Nordic countries seem set for growth this year after an economic decline due to COVID-19. In Sweden, for example, GDP is forecast to increase by 3.0% in 2021 after a 2.8% contraction in 2020 and the Norwegian and Finnish economies are expected to expand by 3.2% and 2.0% respectively. S&P Global Ratings believes companies that own and operate real estate assets in the region will have mixed fortunes through 2022. However, their comfortable ratio headroom and liquidity buffers should help them manage weakening of the property market and higher debt.

Last year, most of them weathered the pandemic's impact relatively well, with average net rental income down by only 1.8% and even a slight decrease (1.6% on average) of our adjusted debt-to-debt-plus-equity ratio. This was thanks to strong cash flow generation and some positive asset revaluations, mainly for community services and residential asset. What's more, funding conditions remain favorable and better yields than nominal interest rates continue to attract investors, especially for low-risk asset types such as residential, public-sector, and logistics properties.

Real estate, including commercial real estate (CRE) make up about 48% of Nordic banks' corporate loan books, well above the European average of 27%. Yet nonperforming loans in the sector are among the lowest, at about 0.8% at year-end 2020, despite the COVID-19-related economic impact. Nordic banks started 2021 with strong capitalization and earnings capacity, stable funding, and solid liquidity ratios, which we believe will continue to mitigate potential concentration risks from the property segments.

Retail Property: E-Commerce Is Clouding Long-Term Prospects

In our view, the near-term outlook for retail property owners has improved with the acceleration of vaccinations across the region. Conditions are good for shopping centers to see increased traffic and demand in the near term. We therefore forecast a 3%-4% rise in private consumption in 2021 2022 after a 4.7% decline in 2020. The pent-up demand is also to some extent reflected in the consumer confidence indicator in Sweden, which rose to 103.2 in April 2021, the highest reading since September 2018; and strong retail sales in March, up 9.1% year on year. The retail property sector also benefits indirectly from government support to help tenants in difficulties and limit bankruptcies.

Retail property companies' like-for-like net rental income declined by 5.9%-9.8% and portfolio revaluations by 3.9%-4.9% in 2020. However, due to fewer restrictions and strong government support, they fared better than their European peers, which reported a drop in like-for-like net rental income of 15.2% and a 6.2% contraction of property value on average.

There is still considerable uncertainty for the long term. The continued growth of online shopping and changes in consumer preferences due to the pandemic signal a structural shift from traditional retail channels. This may eventually translate into lower rental growth and occupancy rates. Vacancies have already started to increase in the Nordics (by more than 2% in 2020) and rent reversion has turned negative (1.0%-3.1%) for some companies, unlike for most other peers in continental Europe (see chart 1). We are also mindful of the higher retail density in the Nordic countries than in Europe, although this is somewhat offset by stronger sales in shopping centers.

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Chart 2

For our base case in 2021, we expect continued pressure on net rental income and occupancy rates, and assume the sector will post only flat to modest EBITDA growth. We also assume some further negative property revaluation as appraisers incorporate the potential revenue impact over the longer term. We believe grocery-anchored retail centers with a more diverse tenant base will do better than shopping malls in secondary locations where there's a higher share of fashion outlets. In particular, the proportion of fashion in online sales has already risen (to 30% in 2020 from 20% in 2019, according to PostNord E-handelsbaromter). This in our view could imply significantly lower demand in physical stores.

Office Rentals Are Slowing As Demand For Office Drops

So far, the pandemic has had a limited impact on the office sector, since the majority of tenants have been paying rent despite low space utilization. Most Nordic property companies showed flat to slightly positive like-for-like rental income growth and increased asset values in first-quarter 2021, continuing the trend from the previous year.

We think it is too early to draw any conclusions regarding the long-term effect of employees working from home instead of at the office. However, we expect, for example, continued pressure on rent and leasing in Stockholm's central business district (CBD) and inner city. Rental income was down 4% and 3% respectively, in 2020, according to Jones Lang Lasalle (JLL), due to slowing economic activity and the shift to work from home, which led leased volumes to drop by about 40%. Vacancies in other Nordic capitals' CBDs also rose, albeit from relatively low levels.

The decline in Stockholm and Oslo in 2020 came after several years of strong rental growth in Nordic CBDs in recent years, outperforming other European cities (see chart 3). Yet prime yields have remained stable because, as we understand, the rental income decline is primarily due to rent concessions and the longer time needed to close new leases. We expect rents and occupancy to remain under pressure in Stockholm and Oslo before stabilizing by the end of 2021, since the expected recovery of Nordic economies should revive demand for office space, and new supply remains limited (see chart 4). We expect a more pronounced recovery in 2022 once economic growth takes hold.

Chart 3

Chart 4

The polarization in demand between high-quality office space in prime locations and low-quality offices will likely intensify as employees continue to work from home, with the former performing better over the medium to long term. Nevertheless, we think the Nordic office markets may prove more resilient than those in larger European cities like London and Paris, since no cities are large enough to require long commutes. Furthermore, even before the pandemic, remote working was already part of the Nordic business model.

Residential Property Markets Should Stay Buoyant

Solid demand, housing shortages, and urbanization will continue to fuel growth, with the regulated segment being the most resilient. Residential properties in the Nordics have weathered the pandemic-induced economic shock fairly well. Real estate companies we rate with residential assets reported like-for-like rental growth of 1.2%-3.6% in 2020, down only slightly from 2019. As of Dec. 31, 2020, occupancy remains high, averaging 97.5%-98.5%, in line with pre-COVID-19 levels, with rent collection at normal levels.

Regulated residential markets have shown better results than unregulated markets on average where rent levels are higher. For instance, Heimstaden reported a 1.3% decline in like-for-like rental income in Oslo for first-quarter 2021 and, in general, vacancies have increased in Nordic capitals such as Helsinki and Copenhagen, which are exposed to market rents. We attribute the decline in occupancy rates to an increase in rental housing and new supply in some regions.

The Swedish rental market is tightly regulated, with rental prices substantially below market values or replacement costs. The average rent per square meter was Swedish krona (SEK) 1,169 per year as of year-end 2020, according to Statistics Sweden, compared with SEK1,877 per year on average for a new unit. This implies a very low risk of vacancies for the foreseeable future, since due to rent regulation there is virtually no new supply coming on stream. We expect some short-term pressure on rents and vacancies throughout 2021 for some Nordic capitals exposed to market rents. Yet market fundamentals for Nordic residentials remain favorable with strong demand stemming from rapid population growth, structural housing shortage, and limited new supply.

In 2021-2022, we project rental growth at 1.5%-2.5% supported by indexation and rent increases related to value-enhanced investments. The companies we rate in the residential sector--such as Akelius Residential Property (Akelius), Heimstaden Bostad, and Samhallsbyggnadsbolaget i Norden (SBB)--all have extensive refurbishment programs.

Under these conditions, residential real estate investment trusts (REITs) we rate should maintain comfortable headroom between their credit metrics and our rating thresholds. We expect positive like-for-like revaluations averaging 2%-3% in line with 2020, depicting the sector's resilience.

Demand For Community Services Properties Remains Strong

This segment benefits from long-term rental agreements, high occupancy rates, and stable tenants. This explains why it has only been marginally affected by the pandemic's economic impact. The majority of leasing contracts are linked to inflation where rent is set on a cost-plus basis determined by public spending on elderly care homes and schools. This supports predictability and stability of cash flow although the potential for rent increases is somewhat limited over the medium term.

We anticipate that community service properties will continue to enjoy long-term demand, thanks to urbanization, demographic changes, and ageing population. For instance, the proportion of people over 80 years old (about 5%) in Sweden is set to reach about 8% by 2030, according to Statistics Sweden, implying increased demand for nursing homes. In line with strong population growth, the Swedish government also requires 1,500-2,000 new schools and preschools by 2026 (Source: Boverket/Finance department 2019).

The risk of rent nonpayment is also low due to creditworthy tenants, since Nordic community services operators are funded directly or indirectly via public spending. This is an advantage versus other European operators funded via health care insurance and various fees. Furthermore, the risk of oversupply is mitigated by high barriers to entry because the market is highly regulated. In our view, Nordic property companies' relationships with municipalities is crucial when sourcing new projects and expanding this type of asset portfolio.

Key considerations, in our view, include the degree of property specialization supporting tenant retention, and salvage value. We believe properties in large cities or regions should enjoy higher alternative uses than those in smaller or peripheral cities, given urbanization trends.

We think yields could compress further in 2021-2022 because of strong investor interest in the sector due to rental growth, high occupancy rates, and stable creditworthy tenants.

E-Commerce Growth Is Boosting Logistics Activity

The demand for Nordic logistics assets remains strong, fueled by increased online sales during the pandemic. In Sweden, for instance, e-commerce was up 40% last year according to PostNord E-barometern 2020, including 95% growth of consumer staples or groceries. The strong growth of e-commerce also contributed to the share of retail sales increasing to 14% of total sales in 2020 from 11% in 2019. We expect this trend will continue, implying continued need for logistics assets.

International investors have shown particular interest in Nordic logistics assets, which accounted for around half of the transactions in this market in 2020. In our view, the main attraction is the higher yield gap to nominal interest rates relative other property sectors, and long lease contracts. This is also evident in the valuations of Nordic logistics properties. A CBRE report suggests that prime yields fell to 4.15% in Stockholm and 4.75% in Copenhagen in 2020, from 4.5% and 5.2% respectively in 2019. This was also supported by large benchmark transactions such as Blackstone's acquisition of the SEK2.1 billion Nyfosa portfolio or Castellum's disposal of a SEK5.0 billon Swedish asset portfolio at a 20% premium to book value. We think further yield compression is likely, due to growth prospects for the sector and strong investor demand. While we expect supply of new assets to pick up, we believe demand for logistics space should continue to outpace supply, in particular in prime locations

Credit Conditions Bode Well For Real Estate Investment Activity

Favorable access to capital markets and low interest rates should make for another strong year of investment activity. Transaction volumes in the Nordics reached €9.1 billion in the first quarter of 2021, according to Pangea Property Partner, following on from the strong trend in 2020. Investors still favor residential, logistics, and public-sector properties with stable cash flows and strong counterparties. Larger transactions included SBB's SEK9.3 billion acquisition of Offentliga Hus and Balder's SEK5.0 billion acquisition of Masmästaren.

Given ample liquidity in the market and the low-interest-rate environment, the overall yield gap means real estate remains an attractive investment. This in our view implies that capital will continue to flow into the sector, largely protecting asset values. Typically long-term investors, such as pension funds, and other institutional investors are increasing their share of alternative investments. We believe this is positive news for rated real estate issuers. In addition, we believe the market may attract more foreign investors, which represented only 25% of buyers in first-quarter 2021 (source: Cushman Wakefield).

Already we see retail property transactions slowly gaining momentum. We note that Citycon sold three assets for a total of €147 million during the first quarter of 2021 at a price slightly above the last appraisal value. Although we expect investors' appetite for retail assets to remain muted, we think certain assets in a good location, with potential for further development, may catch their eye should traffic and retail sales pick up significantly over the coming 12-24 months.

Asset Value Growth Is Keeping Leverage In Check

Debt has surged among the Nordic property companies we rate over the past seven years, mostly because of acquisitions. Last year marked the strongest annual growth rate (12%-13%), with debt climbing to more than SEK335 billion from SEK110 billion in 2014 (see chart 5).

Chart 5

SBB acquired Sveafastigheter Bostad in November 2020 for SEK2.8 billion, as well as Offentliga Hus i Norden AB in December 2020 and the beginning of 2021 for about SEK9.3 billion. Heimstaden Bostad AB acquired Residomo in the Czech Republic for SEK13.0 billion and residential assets worth SEK12 billion in Sweden, Denmark, Netherlands, and Germany. Subsequently, Heimstaden Bostad became the largest private residential property owner in the Czech Republic by acquiring Residomo. We also note continuous attempts by SBB and Fastighets AB Balder in 2020 to acquire Entra ASA, which has a portfolio of Norwegian krone (NOK) 57 billion. Companies are continuing to focus on debt-funded external growth so we don't expect debt to reduce in 2021-2022.

At the same time, companies' asset portfolios increased more than their absolute debt. We also note companies' issuance of equity and equity-like instruments to contain or even reduce leverage.

Low Interest Rates Help Sustain EBITDA Interest Coverage

We expect average EBITDA interest coverage ratio to remain well above 3x on the back of lower average cost of debt, which decreased to about 1.7% in 2020 from 1.8% in 2019 (see chart 6). Despite the spread widening during the pandemic, issuers benefitted from the lower base rates and manage to tap the European bond market at competitive rates. This is a 1.5x improvement from 2009, mainly due to significantly lower financing costs and active liability management. However, interest coverage was below what we expected for real estate companies in Europe, the Middle East, and Africa in 2020. We expect interest coverage to average 3.5x-4.0x in 2021-2023, due to continued lower funding costs and low interest rates, since we assume Nordic central banks will keep the key rate at zero until the end of 2024.

Chart 6

Negative Asset Valuations May Harm Creditworthiness If The Decline Exceeds 5%

Other than for retail, we expect asset values to stabilize in our base-case scenario for most rated real estate companies. However, we think a material change in investor sentiment and an unexpected hike in yields could result in declines. We estimate that companies can absorb a drop in portfolio value annually in 2021-2022 that is 2.5% more than in our base case, but a drop of 5% more than in our base case in 2021, and an additional 2.5% in 2022, could cause credit metrics of three companies to breach our rating thresholds (see charts 7, 8, and 9).

Chart 7

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Chart 9

Last year, currency volatility hurt investment property valuations reported in euro. Nordic real estate companies we rate reported about a 130% negative impact from currency translation in 2020 (see chart 10) compared with fair value movements for that year, with Akelius Residential Property AB, which owns properties across the globe, taking the largest hit. This value decline is the steepest in five years. We expect the associated uncertainty to lessen in the second half of this year, since we anticipate limited foreign exchange volatility for the Nordic currencies. That said, the overall impact on credit metrics will likely be limited by natural hedges and companies' hedging policies.

Chart 10

Capital Market Access Supports Sound Debt Profiles And Comfortable Liquidity

Nordic real estate companies are increasingly financing growth and acquisitions by issuing debt directly in the capital markets, particularly in the first quarter of 2021 (see chart 11). Companies have also been active on the Eurobond market. The prime driver of disintermediation has been more favorable conditions for debt financing in the capital markets for large real estate companies, or those with an investment-grade rating, rather than bank financing conditions. Another contributing factor is that companies are actively diversifying funding and reducing their dependence on banks. We understand that bond market financing represented 65%-70% of real estate companies' debt.

Low interest rates in recent years have resulted in strong demand for higher-yielding instruments and, consequently, there has been a significant inflow into fixed-income securities, creating liquidity and generating strong demand for corporate bonds.

Chart 11

Real Estate Lending Still Poses Concentration Risks For Nordic Banks

Nordic banks' exposure to real estate activities, including commercial property, is higher than in Continental Europe (see chart 12). Overall, real estate lending remained stable in 2020 as banks continued to refinance and provide new credit to the CRE sector as corporate bond market spreads increased significantly. With the rebound in capital markets this year, we expect real estate companies to replace some bank funding with market financing as bond yields decrease. Even so, given banks' lending activities during the first quarter of 2021, we think their large CRE loan books are unlikely to reduce over the next two years.

We view as positive that bank regulators in Norway and Sweden have introduced risk weight floors, given banks' high exposure to CRE and potential losses in an adverse economic or interest rate scenario. We don't expect the requirements to limit future lending capacity, owing to banks' high capital buffers. Rather, we anticipate that banks may need to increase lending margins due to the higher cost of capital. However, this didn't happen in 2020, since margins stayed stable overall, and some Nordic banks already apply higher risk weights than the new risk-weight floor.

Chart 12

Banks' asset quality remained robust in 2020, underpinned by low underlying losses. Nonperforming real estate loans totalled a low 75 basis points, well below that in banking sectors elsewhere in Europe. Large CRE lending portfolios expose banks to a potential drop in asset values and rents. However, a mitigating factor is their approach to CRE lending, which focuses on cash flow from long-term leases, rather than speculative or value-based lending. Although concentration risk will remain, we expect Nordic banks' healthy capitalization and strong profitability would ensure resilience. This in turn would support both the bank and real estate sectors in the event that market conditions worsen in 2021.

Chart 13

Companies Can Cover Debt Maturities Up To 2022 If Refinancing Becomes Difficult

The majority of Nordic property companies we rate have low debt maturities in 2021 and 2022 and adequate long-term undrawn committed credit lines, which they can use if refinancing conditions become difficult. We believe their liquidity needs are adequately covered for the next 12 months (see chart 14).

Chart 14

The companies we rate have an average 12-month liquidity multiple of about 1.5x, adjusted for large acquisitions, which are typically funded by new ad hoc issuance (see chart 15). In addition, decreased reliance on mortgage-secured bank funding has reduced the share of asset encumbrance. We think this also lessens refinancing risk because companies have the option of selling assets more easily, if needed, to meet funding shortfalls. Unsecured debt also contributes to higher recoveries in the event of default.

Chart 15

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