As with all asset classes, Covid-19 has left its mark on real estate, accelerating trends that were already in place and increasing the headwinds faced by parts of the market. But as the prospect of a return to some kind of normality increased with the successful rollout of vaccines, investors took the opportunity to buy into an asset class that should benefit from a return to growth.
“We have seen some good fund flows; the asset class is back in vogue this year in a way it hadn’t been until recently,” reports Guy Barnard, co-head of global property equities at Janus Henderson Investors.
The firm’s message to clients for a while now has been the impact of fundamental changes to the way we live, work and play, and how those feed into levels of demand for different types of real estate. Mr Barnard points to the structural themes of changing demographics, digitalisation, convenience lifestyle and sustainability, explaining how even pre-pandemic they were having a pretty sizeable impact on returns across parts of the real estate sector.
“The pandemic has just poured lighter fuel on what was already a pretty hot flame,” he says. “The poster child for that has been the demise of retail, the big shopping malls in the US and UK on the one side and on the other the growth in e-commerce fuelling demand for industrial and logistics assets on the other.”
When the impact of the coronavirus tore through markets back in March last year, those sectors facing headwinds saw the biggest sell-offs while the structural, defensive real estate ones stood up better. Janus Henderson took this opportunity to build exposure in what Mr Barnard calls “cheap but not broken” companies, where balance sheets were robust, buying some hotel names, some exposure to selective office markets, healthcare in the US and some residential in the big gateway cities.
When news of the vaccines broke in November the situation changed.
“Then the market was looking forwards and could see a path to recovery, and the worst case scenario that had been priced into those more challenged sectors saw share prices rebound very strongly in areas like hotels, retail and to some extent, offices,” he says. “We saw 100 per cent share price rallies in some cases in companies in those sectors between November last year and early March. In some cases we are now back at pre-pandemic levels.”
Although parts of the market were damaged cyclically by the pandemic, and will bounce back, in others structural change has been accelerated and, in Mr Barnard’s view, that is a permanent impairment to their income and their values. The best returns going forward, he believes, will continue to come from those structural winners.
Value to be found
Real estate investors should of course own the sectors that are likely to benefit from structural tailwinds, says Rogier Quirijns, head of European real estate at Cohen & Steers, but should also be prepared to diversify into the value-orientated parts of the market.
“You want to be a little cautious, but not too negative or narrow-minded,” he says. Retail looks attractive on a valuation basis, and there are still opportunities to add exposure in the office sector.
“Retail can be more of a trade than an investment, but after two years of pandemic, people are tired of shopping online,” says Mr Quirijns. “They want to go out, see some shops, see some people, see a movie, have dinner, have a little bit of an experience. To spend a bit of money offline, rather than online.”
European shopping malls could surprise to the upside, he believes, though cautions that rents still need to correct in the UK so is less bullish there.
Much has been written about the impact of coronavirus on offices, with widespread working from home during lockdowns leading some to predict their ultimate demise. But with many countries now starting to open up, and some encouraging workers back to the office, what does this mean for investors?
“The health crisis has been a huge experiment for the office sector, accelerating existing trends,” says Joanna Tano, head of research at BMO Global Asset Management. “We now know we can work from home, and while we know that will be part of the future, it is not the whole answer and our view is the office will continue. It will not cease to exist.”
Offices are important to companies, she says, as building brand, culture and reputation is done best by being physically together. “Productivity, creativity, identity, knowledge – all these things are fostered by being together.”
Although working from home undoubtedly has its benefits, be it time saved by not commuting, living in a preferred location or being able to hire talent from further afield, it can also mean social isolation for some, and this needs to be taken into account by companies who claim to prioritise ESG in all they do.
“Flexibility will be key,” says Ms Tano. “And when people are in the office they will want more collaboration space, more amenity space. Sustainability, wellbeing, that ‘E’ in ESG. Just providing desks is not acceptable any longer. The quality of that environment and what people do when they go there is evolving.”
This is likely to drive a split in the market, with those flexible modern spaces with access to open air in higher demand, with more resilient rents, to the detriment of the secondary market, which could see the accelerated obsolescence of some buildings, she explains.
Office evolution
The bar has been put higher for what an office must do, says Zsolt Kohalmi, global head of real estate and co-CEO of Pictet Alternative Advisors, and there are a host of changes that will have to be made. No offices ever had air sensors, and it has been a long time since windows have been openable, but tenants will be looking for things like this now. “And because they are also the biggest environmental footprint for many companies, it will become ever more important to say: ‘I rent a green office.’”
The challenge today for investors, as with all asset classes, is that real estate is not cheap, he says. “So do you buy something that is out of favour, at an interesting entry point, or something with the structural tailwinds, but at a much higher point? There is no universal answer for this.”
In an environment where the threat of inflation is very much on the increase, real estate can offer some protection, says Mr Kohalmi. In most jurisdictions – though UK commercial is an exception – rents are CPI indexed, and move in line with inflation. He points to a study done by BlackRock which examined how real estate performed versus stocks, government bonds or investment grade in various environments, and which showed that whenever there was inflation, real estate outperforms, and only underperforms when there is high growth and low inflation.
Although inflation looks likely to rise, interest rates should remain low, simply because governments would go bankrupt were they to go much higher, believes Mr Kohalmi. In this environment, core plus real estate, those properties with low to moderate risk profiles, should offer investors strong, sustainable income streams with some inflation protection.
“Core plus is a long-term game, where you aim to buy a big logistics building inhabited by, for example, Amazon or Hermes outside of a major city, or an office building with a very long-term rent. And, if interest rates remain low, then these are very interesting fixed income alternatives. There are not many places you can get some capital gain and create a current cash flow.”
Value add investments on the other hand are shorter-term investments, in close-ended funds, of perhaps three to seven years, he says. “You buy the asset relatively highly leveraged, and as soon as you do, you are on a treadmill because you are aiming to create 15 to 20 per cent annualised returns by transforming it. And I think value add will do well because we have so many old buildings, and the imperative to improve our buildings from an ESG perspective, to maintain their value and keep occupational interest, means there will be a lot of work to do.”
Mr Kohalmi, who describes himself as “a direct investments guy”, claims the problem the listed sector has for many investors is that household names tend to cover many sectors. “It is hard to untangle them, how much should you worry about the X per cent retail and X per cent office versus the X per cent light industrial. There are not that many pure plays available in the listed universe for the sectors and geographies that are in vogue, and the few that are, tend to be trading at a significant premium.”
Delta delays
Although the outlook for real estate on a global level is positive, the emergence of the Delta variant of the coronavirus means reflation sectors like property are going to have a delayed pick-up, says Jeffrey Sacks, Emea head of investment strategy at Citi Private Bank.
“We do think the Delta variant has further to run but that it will blow out reasonably quickly. One of the indicators we are looking at is India, where we had the surge in infections but they are now coming down equally quickly.”
Citi has been overweight equities and other areas like commodities and property that benefit from a strong growth upturn and a strong inflation upturn. But the timescale for beating the pandemic is slightly more drawn out, which will have an impact on growth and a secondary impact on property.
Interest rates will stay lower for longer, and that will be reinforced by the Delta variant. The Delta variant is going to make authorities more concerned not less about the fragile growth upturn, which will result in lower rates for longer, he says. “Even the ECB aren’t going to raise rates, and they were at the most dovish end of the central banks. And of course lower rates are good for property – it helps affordability.”
In addition, Mr Sacks explains that many listed property companies are also paying decent dividend yields, with many in possession of strong balance sheets and cashflows, so they are in a position to raise those dividend payouts.
As with portfolio construction in general, a diversified approach is the right way of building property exposure, he says.
“There are ways to do well by investing directly, while listed property companies have attractions because of their yield. We like the outlook for Reits, but on a selective basis, and we are finding quite a lot of fresh ideas in private equity.”
Indeed, Citi brackets private equity in with real estate – PERE – and the recommended weighting for that in client portfolios is around 10 per cent, though sector overlays in the remaining 90 per cent can push overall exposure to property up.
As buying into real estate is now more expensive than it was five years ago, investors should expect lower returns over the coming years, says Thomas Veraguth, global real estate strategist at UBS Global Wealth Management. “Despite this, our mild inflation, growth and yield scenario is supportive for an ongoing comparatively robust performance,” he adds, expecting rental growth to compensate for higher inflation and capitalisation rates.
“Fundamentally we do not expect investors to reduce their real estate allocation and the balance between supply and demand should not be a threat to future returns,” says Mr Veraguth.
He turns more bullish on private equity real estate. “Managers’ ability to leverage their investments is currently optimal, which promises good vintage years in 2021 and 2022, which again is a positive for the projected returns over the coming years.”
Lagging behind
The view is more cautious at Credit Suisse though, which expects real estate to lag global equities. “We believe that further upside is limited as a resumption of yield rises alongside an economic recovery could hurt the rate sensitive sector due to higher financing costs and lower valuations in underlying property markets,” says Sarah Leissner, real estate strategist at Credit Suisse.
Real estate companies’ earnings growth continues to weaken as the negative impact from the pandemic is gradually reflected in underlying markets, she warns. “In addition, the earnings outlook remains muted as the increased popularity of e-commerce and working from home weighs on the outlook for retail and office markets, in particular.”
VIEW FROM MORNINGSTAR: Investors revisit Reits
A sharp snapback of the Covid-19 lows, heightening inflation, and few income opportunities have pushed investors to an often-forgotten asset class: Real Estate Investment Trusts, or Reits.
These funds in Europe and North America took in $9.3bn in 2021’s second quarter, the highest quarterly inflow since the first quarter of 2013. Assets under management now stand at $339bn, up 27 per cent from June 2020.
It has been a choppy ride. Shuttered storefronts and vacant office space led to a painful sell-off for the Reits that own them, with the FTSE EPRA/NAREIT Developed Index suffering a 42.4 per cent drawdown during the depths of the coronavirus panic, far worse than the MSCI World’s 34 per cent loss. Just as frustrating was the lacklustre recovery, the global real estate index gained just 9.2 per cent versus a 24.9 per cent rise for the MSCI World from April through October 2020.
That changed as the vaccine rollout spurred a resurgence in stocks tied to the reopening theme. The iShares Global Property Securities Equity Index Fund, which tracks the FTSE EPRA/NAREIT Developed Index, returned 36.5 per cent from November 2020 through June 2021, better than the MSCI World’s 32.9 per cent gain over the same period. Retail Reits led the charge, with mall stocks such as Simon Property Group and Unibail-Rodamco-Westfield returning 100 per cent or more over that period, driving the FTSE EPRA Nareit Developed Retail Index to a 61.7 per cent gain.
Besides compelling recent performance, inflation concerns have also propelled Reits onto investors’ radars. Rising property values are one of the most common symptoms of an inflationary regime, a characteristic that provides relief to property owners worried about lost purchasing power. Many retail and office contracts contain provisions that increase rent along with the rate of inflation, but without that flexibility, the future rental income loses its value.
Residential contracts are not filled with as many provisions as commercial leases, but with shorter contract periods and favorable demand, those landlords can push through rent increases during inflationary spikes as well. Indeed, according to Apartment List, the median national rent in the US rose 9.2 per cent in 2021’s first half, a sign that landlords are passing higher costs onto tenants. The FTSE EPRA Nareit Developed Residential Index has risen 17.1 per cent since the start of the year, outpacing the 15.5 per cent of the broader Reit Index.
And with broad market yields at historic lows, income-generating Reit funds appear even more attractive. Reits are obligated to distribute at least 90 per cent of their net income via dividends, which leads to higher yields; the iShares Global Property Securities fund’s 2.2 per cent is above the MSCI World’s 1.4 per cent. Investors hungry for more can seek out higher-yielding options that take on more risk; Brookfield Global Listed Real Estate carries a 3 per cent yield, though has been more volatile than peers.
Though not guaranteed, the aforementioned ability of property owners to raise rents to keep pace with inflation can allow Reit managers to raise their dividends at a similar pace.
Bobby Blue, manager research analyst at Morningstar
