Faced with a more challenging outlook for returns, real-estate equity investors must get more sophisticated and active, argue Ben Sanderson and David Hedalen.
Read this article to understand:
- Why simple beta strategies will no longer be so effective in real estate equity
- Why active asset management and an understanding of fundamental economic drivers will be critical in the years ahead
- Why investors need to position their real estate portfolios now for a net-zero future
The era of ever looser monetary policy is over. While there are signs inflation in many advanced economies may be close to peaking, interest rates seem likely to remain appreciably higher than in the years that followed the global financial crisis (GFC).
That in turn suggests investors across asset classes will have to accept the prospect of lower returns than they have become accustomed to. Real estate equity is no exception.
Simply taking exposure to the overall direction of the market will no longer offer such handsome rewards. Investors must be smarter in their location, sector and individual asset investment decisions. They can no longer simply ride the loose money train that had bid down yields across the board; they must roll up their sleeves and do the hard work to find value.
As Figures 1 and 2 illustrate, the long-run annual capital growth rate in the UK market from 1990 to the onset of the GFC in 2007 was 2.7 per cent. Post the GFC (2010-2021) – a period marked by easy monetary policy – the growth rate was 3.1 per cent per annum.
Rental growth, a fundamental driver of capital growth, was marginally higher in the pre-GFC era (1.2 per cent) than between 2010 and 2021 (one per cent). So, despite weaker fundamental growth coming via rents, capital values continued to increase and at a much higher rate due to yields being chased downwards.
Figure 1: Capital growth in UK real estate, 1990-2021 (per cent)
Source: MSCI UK Monthly Index, January 2023
Figure 2: Market rental value growth in UK real estate, 1990-2021 (per cent)
Source: MSCI UK Monthly Index, January 2023
In our view, higher interest rates will put a floor on that yield compression and turn the focus to the fundamental component of the capital growth equation: achieving rental growth through active asset management.
What this means for investors
Figure 3 shows our return forecasts for various categories of UK real estate. As can be seen, in some cases annual returns over the next five years could be barely half of those achieved over the past two decades. [It is worth noting our five-year forecast is skewed somewhat by the likelihood of negative returns this year.]
Figure 3: Return forecasts for UK real estate, UK MSCI/IPD (per cent, per annum)
Source: Aviva Investors, MSCI, March 2023
This means investors are unlikely to be as willing to employ significant leverage or conduct financial engineering to juice returns as some sought to do during the long era of ultra-low interest rates.
Simultaneously, investor behaviour is likely to be influenced by longer-term structural shifts that will require deep understanding of the fundamental drivers of different sectors and regions.
For instance, in a post-COVID world, most occupiers are using real estate in a smarter and more flexible way, more keenly aware of its cost. That said, while some occupiers are going “full hybrid”, others are more cautious. The long-term future of work, and its impact on offices, remains uncertain, although it is clear investors need to be more discerning on their exposure.
The diversity of properties within some sectors has hugely accelerated following the pandemic
Investors are also having to account for the fact the diversity of properties within some sectors has hugely accelerated following the pandemic. Take retail. It now includes high street shops, outlets, internal shops within outlets, shopping centres, retail warehouses, fashion retail parks and bulky goods retail parks.
Presented with greater options across the risk spectrum, investors must become more selective in the types of assets they own. Rather than constructing balanced portfolios containing assets from across the risk spectrum, growing numbers are looking to acquire assets offering similar risk-return profiles to match their clients’ desired investment outcomes.
This process is being fed by growing interest in thematic investment. Whereas the bulk of the real-estate investment world has historically focused on prospects for individual assets and sectors, that is changing, with more attention on major longer-term trends and structural changes impacting the market more materially.
For example, some investors looking to take advantage of demographic trends may be attracted by the living sector, catering to different age groups such as students or the elderly. Others are being drawn to sectors with very low volatility and stable income.
Further complicating matters, the type of tenants is becoming more diverse as operational real estate becomes more mainstream.1 That means the models used to value investments are outdated and in need of upgrading and greater flexibility. Owners simultaneously need to account for the increasing complexity of running real-estate assets.
This changing and increasingly complex picture will require both investment discipline and scale to successfully access a broad range of opportunities across the market.
A different approach to alpha
Balanced core portfolios have been at the heart of real estate strategies for decades, following what appeared to be a relatively low-risk approach to provide steady income to match insurers’ and pension funds’ current and future liabilities.
But while this view prevailed during the long period of low interest rates and inflation, the world has changed so much in the last five years that such strategies are now far riskier than many investors appreciate.
In any case, with returns expected to be considerably lower than most have become accustomed to, managers will need to be able to articulate a clear and compelling investment process and explain how they expect this to generate alpha.
Those able to improve the earnings potential of individual properties will stand out
For instance, those able to improve the earnings potential of individual properties will stand out. This means careful selection and asset management skill are likely to become key differentiators. When considering new sectors, there is also a strong rationale to partner with third parties that offer proven operational expertise and access.
Asset managers with activities across a wide spectrum of real asset markets should be better placed to generate value and build solutions to meet different client needs than those with a narrower focus.
One of the benefits of having a multi-asset real assets platform is that signals from one market can provide valuable insight to inform decision-making in another. As an example, recent signs of stress in the UK real estate market first emerged in debt, not equity markets. Given the opacity of private markets, this real-time information offered an advantage to real-estate equity managers sitting alongside a real-estate debt team.
Net zero: Opportunity or obsolescence
Adding another layer of complexity, the sector is reappraising building stock through a net-zero lens. It is not inconceivable well-located real estate previously considered high-quality prime assets will become vulnerable to sustainability-related obsolescence.
A low-yielding prime asset might tick all the traditional boxes for a balanced core portfolio – location, strength of tenants and length of leases – but sustainability considerations can mean this property’s prospects are far less healthy than they appear at first glance.
Investors now realise they must lock in net-zero commitments for 2030 and beyond. The market is going through a period of price discovery as it weighs up what this means for “brown” and “green” assets.
Demand for more precise and vigorous sustainability-based valuations will only intensify
Demand for more precise and vigorous sustainability-based valuations will only intensify, as will the premium on better-performing buildings. Properties with bigger carbon footprints that are not on a net-zero pathway are at higher risk of obsolescence. Even properties in prime locations could struggle to attain high Energy Performance Certificate (EPC) ratings and might be exposed to far greater obsolescence risk than realised.
Whether they are looking to lease in a shopping centre, office or residential building, tenants will increasingly favour those assets with high EPC ratings and shun those with lower scores. After all, spiralling energy prices mean there is a bigger incentive for people to care about this issue than ever before.
Investors who can price this risk best are likely to outperform. While there have been some suggestions environmental, social and governance (ESG) factors will drop down the agenda, the real estate market tells a very different story. Assets on a firm path towards net zero are likely to be in even greater demand.
While these effects may take a few years to become fully apparent, it is already clear businesses want high-quality space that provides a better environment for employees. The newest, most flexible space is likely to do well, while older, less energy-efficient buildings will do worse, reflecting the cost of upgrades.
- Real estate returns will be challenged in the coming years as we exit the era of low interest rates and inflation, but opportunities remain for discerning investors
- Flexibility, scale and a deeper understanding of the fundamental drivers of locations, sectors and individual assets will be critical in finding alpha
- Investors need to position portfolios now for a net-zero world, to identify opportunities and avoid asset obsolescence