates or potential drops in rent following lease renewals, assuming a conservative 10% hit to rents under leases that are due to expire or reach a break point in the remainder of 2020. We estimate the rent at risk for 2020 at less than 10% of the landlords' annual revenue currently.

A 0%-5% like-for-like decline in valuations.  This reflects property appraisers' potentially weaker cash flow expectations (owing to lower occupancy rates, rental uplift, or indexation than anticipated); a decline in market transactions in the current quarter; and a potential rise in the capitalization rate. While we believe that these factors could result in valuation losses, we have no visibility on what the appraisers' independent decisions might be at this stage.

Fewer disposals and acquisitions in 2020.  While the investment market remains subdued, we expect it to resume when economic activity does. We also believe that the rated office landlords should still manage to close asset disposals at prices equal to or above the book value.

Our financial projections for 2020-2021 now assume:

• An increase in ratios of debt to debt plus equity as a result of our estimated valuation declines, but remaining well within our rating expectations. These ratios will also remain better than before the 2008 financial crisis.
• A weakening of EBITDA-to-interest ratios due to a decline in revenues, and potentially, an increased cost of funding due to rising spreads. However, these ratios should remain strong in most rating categories.

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Our alternative scenario

The degree of the impact of the COVID-19 pandemic remains uncertain, as it depends on the total duration of the pandemic and the pace of the economic recovery. Yet our sensitivity analysis shows that even in the event of a harsh like-for-like decline in office rent of 10%, most ratings would likely remain unaffected, thanks to the comfortable headroom under our ratio thresholds. On the other hand, a harsh decline in asset valuations of 10% or more would likely lead us to lower most ratings, but this scenario is not what we currently expect.

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Related Research

• COVID-19: Implications For European Real Estate Investment, As Tenants Begin To Suspend Rent Payments, March 26, 2020
• The Lowdown On Lockdowns, April 27, 2020