Covid-19 coronavirus: Impact on the real estate market in China
02 April 2020
It is difficult to tell whether real estate investment in China will bounce back strongly in short order in the wake of Covid-19 in the way that it did when SARS receded in 2003, because economic conditions and the stage of the real estate cycle are different from what they were at the time of SARS. At this point, however, the general consensus is that Covid-19 will cause a sharp shock to the global economy in the first half of 2020, followed by a bounce-back. Overall, we expect capital flows from the U.S. and Europe to APAC to continue, and the impact on real estate markets in China will be generally harsh but short-lived.
Different real estate asset classes have been impacted by the virus to varying degrees. The immediate hit to demand has been evident in the retail and hospitality sectors, while office properties have also been negatively affected as corporate expansion and relocation plans have been put on hold. On the other hand, logistics facilities supplying e-commerce retailers and third-party logistics companies look likely to remain resilient in the face of increased warehousing demand for fresh food, medical supplies and the delivery of online purchases. This is particularly true for cold chain logistics, which is one of the most in-demand segments of logistics real estate. An increased focus on business continuity planning could also provide a boost for data storage and data centres.
The environment for real estate investment in China has changed considerably since the time of SARS (making it more difficult to gauge the strength of a rebound), while the focus and nature of such investment has also shifted from traditional subsectors like office, residential and commercial properties to areas like logistics, data centres and prop-tech. The Covid-19 outbreak highlights what SARS has already taught many investors in the region, which is the value of diversified investment across real estate asset classes to manage against market disruptions.
Outlook for 2020
While it is difficult to predict how the impact of Covid-19 will play out in Chinese real estate markets, the following trends are notable:
We expect deal volumes to gradually pick up during the second and third quarter of 2020, as the impact of stimulus policies implemented by governments begins to be felt. That should help buffer any risk premiums, and, in the longer run, investments into modern logistics and smart warehousing present an exciting opportunity for investors.
More non-performing asset and alternative credit opportunities
Twelve years on from the last financial crisis, the markets were already pessimistic before the outbreak, spurring more and more activity in the non-performing asset industry given the backdrop of economic dark clouds. The volume of special situations, restructuring and distressed opportunities and the range of credit investment strategies have increased and grown dramatically, and we expect these segments of the market to be particularly hot as the cycle turns.
Arrival of foreign-owned asset managers
The China-U.S. economic and trade agreement (phase one) has created a new opportunity for foreign investors to enter the domestic market. Under the trade agreement, China allows U.S. financial services firms to apply for asset management company licences that permit them to acquire non-performing loans directly from Chinese banks, beginning with provincial licences. We have already seen Oaktree establishing the first wholly foreign-owned asset manager in Beijing this February and expect many others to follow, sharing their knowledge and experience in the industry and profiting from opportunities in the region.
Foreign investment in distressed properties
At the same time, we have also seen more foreign investors investing in distressed real estate properties on a single-deal basis or forming investment platforms with Chinese founders or developers. In 2018, for example, Warburg Pincus partnered with a Beijing-based asset management firm, Hande Group, to invest in distressed and special situation real estate in mainland China, and we expect similar transactions to follow.
The Covid-19 fallout
In responding to the repercussions of the virus, investors are likely to take a number of steps both to address exposures and secure protections going forward. For example:
In mainland China, we anticipate that entities will seek to invoke ‘force majeure’ protections under contract law or respective agreements in order to avoid breaches following the virus outbreak. According to the China Council for the Promotion of International Trade, it had issued 5,637 force majeure certificates by 11 March 2020 to facilitate resolution of contractual disputes, with an aggregate contract value involved of approximately RMB 503.5 billion. A few local High People’s Courts have promulgated guidance or judicial opinions treating Covid-19 as a force majeure event, but judgments are generally being made on a case-by-case basis according to the degree to which the defaulted party is actually impacted by the outbreak.
We expect to see warranty and indemnity (W&I) insurance featuring much more prominently in offshore and cross-border transactions going forward. On the one hand, such protection allows sellers to make a relatively clean exit via the insurance, and, on the other, it affords buyers better protection than simply relying on the warranties and indemnities made by sellers who may now find themselves in distress.
International investors, especially those who have an obligation to disclose potential risks, will also need to pay increasing attention to the impact on the market for directors’ and officers’ (D&O) insurance. Potential claimants may initiate claims against directors on the basis that the management has not adequately or appropriately responded to the acute changes in the business environment created by the disease or taken the necessary steps to mitigate the effects. Major shareholders and their appointed directors will also need to focus on D&O policies in future transactions to see if, and to what extent, they will protect directors and officers against claims connected to Covid-19.
Mitigating the impact going forward
Though real estate is generally considered a safer asset class in a market downturn, in the current climate investors would be wise to act with extra prudence when locating assets and assessing valuations, particularly as cap rates could be further compressed going forward. We would advise consideration of the following:
Pay special attention in due diligence
One key step is to pay special attention in the due diligence process to the legal and operational risks caused by the virus outbreak. Extra focus should be placed on the impact on any material performing contracts of the target (ongoing lease agreements, construction or renovation agreements, land grant contracts, for example), any potential claims that may arise as a result, and the consequences of such claims.
Consider potential delay in project timetable
If the underlying project is a parcel of undeveloped land, a construction-in-progress or a value-added project that requires renovation or substantial capital expenditure, investors should consider a potential delay in project development or repositioning and stabilisation, including the target’s application for regulatory approvals, when formulating the business plan and financial models for underwriting the relevant project.
Structure appropriate investor protection mechanisms
Investors might consider staging the closing of an investment, or payment of the purchase price or management fees, in multiple tranches that in each case tie into the milestones of the development progress or regulatory approvals. In negotiating documentation for a real estate deal, other investor protection mechanisms also help, such as tightly drafted representations and warranties by the seller (backed by seller guarantee or W&I insurance) and price adjustment mechanisms and specific indemnifications tailored to capture coronavirus-related issues and any indirect operational and financial impact arising as a result of the outbreak.
Set proper conditions precedent and long-stop dates
As the adverse effects from Covid-19 are arguably foreseeable at this point, and therefore unlikely to constitute a material adverse change in the context of a new acquisition or investment, investors should seek to build in conditions precedent that address specific Covid-19 related risks discovered during the due diligence. A proper long-stop date may also help give the investor a walk right in the event the target is unable to resume ordinary business in the medium term.
The real estate markets in China look set to endure a sharp but hopefully short-lived shock as a result of the Covid-19 outbreak. As activity levels return, investments into modern logistics, smart warehousing and data storage will present exciting opportunities for investors, who will continue to seek to diversify their real estate exposures.
The distressed and non-performing assets industry is set to grow in China and elsewhere, with clients increasingly focused on forming credit funds and distressed investment platforms, acquisitions and disposals of distressed assets, including non-performing loans and special situation projects, restructuring, foreign participation in asset management opportunities, and the like.
Negotiating transactions and devising appropriate force majeure and material adverse change clauses will continue to be important, as will adequate W&I and D&O insurance protection. Parties seeking to plan ahead and mitigate the impact of Covid-19 on real estate assets should take extra care in identifying quality assets, assessing their valuation, considering the specific legal and operational risks and mitigating such risks with proper deal construct.
If you have any questions on the issues raised above or would like to have a more detailed discussion, please do not hesitate to contact us.