How COVID-19 and the climate are transforming the real estate sector

The real estate sector has been affected by the COVID-19 pandemic in unprecedented ways - and if we focus on the financial side, the impacts are already visible.

As of 3 April, the unlevered enterprise value of real estate assets had fallen 25% or more in most sectors, especially hospitality and leisure. Some asset classes, especially those with greater human density such as student housing, malls and healthcare facilities, had the hardest shock and have already been sold off in considerable numbers. Other will be negatively affected later due to variations in occupier demand, since as human footfall is restricted, so consumer confidence dampens.

Even with the short-term benefits of increased e-commerce, the yield from logistics real estate could drop off, as goods and human movement slow down. The lockdowns also shrank the expected rate of return for letting and construction considerably. The development of new sites has been delayed; many normal human activities have been curtailed, and social distancing measures will put a drag on the ability of commercial premises to generate steady cash flows.

The bright side is that consumer demand will probably shift towards more efficient properties, especially since the lockdown experience has revealed the downsides of energy-intensive buildings. When it comes to residential properties, where people will likely live and work intensively from now on thanks to remote working, the lack of flexible spaces and efficient energy systems is set to drive new demand. Italy, where the real estate sector's estimated drop in turnover is between €9 billion to €22 billion compared with last year’s Q1 results, is already experiencing a rising demand for high-quality properties that offer a safe, efficient and healthy living and working environment.

Over the long term, real estate remains an attractive asset class as it continues to offer good risk-adjusted returns that are less correlated to other asset classes. Investor appetite in certain segments of the market will rise - and sustainability is ready to play a huge role. Asset owners and investors will probably struggle to mitigate risks deriving from tenants' and users' rising demands for safe and efficient buildings.

But apart from answering tenants' demands in the short term, the sector should focus on the long-term perspective. Many real estate investors are indeed not ready to take the sustainable and digital leaps needed to make properties safer and healthier even if, just a few months ago, the debate about sustainability was becoming increasingly urgent in many sectors, real estate included. Yields and returns for energy-intensive buildings will shrink soon - not just due to increasing regulatory pressures or to different working practices which, in part, will outlive the crisis, but rather because if the sector does not reinvent itself, it will contribute to speeding up the pace of the climate crisis.

Given the magnitude of the crisis we are living through, financial operators should stick to two axioms:

1. The physical crises of pandemics and climate change are interconnected.

2. Real estate sustainability is increasingly being impacted by these crises.

In a globalized world (and even before), crises are rarely unconnected. Rising temperatures and climate hazards can create conditions in which the risk of pathogens being transmitted between animals and humans increases.

As a result, pandemics will probably become more frequent in the future, if rigorous measures to curtail climate change are not taken immediately - and the real estate sector has a serious impact on climate change. Buildings account for around one-third of global greenhouse gas emissions and consume 40% of the world's energy. The sector is underperforming compared to other industries in changing its CO2 emissions, and is still contributing strongly to the climate change crisis.

Moreover, pandemics and climate change have a common peculiarity that hugely affects the real estate market: they both cause physical shocks. Since real estate deals in real assets, the sector is revealing its untested physical fragilities. Hospitals are revealed to be vulnerable in their capacity and flexibility, for example. Residential units once used intensively are shown to be extreme energy consumers. Malls, whose business model is based on the aggregation and proximity of different services, were not prepared for social distancing measures. These shocks, sooner or later, become systemic socioeconomic impacts, with a huge effect on consumer demand and, as aforementioned, on the sector in general.

Some investors are already looking ahead towards achieving long-term resiliency and mitigating any future physical or market shocks, as well as reducing their carbon-footprint.

When it comes to resilience, the priority is to fully understand any weaknesses and then to build capability. Real estate investors should first seize the moment to decarbonize their portfolio and make their operations sustainable - for example, by digitalizing their assets and services for tenants and building users. In order to provide safety and health checks on spaces or to monitor consumption - and thus levels of CO2 emissions - technology can support sophisticated approaches to measuring and assessing sustainability other than purely health-related risks/opportunities.

Secondly, investors could deploy a portion of their resources towards building renewable-energy infrastructure and retrofitted buildings. The returns may shrink in the short-term, but such investments would be intended to target both risk reduction and market opportunities in order to stay ahead of the competition - and to build resilience for the crisis ahead.

Third, it is possible to combine traditional investing with environmental, social and governance-related (ESG) insights to improve long-term outcomes. Companies with a strong record on material sustainability issues have the potential to outperform those with poorer records. Real estate companies managed with a focus on sustainability should be better positioned to weather adverse conditions while still benefiting from positive market environments.

While the financial side strongly suggests focusing on interest rates, macro-fundamentals and debt structure - all of which still play a significant role in investment decisions and returns - COVID-19 and climate change remind us that real estate is a sector driven by human habits. And as habits are changing, the rising demand for safer, healthier and more sustainable buildings will lead the market while also determining the speed at which this industry can reimagine itself.