As the trajectory of COVID-19 continues to evolve, Isabel Gossling looks at the implications for European real estate and long-lease strategies.
Read this article to understand:
- COVID-19 impacts on European real estate
- Intensified focus on ESG metrics
- The resilience of long income strategies relative to traditional real estate
The European real estate market is still coming to terms with the economic impact of COVID-19 and the path of the recovery.
It was no ordinary downturn; there is nothing routine about the recovery either. The speed at which demand recovered led to growing pains, impacting energy markets, testing supply chains and the labour market. The rapid snapback created a potent mix of conditions and sent German inflation to its highest level in almost thirty years.
Meanwhile, the recent emergence of new variants such as Omicron has raised new questions and could further test consumer confidence, central bank resolve and corporate balance sheets – all highly relevant considerations for European real estate investors.
Policy guidance from the European Central Bank will continue to be closely monitored, impacting, amongst other things, the relative return provided by real estate investments (see Figure 1). Many institutional investors have targeted real estate while interest rates have been ultra-low, hoping to supplement low yields in their fixed income portfolios. Although not widely anticipated, a significantly revised monetary policy response has the potential to impact asset pricing.
Figure 1: Prime office yield premium over government bond yields
Source: PMA, Q2 2021
Flux in the office and retail markets
Although there is an expansion underway, there are obvious supply chain bottlenecks and conditions remain difficult to predict. In the office market, appetite for space is much less certain than it was before the pandemic.
There are questions around the extent to which hybrid working will impact long-term office demand
Nevertheless, many firms are actively recruiting, and, in select cities, rents on high-quality prime space are increasing. Locations with good amenities, transport links and access to pools of talent continue to stand out. However, fundamental questions remain over the extent to which hybrid working will be adopted and impact long-term demand for office space and attendant services.
The retail market is also in flux. Valuations were already under pressure before the pandemic due to the rise of e-commerce. Now, more than 80 per cent of the adult population in the EU is online daily,1 and e-commerce activity is accelerating.
E-commerce revolution and focus on materials handling
Meanwhile, the pandemic has focused minds on the importance of resilient supply chains and efficient materials handling. Demand for logistics space has surged as consumer purchasing trends and technology have combined in the e-commerce revolution. This is a pan-European trend: take-up reached record levels in the first half of 2021 in 30 markets monitored by research consultancy Property Market Analytics2 and this trend has been sustained throughout the year.
Demand for logistics space has surged due to the e-commerce revolution
While demand continues to grow, in many locations there is limited land on which to build, and development pipelines have been further restricted due to supply issues with key materials and a shortage of labour. The greatest investment interest has been in large warehouses (those over 10,000 sqm) offering modern, automated stock handling and smaller units suitable for critical ‘last-mile’ fulfilment.
One important point to note is how swiftly this market is evolving. For example, landlords have become more cautious about offering longer-term leases in case it excludes them from future market-based rent increases in the short to medium term. This is indicative of the pace of change, as logistics handlers weigh up sensitive trade-offs between resilience and efficiency.
Intensified focus on ESG metrics
Another unmissable trend is around environmental, social and governance (ESG) factors. Buildings with positive environmental characteristics, particularly those meeting specific energy efficiency criteria, are in ever higher demand from investors and command a green premium.
Greater focus on energy efficiency and carbon emissions has been an obvious trend accelerated by the pandemic; it does not make sense to run buildings as wholly ‘open for business’ if they are not being used to full capacity.
There is scope to make material improvements through effective landlord and tenant collaboration
Now the focus on net zero is intensifying and fuel costs are rising, the impetus is greater still. There are concerted efforts to manage and develop buildings to meet certifiable environmental targets. Our experience suggests there is also scope to make material improvements at comparatively low cost through effective landlord and tenant collaboration and tighter monitoring of energy consumption.
Consideration of the social impact of buildings is also coming to the fore with properties demonstrating a clear social purpose, such as educational or healthcare assets, representing attractive investment opportunities. Life science assets are also getting attention as the pandemic has highlighted the critical importance of scientific research in responding to new challenges and maintaining health. The best assets, alongside established universities, are socially and strategically important, with signs that a favourable innovation cycle has begun.
Real estate long income: seeking lower volatility and resilience
The structural shifts and macro uncertainties suggest lower-risk ways to access property could make sense for institutional investors. One option is to focus on the quality of income that can be generated from investment-grade (IG) tenants and long leases rather than targeting returns through taking on rental growth and vacancy risks.
Such an approach has several potential advantages. Firstly, returns from long-lease properties have historically tended to be less volatile than traditional real estate, as the bulk of the value is captured in contractually agreed rent from robust tenants rather than being realised at the point of exit, when the property is sold. This means returns are (partially) de-linked from the economic and market environment.
Assets delivering social value over the long term may prove a natural strategic fit
Secondly, valuations tend to be less sensitive to interest-rate fluctuations than higher-risk real estate strategies and alternative secure income products in public markets, such as bonds. Third, rent is indexed in line with inflation over time, which has obvious appeal when inflation starts to rise. Finally, assets delivering social value over the long term, typical of long-lease strategies such as social infrastructure or life science, may prove a natural strategic fit, especially for investors putting greater emphasis on ESG factors.
Carefully selected long-lease properties can generate cashflows similar in credit quality, duration and predictability to IG debt, and hold up favourably in absolute and risk-adjusted terms, even with the potential for interest rate increases further down the path of recovery. This has not gone unnoticed in a world where over 50 per cent of all euro IG corporate debt delivers negative yields.3 It does mean, however, that competition is fierce for the best assets on 15-year leases; success is heavily reliant on keeping close to the market, leveraging key relationships, and taking an innovative approach to unlocking new opportunities.
A quick look in the rear-view mirror suggests long-lease strategies can pay off in a variety of market environments.
Long-lease strategies can pay off in a variety of market environments
The path of COVID-19 continues to evolve. However, even when it threatened to stall the global economy, quality assets let on long leases to IG tenants were utilised, the number of tenants falling into arrears was negligible, measurable progress could be made with carbon intensity, and assets maintained their value: all positive characteristics that will remain important in this next phase of the pandemic.
As we survey the market, our view is that rate increases will be gradual and limited, but we are mindful the course of economic recoveries rarely runs smoothly. The emergence of the latest variant has given a stark reminder of the scale of the unknowns.
This article was first published in Das Investment.