After a month, it is possible to begin to see more clearly the impact of the lockdown on the markets, and most of our clients' real estate portfolios have proven surprisingly resilient to the crisis, with occupancy and rent-collection levels exceeding initial projections.
Some of our clients' segments had little or no impact, such as self-storage, medical buildings, office buildings, industrial properties and private debt; or the impact was smaller than expected during April and May, as was the case with single-family and multifamily residences, and senior housing. The greater concern is with strip malls and hotels, although the specific characteristics of these properties in our portfolios and the actions of the operators have considerably reduced the risks of losses in these assets.
Our operators acted quickly and implemented several cash-preservation measures including suspending rent distributions to investors, halting improvement works, streamlining maintenance, reducing headcount (in the most affected sectors such as hotels) and accessing the U.S. government's emergency programs (Cares Act), measures that have provided reassurance to investors.
Almost all operators have already applied for and managed to be included in the Paycheck Protection Program (PPP). This program allows for forgivable loans that cover 2 months of payroll, with no obligation to the government, and the capital does not have to be repaid if it is correctly used to pay employees. Corporate tenants, mainly in the retail and office segments, have also benefited from this financing, helping to substantially reduce the default risk in these segments.
With respect to residential properties, tenants are also already receiving a government stimulus of US$ 1,200 per person, plus an additional US$ 500 per child, which has significantly reduced delinquency, since rent is one of families' priority payments.
Additionally, most of our operators have already obtained an extension on the payment terms of the properties' financing. Most of the financing of our clients' Multifamily properties is provided by the agencies Fannie Mae and Freddie Mac, financial institutions guaranteed by the U.S. government (GSEs), which deferred debt service payments by at least 3 months.
The Paycheck Protection Program (PPP) is a central piece of the Cares Act. In the first round of the program, US$ 349 billion in government-guaranteed forgivable loans were extended to small businesses to cover payroll-related costs and utilities, as well as mortgage and rent payments. The program opened for applications on April 3 and was oversubscribed by April 16. Due to its popularity, lawmakers passed new legislation to replenish the fund with another US$ 310 billion, and the Small Business Administration (SBA) resumed approving loans on April 27.
At this time, the U.S. Congress is discussing the approval of a new fiscal relief package totaling US$ 3 trillion, which has been advocated for by Jerome Powell, chairman of the Fed. The bill, named the Heroes Act, contains several measures to support the real estate market: US$ 75 billion in mortgage relief and US$ 100 billion in rental assistance to support multifamily owners who cannot pay loans if tenants default. In addition, there is another round of direct payments to individuals, as well as an extension of the enhanced unemployment benefits, aimed at keeping Americans current on their bills during the worst pandemic in more than a century.
We have been speaking weekly with the U.S. operators to closely monitor the performance of the assets and the expectations for resuming rent distributions on those properties that had withholdings for cash preservation and short-term sustainability, which we still cannot predict precisely, as it depends on the course of the virus. In the medium to long term, we have adjusted our expectations and understand that the possibility of capital losses for the properties in our clients' portfolios is quite limited, largely due to geographic diversification and our specific theses in each asset class, combined with the competence and financial robustness of the operators approved by our investment team over the last several years.
The fact that several properties continue to distribute returns reinforces these expectations, and moreover the characteristics of the rescue programs approved by the U.S. Congress and the new packages under discussion make it clear that the U.S. government has chosen the real estate sector as a privileged target of its relief measures, which, to date, has clearly benefited the performance of our clients' portfolios.
Multifamily residences
Multifamily properties, which are historically one of the most resilient assets in crisis events, have been little impacted by the pandemic so far. Beyond housing being an essential requirement for the population and a priority in household spending, the sector also receives more government support compared to other asset classes.
In addition, operating properties with a high number of units geared toward the middle class in expanding cities, Ativore's niche focus, help mitigate default risks, which was confirmed by last month's results. Overall, our portfolio observed an occupancy rate above 92% and a rent-collection rate of 90% in May. In the operators' opinion, these numbers were very positive because they exceeded expectations, even while being slightly below the prior month by 1% and 3%, respectively.
Additionally, the multifamily properties that make up our clients' portfolio exceeded 70% in lease-renewal rates, above the market's 55%. No revenue increases are anticipated, however, as operators have been making concessions to ensure tenants' rent payments, in addition to freezing the increases originally provided for in contracts.
Much of the security that the assets have shown is a result of our operators' swift action with respect to the government programs. Most of our Multifamily portfolio applied for, and has already received, the government support from the Paycheck Protection Program (PPP). This program allows for forgivable loans that cover 2 months of payroll, with no obligation to the government, and the capital does not have to be repaid if it is correctly used to pay employees.
Alongside this, most operators have already negotiated an extension on the debt payment terms of the properties with their financial institutions. Most of the financing of our clients' Multifamily properties is provided by the agencies Fannie Mae and Freddie Mac, financial institutions guaranteed by the U.S. government (GSEs), which deferred debt service payments by at least 3 months.
In addition to this support for operators, tenants are also already receiving a government stimulus of US$ 1,200 per person, plus an additional US$ 500 per child. This amount will ease the level of delinquency, since rent is one of families' priority payments, especially from the moment the courts resume operations and issue eviction orders to defaulters, which should be expected only in the second half of the year.
In conclusion, Multifamily property operators have acted conservatively and, in our opinion, correctly, with most of them preferring to withhold distributions to investors in the 1st quarter and projecting withholding for the 2nd quarter as well, at some level or in full. However, and despite the possibility of a more extensive economic recession affecting even the most resilient sectors, the current results demonstrate the great robustness of the multifamily real estate market, which is why about 50% of the real estate private equity investments of Ativore's clients are tied to this sector, generating stability and greater security for their portfolios.
Commercial buildings
Office buildings make up the largest commercial real estate asset class in the U.S. and have long-duration leases, which generally translate into greater stability for these assets. However, the pandemic caused unforeseeable financial difficulties for many companies across various sectors, which have suffered large short-term losses, leading to an increase in the number of requests for rent payment flexibility and a roughly 7% growth in defaults in this market.
Despite this, the properties selected by Ativore should perform well above average over this period, as they focus on properties housing tenants with long leases, high credit quality and that were little impacted by the crisis, substantially reducing the risk of default and of reduced distributions to investors.
Alongside this, the recent actions of the U.S. government and of private financial institutions in the U.S. have generated capital injections to retain employees and structure, in addition to flexibility on debt service payments, creating positive momentum for the sector that tends to reduce risks for our operators and investors.
Self-storage
The self-storage sector historically maintains good performance during recessionary periods; for example, in 2008 the assets saw 38% income growth in the 5 years following the crisis, and now, in 2020, they are demonstrating resilience to the crisis related to the COVID-19 pandemic, without experiencing major impacts on occupancy and rent-collection rates.
To date, none of the 4 largest companies in the sector in the U.S. have reported a drop in volume, with warehouses located near universities showing growth in the number of rentals due to the cancellation of classes, as well as refrigerated spaces rented to food resellers. In addition, most financial institutions are providing flexibility on the payment terms of the properties' financing, in most cases allowing a grace period of 3 months or more.
As an extra security factor, Ativore focuses on investing in self-storage properties in less dense locations, with cheap rentals and 100% automated services, remotely managed, with little or no physical human interaction, in line with all the restrictions imposed by the epidemic. In these markets, the predominance of amateur competitors, with manual services and a high level of human interaction, tends to further reduce the vacancy risk of our operators' properties.
In addition, according to the National Real Estate Investor, the projection of new properties for the next 4 years was adjusted down by 40%, which will increase demand for existing warehouses once the quarantine ends, generating subsequent appreciation of the assets.
Senior housing
Senior housing residences continue with very cautious measures regarding residents to avoid as much as possible any possibility of contamination, since they are part of the main risk group affected by the coronavirus. The properties are adopting creative solutions to allow visits from family members, such as special glass rooms so that the elderly can see their relatives while still respecting social distancing rules.
Overall, the segment observed a high tenant-retention rate, since there is a common belief that these locations are safer because they provide medical care in a more isolated manner than the public health system. In addition, being a service considered important and aimed at the American upper class, the sector's rent-collection rate did not decline, reaching 100% at several properties.
On the financial side, the flexibility from financial institutions regarding the payment terms of the properties' financing is already generating relief for the properties' cash, allowing a greater focus on working capital to retain all employees and maintain sanitary measures, which are even more fundamental in the case of senior housing.
Due to high uncertainty for the near future, our partners chose to conservatively withhold distributions to investors, in view of the possibility of needing cash for operating expenses, which tend to be higher in this segment.
Healthcare buildings
Office buildings focused on healthcare tenants (MOB) were one of the asset classes least impacted by the crisis, since most tenants have maintained their activity as they provide essential services. With hospitals and health units being flooded by an influx of patients, MOBs have been receiving more and more patients seeking testing and consultation services, and insurance companies themselves have been encouraging patients to avoid the crowds of large hospitals and to seek rehabilitation in external settings, which generally have lower cost.
In addition, as in the case of the properties in our portfolio, several buildings house companies focused on sophisticated services and medical technology seeking solutions for the pandemic – such as vaccine production, genome sequencing and artificial intelligence – which continue to operate normally.
Additionally, the “small business loans” program, part of the Cares Act, will help smaller companies meet their rent payments, since the program allows extremely cheap loans with flexible terms if used to pay rent and bills.
As soon as the market returns to normal, these well-located assets with the infrastructure to meet modern medical needs will be in high demand. Specifically, demand for medical office buildings may grow in non-urban markets as young millennials begin to move away from major centers.
For the Ativore portfolio, there is no forecast of a decline in occupancy rates, since the contracts are long-term, nor a substantial decrease in revenues in the short term or increase in costs, as the contracts provide that tenants are financially responsible for the maintenance, insurance and taxes of the properties. Therefore, distributions to investors, which occurred normally in the 1st quarter, are expected to occur at 100% of value in the 2nd quarter as well.
Industrial
The industrial sector is, in general, operating below its maximum capacity, since social distancing measures forced some plants to halt or substantially reduce their activities. Alongside this, the greater difficulty of managing an export logistics chain contributed to reduced activity in April and May, although an increase in activity was observed in specific segments such as the production of healthcare equipment.
Although they may also suffer some impact, the industrial properties that make up our clients' portfolio have characteristics that make them more resilient during the crisis generated by the pandemic. The strong growth of online retail has benefited properties with production and/or storage near major consumer centers (known as “last mile”), such as Kansas City. In addition, the recommendation for social distancing has put the spotlight on modern structures and flexible spaces with the capacity to implement automation and robotics, as is also the case with this warehouse.
It is also important to highlight that the financial institutions financing the debt portion of the assets are providing flexibility on the payment of the properties' loans, allowing deferral of at least 3 months, which substantially minimizes the risks of capital loss and to the financial health of the business. Alongside this, properties with tenants whose main customer is the U.S. government, as is the case with one of the occupants of the Kansas property managed by Avodah, have a competitive advantage due to the lower probability of default or reduction in activity.
In the long term, after the end of the epidemic, a stimulus to increased domestic production of goods is still expected, avoiding dependence on the foreign market, mainly Chinese, which should benefit the industrial market, generating good opportunities to occupy vacant spaces.
Private real estate debt
The private debt market in general did not register an increase in defaults, being seen as a fairly defensive investment in times of crisis. The assets in the portfolio of Ativore's investors are not being impacted because both senior debt and mezzanine debt have priority in collecting on the debt relative to equity investors. In addition, since the private debt market is unregulated, institutions are not required to follow government guidelines on payment flexibility, which further reduces the probability of default.
In the case of senior debt, the properties held as collateral for the loans can generate high profits if foreclosed, as they are foreclosed at heavily discounted values, between 50% and 70% relative to market price.
The mezzanine debt in our portfolio has very effective contractual protections against the recent declines in U.S. interest rates, which, in a normal contract, would reduce the value of the installments to be paid by borrowers and consequently decrease investor returns. In this case that does not happen because there are minimum floors for the installment payment values, which, even if interest rates in the economy fall to zero, will remain the same, contributing to the stability of the investment's return. Beyond this, the contracts have high penalties in the event of default that provide security to the lender and to investors, with returns ranging between 13% and 20% per year.
With the slowdown and greater uncertainty in the economy, large banks are hesitant to grant new loans and, those that do, are more diligent in their credit analyses, delaying a process that was already considered slow and that favored the search for private debt markets, where the approval of a request can occur in two weeks, versus a minimum of 3 months for a good portion of traditional banks.
Single-family residences
The single-family houses segment has generally shown an increase in the number of rent defaults caused by the economic slowdown, rising unemployment and falling household income. The effects have been more observed in cities with economies concentrated in a single sector and in properties focused on Class C and D, more prone to financial difficulties.
Ativore's portfolio is located, in its vast majority, in Atlanta and nearby cities, where the economy does not depend on a single sector, and the managed homes are geared toward Class B residents, who are suffering less from unemployment, allowing them to continue honoring their rents.
In addition, tenants who had their income reduced by the pandemic are obtaining government support of US$ 1,200, with an additional US$ 500 for each child, which decreases the chance of default since housing has historically been one of families' priorities, especially during this quarantine period.
It is important to note that unleveraged properties, as is the case for all of our clients, are extremely defensive and may experience momentary losses of rent distributions, but should benefit from the compression of capitalization rates and price appreciation when the market returns to its normal activity.
Demand for single-family residences in suburbs is expected to exceed supply, which is at its historic lows, and for the market to continue growing in the near future, with the millennial generation forming their families without the need to live in major urban centers, thanks to the ease afforded by remote work, which is already becoming a reality. Thus, the risk of capital loss in these properties is low, especially when there is flexibility on the timing of sale.
Retail
With two full months of isolation measures having passed, retail confirmed that it is one of the sectors most affected by the pandemic, with hundreds of stores temporarily closed. Even businesses still open have suffered the impacts of restrictions on the movement of people, with the exception of specific niches such as pharmacies, convenience stores, deliveries and grocery stores, which reported increased sales.
Strip malls, like those our clients hold in their portfolios, which were not subject to mandatory closure like large shopping centers, benefit slightly in this context, especially those with tenants offering delivery services. However, with falling store revenues, many tenants had difficulty meeting their rent obligations. According to the data company Datex Property Solutions, large national retail chains (with monthly gross revenue exceeding US$ 250,000 or more than 10 establishments) paid 58% of rent last month, versus 96% in the same period the prior year.
In general, the market expects an increase in defaults and a rise in the vacancy rate in the coming quarters, as many smaller businesses do not have the financial health to sustain closure for more than 3 months.
On the positive side, our operators in the sector may benefit from the Paycheck Protection Program (PPP), which will help smaller companies meet their rent payments, since the program allows forgivable loans if used to pay rent and bills, reducing the impact on the properties in their respective portfolios.
With the exception of very particular cases, no distributions to investors should occur throughout 2020, and even with the efforts of the U.S. government, the properties are expected to lose market value in the short term. However, it is already possible to observe partial market reopening actions in some states such as Florida and Texas, which should contribute to a reactivation of the sector.
In the long term, the recovery in prices should occur after the normalization of hotel operations. This is because with U.S. interest rates very low, there is a tendency toward compression of market cap rates, which have an inversely proportional relationship to property values, that is, the lower the cap rates, the greater the appreciation of hotels, which should benefit the operator in choosing the best exit timing for each of the assets.
Hotels
The hotel sector was the most heavily impacted since the start of the pandemic, with border closures and recommendations or mandates for social distancing generating a massive cancellation of trips and reservations. The sector reported an occupancy rate of between 5% and 10% in recent months, which led to mass layoffs of employees and the immediate bankruptcy of smaller hotels, with large groups having set up contingency plans and closed several hotels, concentrating guests in a single location.
As with other asset classes, hotels also have the possibility of benefiting from some Cares Act programs, such as the Paycheck Protection Program (PPP); however, since most hotels needed to substantially reduce their payrolls through layoffs, the amount raised through these loans will not be forgivable and will have to be repaid going forward.
Thus, one of the main financial reliefs comes from the flexibility of financing institutions, which have negotiated the deferral of hotels' debt installment payments for a period exceeding 3 months, a longer term than other asset classes. Even so, there is a possibility that the assets will need additional capital injections to conservatively ensure their proper operational functioning, which we were able to observe in the case of the hotels that make up the investment portfolio of Ativore's clients.
It is important to note that the impact is much greater on smaller operators, while large operators such as Driftwood – among the 10 largest in the U.S. – which have cash reserves and investments with conservative leverage, have a much higher probability of weathering crises of this magnitude with loss risks duly mitigated.
Based on this scenario and the forecast that activity will not return to normal until the end of 2020, operators do not anticipate distributions to investors, but it is worth remembering that this segment is one of those that historically shows the fastest recovery relative to other asset classes, since it has the ability to adjust the prices of its services daily. Therefore, as soon as travel routines return to normal, the tendency is for hotels to also gradually increase their occupancy rates to the level expected and observed pre-crisis, which should occur over the course of 2021 and 2022.
Single-family residence flipping
Over the last month, the flipping market observed a decline in transaction volume and property prices, a trend that was already expected since the start of the pandemic news. With most states imposing orders or recommendations for the population to avoid travel, the market showed a substantial decrease in the number of showings and new deals, and even negotiations that were underway suffered a slowdown due to buyers' economic uncertainty and uncertainty regarding prices. In general, single-family residences in the U.S. saw a decline of 15% to 20% in negotiated values, decreasing operators' profit margins. In addition, in most locations it was necessary to halt all improvement works on the properties, which also extends the expected negotiation timeline to after the end of the quarantine.
The drop in demand and the economic slowdown give an advantage to operators who have a broad network of contacts and operate with creative solutions to put properties up for sale, offering discounts, assembling property portfolios, conducting virtual tours and investing in online advertising. Additionally, since housing is an essential requirement for the population, post-crisis measures are expected that facilitate the taking of financing for property acquisition by the American population.
The general perception of operators in this market is that there will be no normalization until the end of the epidemic and that prices will gradually recover over 6 to 10 months. For those properties that were acquired in cash (as is the case with the properties in our clients' fund), the risk of capital loss is substantially lower, as the operator may choose not to sell the property until the market normalizes and there is no debt service payment.
