Property and real estate investments are in general considered as safe-haven investments because bricks and mortar are real assets which can survive a storm in the equity markets. This claim can be considered as true if an investor invests directly into property. But as fund managers try to optimize the return for their investors, this might not be true for direct property funds and real estate investment trust (REIT) funds investing in commercial properties in the aftermath of the COVID-19 pandemic. Under current economic conditions, the optimization of returns— especially the use of leverage (debt capital)—may cause a problem for investors.

A number of corporations have learned during the lockdown that they can operate very efficiently in a working from home (WFH) or virtual office environment (VOE) and may now ask themselves if they still need the same amount of office space in the future. The current working experience shows that their employees can work from home without any problems. In some cases, the employees may even enjoy working from home because they don’t have to commute long distances to reach the office, which is often located in very expensive prime spaces in the city center.

Since listed companies are always looking for ways to cut costs, this may become a topic of board and supervisory board meetings. The potential cost savings for companies which reduce their office space can be significant and may boost the overall profitability of the company. This means that landlords may have a lower future income from their properties since they might not be able to rent out all their space or may need to reduce the rent to attract new tenants. Both of these options have a negative impact on cash flow and, therefore, the potential to become a major issue for landlords and their investors as well as other business partners. This is especially true if leverage has been used to boost the return on equity in the fund or REIT.

Using leverage seems to be fine in a regular market environment, but it shows its ugly side during and after an economic crisis. This is because any leverage causes regular interest rate payments which can become higher than the income from the rent. This puts the owner of the property (or parts of it) under high pressure. It also means that creditors may require a payback of all or parts of outstanding debt to reduce the risk in their own books. Such a recall of debt by the creditor can cause a bankruptcy of the lender, i.e. the owner of the property. This cause and effect has been shown in the private and banking sectors during the financial crisis in 2008/2009.

I am not saying that we will face another global financial crisis triggered by the real estate sector, but investors need to be cautious about their investments in property funds or REITs since a number of experts are already waving red flags on the leverage used by some of these vehicles. That said, I would assume that a high percentage of the outstanding debt of property funds and REITs can be found in high-yield bond funds, which means that a possible crisis in the real estate sector will also impact investors who are chasing returns in the bond sector. In addition to this, fund investors are also facing the risk that their fund might be gated because such a crisis normally leads to high redemptions in all kinds of property-related funds in an environment where the underlying assets are hard to sell for a fair value.