- The level and durability of rental income generated from constituent properties of the MSCI UK Quarterly Property Index declined between December 2019 and June 2021, with some segments hit much harder than others.
- Rental income from leisure properties saw the 10-year cumulative probability of default increase by over 100% between December 2019 and June 2021, while the office and retail sectors saw only marginal shifts in their default probability.
- Despite such a significant shift in default risk, leisure yields expanded by only 75 basis points over this period, while shopping centers, with only marginal deterioration in default risk, saw yields expand nearly 200 basis points.
The COVID-19 pandemic has weighed heavily on the business models of many companies — particularly some in leisure, retail and services. For that reason, many companies’ financial positions have deteriorated and the potential for them to default on rental payments has risen. For real estate managers and investors, the ability to track the covenant quality of their tenants, and translate that into a probability of default over the length of their lease, is essential — especially in such an environment. These metrics can be applied to the underwriting of new lease agreements or new asset purchases or the continual monitoring and reporting around the risk to portfolio cash flows. Our analysis uses the properties within the MSCI UK Quarterly Property Index to illustrate some of COVID-19’s impact on U.K. real estate’s cash flows since the end of 2019.
Tracking Rental-Income Streams
Changes in weighted portfolio or segment risk scores can obviously be driven by changes to individual tenants’ risk scores, but also by changes in how their associated income impacts the contribution their scores make to the portfolio total. For example, leases with declining rental income carry less weight, and cases where tenants exit leases or pay no rent contribute nothing at all. Tracking rental income alongside the evolution of tenant risk scores paints a more complete picture of how income and the risk associated with it develops. The income-weighted INCANSTM Global Tenant Scores for segments of the MSCI UK Quarterly Property Index have declined consistently across the major property types since June 2020 (as shown in the exhibit below), following the onset of the COVID-19 pandemic.1 Income generated by properties in the index fell 8.5% from GBP 7.82 billion to GBP 7.15 billion. This fall in income was driven by some tenants exiting leases, some ceasing to pay rent and some paying less rent despite some income gained from new leases signed during the period.
Evolution of UK Real Estate Income Streams During COVID-19
Shifts in Default Lines
Through understanding the relationship between historical INCANS Global Scores and subsequent tenant defaults, we can estimate the probability of default over various time horizons from the point at which a failure score is calculated. After adjusting for cyclical dynamics, we can compute cumulative probability-of-failure curves, which describe the likelihood a tenant may default over the next X number of years.
The exhibit below shows the income-weighted cumulative probability-of-failure curves for select segments of the MSCI UK Quarterly Property Index computed from the fourth quarter of 2019 and second quarter of 2021 to illustrate shifts in these curves from before the market turmoil of the COVID-19 pandemic to the present. This is most starkly illustrated by the hard-hit leisure segment. In Q4 2019, the probability of default over one year was below 0.3% and over 10 years it was around 1.8%. These probabilities of default climbed to 1% and just under 3.9%, respectively. This is particularly notable when considering that the all-property benchmark exhibited a similar default curve to that of leisure in Q4 2019, but shifted to a much lesser extent by Q2 2021. The “standard office — rest of UK” segment, by contrast, exhibited a largely unchanged forward default curve.
Varying Segment Shifts in the Weighted Average Forward Probability of Default
The analysis above begs the question of how income risk is reflected in asset pricing. The exhibit below compares pricing measured by equivalent yield with probability of default. The left-hand panel, which illustrates levels as of Q2 2021, shows that current pricing did seem to reflect income-risk variation across segments with shopping centers subject to higher income risk priced less tightly with higher yields, versus office and industrial markets with lower risk priced more tightly. That said, regional office markets with the lowest default risk were at moderate yield levels.
Most Segments Exhibit a Positive, Linear relationship Between Yield and Default Probability
The leisure segment is again notable since, despite seeing the most significant increase in probability of default, its equivalent yield rose by around 0.75%, in line with other segments that had far smaller increases in default probability.
One potential explanation for this is that, while the COVID-19 pandemic hit the incomes of leisure tenants significantly, real estate investors may have viewed this as a temporary period of weakness and expected that demand for leisure real estate could return to normal, given the physical nature of many activities pursued in these properties. Compare this to the shopping centers and two standard-shop segments at the top of the chart. These segments experienced larger yield increases but saw only modest increases in their default risk over the measurement period. This repricing of retail real estate may be more a reflection of retailers’ willingness — rather than their ability — to pay for retail space.
This analysis also highlights the relevance of changes to portfolio exposures as well as changes in individual tenant creditworthiness. The department-/variety-store segment showed a substantial decrease in income-weighted default probability. This result is, however, somewhat counterintuitive. The overwhelming majority of leases actually saw increases in default risk over the period, and total rental income also declined. However, a tenant with relatively low default risk, responsible for a significant share of rental income, despite seeing its own default risk increase marginally, brought down the segment’s weighted average probability of default as much weaker tenants failed, stopped paying rent or exited their leases, ceasing to contribute to the segment’s weighted average. In this case the income streams from that segment became smaller, but are expected to be more secure on a go-forward basis because of the reduced contribution from weaker-covenant tenants.
All About the Income
COVID-19 has served as a stark reminder that rental income is the basis of real estate asset value. The security and durability of those income streams are key risk factors for real estate investors to understand in the context of their investment appraisals and portfolio management. The metrics and analyses illustrated above could help investors measure, monitor and manage income risk throughout their investment process. And while our analysis has focused on an index-level aggregation of assets, one of the key advantages of these tools and metrics lies in their use in evaluating risks for portfolios, individual properties and individual tenants.
1Income Analytics’ INCANS Global Tenant Score is a normalized cross-border score that predicts the likelihood that a company tenant will seek credit relief or go out of business. A higher score indicates lower probability of failure or default. The rating is comparable globally and through history.
COVID-19’s Uneven Impact on Office Vacancy