Off balance and out of step

Daniel McHugh explains why real estate strategies need to change with the times.

Off balance and out of step

Read this article to understand:

  • Why some balanced real estate strategies look vulnerable against the threat of inflation
  • Why investors need to be on the right side of sustainability-related asset obsolescence
  • The opportunities for investors with lower and higher risk appetite

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.

This view may have prevailed during the long period of low interest rates and inflation, but the world has changed so much in the last five years that such strategies are now far riskier than many investors appreciate.

The bulk of the real estate investment world has for too long been focused on prospects for individual assets and sectors, rather than major longer-term trends and the structural changes impacting the market more materially.

There is a real risk much of our industry is sleepwalking into negative returns over the medium-to-long-term – this is especially true of assets where obsolescence will become a problem. When you factor in inflation on top of this, you quickly move towards negative real returns. We estimate more than half of the market could be at risk of this.

Risk, return, regulation and reward. These are at the heart of what real estate fund managers should be incorporating into any credible investment approach if they want to remain relevant in this fast-changing world.

Total UK property returns are expected to deliver mid-single digit returns in 2022. A combination of rental income and some capital appreciation contributes to that, although forecasts vary widely by sector.

In fact, real estate assets that yield between three and four per cent per annum are in danger of generating negative real returns due to a combination of factors that have the potential to blow conventional wisdom apart.

The Consumer Prices Index including owner occupiers’ housing costs rose by 4.8 per cent in December 2021, a thirteen-year high. With inflation running hot, and interest rates increasing in an effort to contain it, we are beginning to see falls in the real value of assets.

Sustainability considerations can mean prime properties are far less healthy than appears at first glance

A low-yielding ‘prime’ asset might tick all the traditional boxes for a balanced core portfolio – location and catchment, strength of tenants and length of leases – but sustainability considerations can also mean this property’s prospects are far less healthy than appears at first glance.

Demand for more precise and vigorous valuations of sustainability features will only intensify, as will the ‘green premium’ on better-performing buildings. This means even properties in prime locations could be exposed to far greater levels of obsolescence and vulnerability to achieving low Energy Performance Certificate ratings than anticipated.

We need to be on the right side of sustainability-related obsolescence. With the built environment responsible for a significant portion of UK emissions, it is important to refurbish older buildings, not just demolish them to be replaced with something new. Our recent acquisitions will see us retro-fit buildings with more energy-efficient materials and cleaner energy sources to bring their EPC ratings up, revitalising their credentials and increasing their relevance for a low-carbon future.

To generate the returns and rewards investors have become accustomed to and get ahead of the macro and structural themes beginning to dominate our world, real estate managers will need to become expert in active equity or debt strategies, depending on their clients’ risk appetite.

Real estate managers will need to become expert in active equity or debt strategies, depending on their clients’ risk appetite

For clients with a lower-risk bias, rather than being vulnerable to steep declines in asset values, it may be more appropriate to allocate to real estate debt, offering secured cashflows with strong covenants. This should generate returns similar to core balanced portfolios, albeit with much less risk.

For those seeking higher returns, by setting a sensible hurdle rate for our real estate active equity investment strategy, we believe this will better reward our clients against the riskier macro and structural environment.

The days of buying a balanced portfolio look numbered and out of step with the market. It is time we move to more sophisticated strategies that reflect the changing dynamics and risks in the market.

This article was originally published in Property Week.

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