Existing real estate trends accentuated by Covid-19 pandemic
With the equity bull market growing long in the tooth, and income hard to come by in a low interest rate world, investors had been growing increasingly attracted to real estate in recent years. Be it by allocating to listed real estate companies, or investments in physical bricks and mortar, the asset class appeared to be in rude health.
But then came coronavirus and suddenly everything changed. Enforced lockdowns saw people working from home and offices lying empty. Shops were shut up while e-commerce thrived and economies around the world nosedived.
A crisis or a change in people’s perceptions and expectations around global growth or interest rates will typically see Reits – real estate investment trusts – react first, both positively when the situation warrants it, but also negatively, in terms of shock and stress, says Guy Barnard, co-head of Global Property Equities at Janus Henderson Investors.
Reits enjoyed a strong year in 2019, but this year has been very different, with the sector being one of the worst performing parts of equity markets when the impact of Covid-19 began to be felt back in late February and into March. There has been some recovery since then, but the sector has lagged wider equity markets and remains down by around 20 per cent year-to-date.
Real estate is traditionally seen as an income-producing asset class, so why have we seen this underperformance in a world where interest rates and bond yields remain incredibly low?
The coronavirus crisis is unprecedented, explains Mr Barnard, and with Reits typically investing in property with long rental contracts, the big concern investors had was that tenants were not going to pay their rent, especially with some governments giving tenants leeway to do that for a period of time.
“People have looked at real estate and what has changed in their mind is the resilience of the income,” he says. “Investors thought this was an income stream that could be trusted, that it will be affected by economic cycles but they would still be paid the majority of the rent the majority of the time.”
Yet once you dig a little deeper, Mr Barnard insists the 20 per cent average fall for the sector is actually very misleading, as some parts of the market have seen stock prices rise significantly, while others have halved in value.
“It is not so much about countries or cities that are dictating that performance, it is more about the sectors,” he adds.
In common with most of the fund managers PWM spoke to for this piece, and as is the case in other parts of the economy, Mr Barnard sees the Covid crisis as accentuating trends that were already present in real estate.
“A number of trends have been playing out in recent years that have been changing the way we live, work, shop, play, and Covid has really been pouring fuel on the fire, making the changes happen in a much shorter space of time.”
So it is a case of picking out the winners, and avoiding the losers, he explains.
The winners, he believes, are companies with reliable income streams we can trust – those where if you looked at their financial statements you would not know there was a pandemic playing out. In these areas, rent collection has remained strong and they are experiencing growing demand. He highlights areas such as industrial and logistics real estate, where the explosion in e-commerce has seen soaring demand for warehouse space. Mr Barnard also likes affordable rental residential, where income streams are proving pretty resilient, and other, alternative parts of the market, for example trying to exploit changes in technology through investments in data centres or tech-focused real estate companies.
At the other end of the scale, the big loser has been retail. The sector was already struggling before the pandemic, but now it is in real trouble, with the growth in online shopping surging ahead. “In the UK it took 14 years for e-commerce to move from 7 to 19 per cent. It has taken less than three months to go from 19 to 30 per cent,” says Mr Barnard. “Some will go back the other way, but those people doing their grocery shopping online for the first time are not going to change.”
Traditional shopping malls in the US and UK have seen significant value destruction which is now spreading into continental Europe. “Companies are seeing balance sheet issues and some are going bust,” he says. “We have no exposure to retail at all in Europe — we have a little bit in Asia where the dynamic is a bit different, the Chinese consumer is back, luxury spending is strong. But that really is the expectation.”
The hotel sector has also been hit, and will be a long-term sufferer, but can expect some kind of recovery further down the line. Meanwhile the future of offices is “the most polarising discussion we have with our clients”, he reports, though does believe there is value to be found in the right kind of buildings with the right kinds of tenants.
Hot money
Reits were at pretty much “all-time highs” when the Covid-19 struck, says Shaun Stevens, global strategist at BNP Paribas Asset Management Listed Real Estate Equity, whose principal focus is the US market.
“There was a sense that things were going to crack eventually, and we would see people moving out. And when Covid came, we saw the hot money went out the door very quickly. Because Reits have the liquidity.”
Institutional asset allocators were quick to reduce their tactical allocations to real estate, he says, spooked by the threatened non-payments of rent.
“It was a very worrying theme, particularly in retail, but also in residential. In the US you were seeing some well-known retailers with strong online presence and very deep pockets, saying they were not going to pay their full rent.“
Although rent collections have been better than feared, there is no doubt investors have been spooked by these threats, he says.
Money has been flowing back into the sector, but Mr Stevens says investors remain cautious, with fears of a second wave of the virus prevalent. “People know they can get into listed real estate quickly if they need to. The general investor is still in wait-and-see mode, and if they do want to make allocations it is into things like data centres and storage.”
It is foolish for investors to try and predict how the pandemic will play out, he warns. “We are not epidemiologists. We can’t try to anticipate things in the way we invest in our portfolio. When you are in the middle of a storm it is foolhardy to try to predict which way the storm is going to go and what will be left afterwards.”
Instead, he has tried to look within countries and sectors where he already has exposure to find companies which have been short-changed by the sell-off.
There are also other factors to consider, insists Mr Stevens, for example demographic changes. He points to the role millennials have played in the growth of urban property portfolios, in cities like Seattle, San Francisco, New York or Austin in the US, or also in London where you have a dense cluster of tech companies.
“I think there has been a big demographic factor in that with young people wanting to be in vibrant urban areas, but they are getting older, households are changing, and they are in different part of the life cycle. Will they want something different?”
Quick thinking
The pandemic has brought both positives and negatives for the real estate sector, says Rogier Quirijns, head of European real estate at Cohen & Steers, and although the balance may be negative, active managers in the listed space should be able to find opportunities.
“It is very important investors understand there are lots of sectors and markets in real estate. There is too much negative press on retail and offices. There is good stuff out there, and there might be an opportunity to pick up retail at the bottom,” he says.
Listed real estate funds may have sold off earlier in the year, but they are now able to move around the market and find some interesting opportunities at attractive valuations.
Commercial real estate is an area he finds interesting, and he has been watching the office space keenly, as he believes both working from home and the looming recession are stacked against them, meaning some attractive valuations are to be found.
“To me it still looks a little bit early as it is not so clear how the recession play out. But if we do want to expand our office exposure, we would be more comfortable going into Germany than Spain. Maybe Paris, certainly the Nordics. We will look at countries that have managed Covid pretty well.”
While listed real estate has the ability to move around the market following all the recent volatility, this is not the case for private markets, he says.
“The open-ended funds, they are still in that first phase,” he warns. “They still need to fix their liquidity issues, they have gated, they don’t know what the values are, they still have to see their first sell-off.”
It is very difficult for a private fund to benefit from what is happening in markets at the moment, he claims.
“They can’t just sell some student housing to buy logistics like we can. In the listed world, both sectors went down initially, but logistics in the private market never did. The private markets will benefit when things get really bad, when rents go down and people can’t get finance. Like after the financial crisis.”
As with many things though, timing can be everything. Pictet Alternative Advisors have run indirect real estate funds for a while, but only launched its first direct fund, Elevation I, recently. As a result, all of the fundraising was done before lockdown hit, and the fund went into the downturn 96 per cent liquid.
“The downturn should lead to some better entry points,” says Zsolt Kohalmi, global head of real estate and Co-CEO of Pictet Alternative Advisors. “We have no legacy assets, and normally when these downturns happen, most of our peers spend all their analysts’ time on trying to save some of the issues they may have. We don’t have those because we are brand new.”
Real estate has tended to be a popular investment in times of volatility because it is bricks and mortar, he says, and there will be some kind of inherent value regardless.
With interest rates so low, investors are searching for income, and real estate is one of the few asset classes that can create a decent, almost fixed income like income, as long as you have the right investments, says Mr Kohalmi. It can also provide some level of protection against inflation.
He sees huge potential in logistics, but also likes residential which has in some ways been enhanced by Covid as people are working from home so much. Retail though, is a “falling knife” which is best avoided.
One area that should be of real interest for investors is the importance of environmental, social and governance – or ESG – themes in the sector.
“Property is responsible globally for 39 per cent of all carbon emissions, and yet we hardly ever talk about it compared to, say, the airline industry, which is sub 5 per cent. But I think many property professionals don’t get it.”
Pictet, he claims, “lives and breathes” ESG theme, and part of what he does is try to find the potential on every building for solar panels, sensors and so on.
“I think ESG is a buzzword for the industry but a lot of the people are very old school. They have not quite adopted it to the level they should. But it is coming. And it will be forced, because the larger institutions that are the end buyers will eventually demand it.”
Passed the test
French firm Mirabaud launched its private equity business a few years ago and recently set-up a real estate offering within that division. Rather than gathering assets and collecting rents, the plan here was to focus on real estate development.
“There is clearly a strong interest for private assets at the moment, as opposed to listed markets,” says Olivier Seux, head of real estate at Mirabaud Group. “And our strategy delivers secure, safe, high returns, with a much higher level of certainty than you would in a pure private equity business.”
There is a real need for additional equity in the real estate development business in France, he insists. The fund’s first funding closure took place last September and it made its first investments during lockdown, investing in both commercial and residential within the Paris region. This area is set to benefit from major public investment in transport, with €35bn ($41bn) earmarked for 68 new stations, and 200km of railways.
Mr Seux sees huge potential for the residential market in France because there is such an imbalance between supply and demand. Meanwhile the French economy is heavily subsidised and sensitivity to the economic cycle is quite low.
The case for commercial is less clear cut, but he does point to the need for significant office restructuring.
“In France more than 50 per cent of office space is obsolete and needs to be restructured to comply with new energy efficiency standard,” he explains. “Developers are well positioned to acquire and restructure these buildings provided they have the equity, and that is where we come in.”
Private bank Credit Suisse favours a differentiated approach when investing in real estate, and is looking to take advantage of some the trends accentuated by the Covid crisis.
“Within listed real estate, we favour the US given its high exposure to defensive sectors and low development exposure,” says Sarah Leissner, alternative investment strategist at Credit Suisse.
Meanwhile, for direct exposure, it favours sectors which are defensive or underpinned by secular growth, such as residential and industrial.
“We still believe that investment opportunities exist in structurally more challenged sectors, such as offices, but would focus on good quality and well-located assets at reasonable pricing,” she explains.
The firm currently prefers listed to direct real estate as the impact on capital values from Covid-19 is yet to be reflected, but is still recommending direct real estate for clients who are looking to diversify their existing portfolios of traditional assets.
