We have previously touched upon the diverse range of underlying collateral the ABS market has seen this year, and there is no sector with more idiosyncrasies than the CMBS marketplace. Recently, Bank of America marketed Taurus 2021-5 UK, a deal secured on a Purpose-built Student Accommodations (PBSA) portfolio in the UK relating to the acquisition of iQ Student Accommodations by Blackstone. Of course, this sector is not entirely alien to the market, with a deal relating to a Student Roost portfolio financed through CMBS in 2019. However, the industry landscape has been distorted in the last two years by record levels of investor appetite and drastic lockdown restrictions. Therefore, and in light of the latest offering, it is worth re-evaluating the sector.
An obvious attraction of the PBSA market is the imbalance between demand and supply. The valuation report for Taurus 2021-5 UK suggested that over 50% of full-time students are unable to access PBSA in most UK cities, with the student-to-bed ratio as high as 3:1 in London and 4:1 in Brighton. Higher education enrolment and UCAS application statistics suggest a steadily increasing trend, bolstering the sector’s outlook. Domestic demographics are also supportive, with the number of UK teenagers turning 18 in the next five years greater than during the preceding five. Meanwhile, for international students, the reasons for optimism are two-fold. Firstly, the Post Study Work Visa policy allows international students to remain in the UK to seek employment for two years, a great incentive for those that wish to move to the UK in search of better career prospects. Secondly, other popular destinations for international students have become less welcoming in recent years, with the US tightening visa restrictions and Australian borders being closed to foreign nationals.
Investors have taken notice of the positive demand and supply dynamic, resulting in record-breaking investment into the sector over the past two years. The volume of transactions hit £5bn in 2019 and neared £6bn in 2020. Yields have come in significantly from the highs of 6.5-7% in the early 2010s, especially in London. Despite the pandemic the market has held up well, as exemplified by a June 2021 transaction of a London property closing at a yield of 3.8%. The current average yield outside London is estimated at 5.25%.
However, ignoring the elephant in the room is impossible: as the pandemic struck and restrictions announced, students retreated to their family homes and universities conducted lectures virtually. Most PBSA providers released students from their contracts, leaving student halls deserted. As uncertainty loomed over the 2020/21 academic year, sector leader Unite Group reported that 21% of bookings had not checked in by the end of September, compared with 4% at the same stage in the previous year. Meanwhile, an October 2020 Knight Frank survey found that the average actual occupancy was 76% across operators, a figure that is normally in the high 90s. These numbers only emphasise the extraordinary investor appetite which has held yields at the tights; as far as we know, these yields are calculated based on an assumption of nearly full occupancy.
While occupancy in the 2021/22 academic year has somewhat recovered, it is still nowhere near pre-pandemic levels for the iQ portfolio. Occupancy in London, where the securitised portfolio is largely concentrated, has recovered slowly and demand hinges heavily on returning international students. Before the pandemic, over 70% of occupants in London student properties originated from outside the UK and the EU, with around two-thirds of those from China. Given the COVID-induced travel disruptions and the threat of lockdowns and quarantine, we can understand the willingness of international students to swap campus life for Zoom and Teams teaching from the comfort of home. If virtual attendance becomes the norm and international students do not require accommodation in the proximity of their university, the positive supply and demand dynamics break down. Therefore, the assumption that occupancy will return to pre-pandemic levels appears doubtful. A shock as severe as the structural shift towards virtual learning might potentially send recovery value tumbling below outstanding debt, inflicting losses on junior tranches of the CMBS. Such an outcome rests on downside assumptions, but we cannot gauge the market’s path to recovery from COVID-19 with any certainty. As a result, in our view the level of income offered provides little comfort when faced with the detrimental impact of this potential structural change.
Moreover, due to the record-tight yields adopted in the iQ portfolio’s valuation, a 0.5% widening in capitalisation rates could cause a 10% drop in valuation. The sensitivity is especially significant given the potential for interest rate rises. A move of this magnitude may lead to a rating downgrade, bringing price volatility and hindering liquidity. As a result, despite the senior notes widening to Sonia+115bp from initial expectations of +100bp, we do not believe the yields offered sufficiently reflect the risk of downgrade and illiquidity premium.
All-in-all, we didn’t see the Taurus deal as attractive. The uncertainty surrounding COVID-19 and remote learning has not cleared sufficiently, and with the deal’s valuation and weak covenants added to broader rates expectations, there were enough reasons for investors to pass. That is not to say we do not like this sector. There is no doubt that the demand for British higher education is strong and will remain so for some time to come. For that reason we hope the next time we review this sector we will see positive developments around our key concerns.