In a pandemic environment it is difficult to view the longer-term repercussions with clear conviction. However, Mozaic Markets believes COVID-19’s legacy on commercial real estate investment will be transformational.
Wise commercial real estate (CRE) investors don’t bet on appreciation. They purchase properties on sound judgement that the building will generate more income than it costs to own.
However, the coronavirus has created material uncertainty over the value of property worldwide. Rent defaults, business closures and increased vacancy rates, pose a very real concern for over-stretched landlords and developers.
And those who have invested in many daily traded property funds have found themselves ‘locked out’ and unable to sell their positions after the economic fallout from the coronavirus pandemic cast doubt over the value of their underlying properties.
These are unprecedented times and whilst the immediate impact continues to unfurl, smart investors are already assessing the longer-term impact of the crisis.
I believe the pandemic is going to transform the commercial property industry in two stark ways:
1. Physical ‘Bricks and Mortar’– with the geographic landscape evolving in response to changing property requirements fuelled by e-commerce and flexible working (for example, from retail to industrial).
2. Financial — with the introduction of new financial instruments which remove barriers to investing and open the door to new types of investors, improve transparency, increase liquidity in this traditionally illiquid asset class, and, create a new valuable revenue stream for property asset owners.
Physical property transformation
The impact of the pandemic in the immediate term is clear, and whilst in exceptional circumstances, like the current environment, it is difficult to view the longer-term repercussions, its legacy could be transformational.
Let’s take offices, retail and industrial.
With most office workers working from home to help limit the spread of the infection, our offices have become our homes with our desks gathering dust.
In the short term, office growth plans are likely to be paused or slowed significantly as businesses rapidly assess their needs as the impact of the pandemic unfolds.
I’m interested to see second and third quarter business results for those who have been able to implement a working from home business model — both financial and productivity.
This could influence future operational business models and could ignite a reduction in office space requirements.
Plummeting values in the retail sector are a heightening concern. Retail was a tough environment before the pandemic of course, due to rising costs and changes in people’s shopping habits.
Notwithstanding a steady series of retailer failures (including restaurants and drinking establishments) which has seen an acceleration in recent weeks as non-essential shops around the world are forced to close indefinitely.
The only winners being those with strong digital platforms.
Traditionally perhaps the least attractive of CRE sectors, comprising warehouses, manufacturing facilities, refrigeration, storage and data centres, industrial is now a growing sector.
It is reported to be one of the out-performers in the pandemic, specifically with e-commerce businesses as consumers shop online in their millions.
Demand for storage for these businesses will undoubtedly continue to grow. Particularly in more densely populated areas, also known as “last mile” delivery locations, and potentially even the high street.
Whilst generally high yielding, real estate suffers from illiquidity, lack of transparency, high transaction costs, execution time frames, and, in the case of commercial property, restricted investor access.
The performance of real estate, both commercial and residential, can be hard to gauge too with many transactions private and, as a consequence, trusted, reliable and easy to access financial information is scarce.
It’s therefore an ideal candidate for digital financial innovation.
Firstly, let’s quickly look at the ways you can invest in commercial real estate today.
Open-Ended Property Funds Concerns
Concerns around the latter are most prevalent at the time of writing with at least seven UK property funds suspending trading as a result of the pandemic, trapping at least £12.7 billion of investor money.
Because property is an illiquid asset and can be particularly hard to sell during times of market stress, funds are usually frozen over fears that the fund would not have enough cash to meet a sudden surge in outflows.
Commercial property funds are arguably much better prepared than they were in 2008 (global financial crisis), with many having built large cash holdings to meet redemption requests.
But with today’s market shock, it is not a case of unmanageable outflows, but the inability to accurately assess the value of a fund’s property holdings.
Financial Conduct Authority (FCA) rules require a fund stops trading if more than 20% of their portfolio cannot be assessed accurately.
Investors therefore now have no choice but to sit tight on their property fund investments during a very uncertain time for the global economy.
If they need urgent access to their capital — they simply cannot access it.
Property Tokens — a new Liquid Alternative
Asset values aside, one of the main issues today is the lack of control an investor has over their real estate assets in times of urgency.
What if there was a digital twin available as an alternative?
A digital twin which, whilst not immune to price fluctuations in a period of market distress, would always be liquid.
Tokenization uses distributed ledger technology (DLT) to turn a real-word asset, such as real estate, gold or even forestry, into a verifiably digital asset (Digital Twin) called a Security Token.
A Property Token is structured as a security or is deemed to be an investment contract that sits on a distributed ledger and is run by a smart contract.
It represents the tangible assets that can be traded in a security token exchange anytime and anywhere in the world, in a fully regulated environment.
Security Tokens can represent an underlying real asset and pay dividends, share profits, pay interest, or invest in other Tokens or Assets to generate profits for the Security Token holders.
A property token would be a digital twin of the real asset and would allow for an investor to request ownership of a property, in the event of a default. With the property acting as a form of collateral.
A digital ‘twin’ is exactly that — one to one. One physical and one digital. They are effectively the same in a sense.
A smart contract, imbedded into the token, can specify that it cannot be leveraged or that senior debt is limited to 65%, for example.
Thus, preventing the over-leveraging issues of subprime mortgage-backed securities which ultimately caused the 2008/09 global financial crisis.
Why Property Tokens are Attractive
The biggest opportunities for property tokens are that they:
The pandemic is unprecedented in many ways and the outcome remains unknown.
But for capital markets and real estate, it could be considered by financial historians a watershed moment with 2020 the year the true potential of tokenization was realised, and a new token economy born.
“An office is a place where dreams come true,” said Michael Scott in The Office (US).
Maybe for investors, that office is digital.