Real estate feels the impact of technology

One of the most interesting current trends in real estate is the possibility that the pre-eminence of financial services as a force in property markets could be usurped by the tech, media and telecoms (TMT) sector. According to Oxford Economics, the TMT sector will grow in Europe by 2.6 per cent per year over the next four years, faster than any other industry and double the pace of GDP, creating huge demand for space for computer programming and data storage.

The TMT sector tends to cluster in certain cities, setting up a virtuous cycle as staff with specialist skills create a local pool of expertise which in turn attracts rival companies and new talent. Tech clusters in Europe can be small tech and media start-ups in fringe office locations in big cities or larger, traditional locations such as out-of-town science parks, often near universities, that have been pushed out of town by tight planning controls.

“While these clusters of TMT companies may be relatively small, they are important in absolute terms and around 20 per cent of all people working in Europe’s TMT sector can be found in just six cities: Dusseldorf, London, Madrid, Milan, Munich and Paris,” says Mark Callender, head of property research at Schroders. “Undoubtedly, the growth of the TMT sector has been an important driver behind the fall in vacancy and recovery in office rents in certain cities such as Cambridge, Karlsruhe, London’s West End and Munich since 2010. TMT companies accounted for a third of gross take up in London’s West End and Midtown market in 2012 and for 60 per cent of known requirements at the year-end.”

Around these clusters, local economies are booming so that in Germany for example Aachen, Bonn, Dusseldorf and Karlsruhe are among the best performing retail markets over five years, so Mr Callender suggests retail or residential property in these locales may be a way to play this trend. The flipside of this tendency towards agglomeration is that it can take potential business from low tech cities.

Returns have diverged considerably in recent years. At the extremes, for example, the Irish property index has lost 13.1 per cent pa over the last five years, while South Africa has gained 12.1 per cent pa, according to IPD. However, there is little tactical activity and funds generally adhere to a benchmark with little hedging, bar currency, as deals take weeks to complete and transaction costs are around 7.5 per cent.

“This market is difficult and even in the five months this year there has been remarkable fluctuation between region and country,” says Michael Lipsch, senior portfolio manager, real estate, at ING Investment Management in The Hague. “At the start of the year, Japan was a focus and its deviation was particularly huge but now there are few remaining opportunities.”

J-Reits (real estate investment trusts) were on an unjustifiable premium of 45 per cent in mid-May, and while monetary policy is a big factor for offices in Tokyo and the financial sector, there has not been much reaction to the fiscal announcements that started in December.

“Net yields in the Tokyo prime office sector were 4.25 per cent in Q4 and 4.05 per cent in Q1, so yields have compressed by 20 basis points but they would have to fall by 130 basis points to get near to justifying this massive premium, all else being equal,” says Martin Bernhard, global real estate analyst at Credit Suisse. “After the recent correction, J-Reits now trade on about a 20 per cent premium and at an average dividend yield of 3.5 per cent. In order to achieve revaluation gains of 20 per cent, direct market property yields would have to fall by about 60-70 basis points from current levels, which is about the decline we expect for the coming years, so we believe that J-Reits are about fairly valued at the moment,” he says.

The European scene

“We like major cities in the Scandinavian market, particularly Stockholm, and Germany as its historical development means there is no one major capital city,” says Kim Politzer, director, research, Europe at Invesco Real Estate.

“This means that some overseas investors are wary about how or where to invest in Germany, but its multi-nodal nature is actually a strength as the major cities have diverse occupational bases. Munich, for example, has a strong manufacturing base so benefits from export dynamics while Frankfurt is closely linked to the development of the ECB and increased bank oversight. Each city has its one story and no one city is dominant. There may not be the liquidity of London or Paris, but there are more options and sector stories to play with.”

 Property markets in peripheral Europe will turn at some stage, but the consensus is to be patient. “We are still nervous of Southern Europe because of the lack of transparency, and in line with our competition we have been watching the region because we expect at some stage in the next 18-24 months the opportunities there will become interesting,” adds Ms Politzer. “Current buyers in Spain, Italy, Portugal and Greece want a substantial price discount for property in these countries but many of those who own property there do not want to sell at a loss, so until we see some distress in the market with banks calling in their loans, or some better economic news to make the purchaser more comfortable, we will be holding fire.”

Otherwise, the US, France and the UK are the markets where investor appetite is greatest.

The US manufacturing renaissance is having a big impact on the Sun Belt region, which has been able to enjoy lower input prices as a result of shale gas developments. Analysts largely prefer shopping centres over malls as they sell day to day necessities, but are primarily opting for quality above all else.

“There is a big focus on prime locations where there is good foot traffic and easy access by public transport, all adding up to a total experience,” says Folmer Pietersma, manager of Robeco Property Equities fund. “The internet supports this bifurcation between prime and other, and it is still sometimes underestimated how strong this trend is. It is not just prime malls but any prime property including for example the high street.”

The same general flight to quality is evident in office space “with the same underlying reasoning – companies want to cluster in London and Manhattan around central business districts and that is a trend that is still evolving. We see a lot of vacancies in suburbia but not in prime. People want top locations. The bifurcation is not only about rent levels but what companies can offer their employees, so companies will often reduce their number of locations but the one left will be in a central location.”

Most excitement around retail is around the impact of e-commerce, where different models continue to develop.

“Instead of occupying the traditional 300 stores, many retailers may, in the future, cut back to 50-60 stores,” says Ainslie McLennan, co-manager of the Henderson UK Property Unit Trust. Leases coming up for renewal in the next three to four years could see tenants coming out of stores. Shoppers now want an experience and retailers are more demanding in wanting a big clean box space, not for example a narrow entranced space with a dark tail at the back.

The Henderson fund holds just 5 per cent in high street retail on concern about downsizing and liquidations. But the reverse side is that there is strong demand for distribution and logistics depots, and smaller depots are a dynamic part of the market, although they must meet the desired specification in terms of loading bays and ceiling heights.

“Click and collect is a growing area as people do not want to come home to a card that has been put through the door, nor have products delivered to their desk that may be too large to carry home so they will choose to pick it up from a store or retail park which is accessible,” adds Mr McLennan. “This has been one factor in retail warehousing doing well, particularly in the South East of England.”

“Online retailers and retailers moving into e-commerce are still at the experimental stage regarding fulfilment,” says Ms Politzer at Invesco. “Some such as Amazon are fulfilling orders from very large warehouses but others are looking at smaller facilities on the edge of cities to fulfil their guarantees for next day delivery. The model is still developing.”

Tesco and Asda are starting to fulfil their orders through “dark stores”, she explains, which are warehouses roughly the size of a big supermarket, but with no customers, just shelf-pickers fulfilling orders.

“It is an interesting market but it is not clear how real estate investors can work with it to secure the best opportunities, and it is not the same everywhere as there are different population clusters and distances between cities vary,” adds Ms Politzer.

The e-commerce world is changing rapidly and fund managers who share offices with equity and bond analysts could have an edge in understanding these businesses.

“Longer term ESG (environmental, social and governance concerns) is important for returns,” says Robeco’s Mr Pietersma. He believes that for a few months investors have been too fixated on dividends. “We need to lower energy bills in the future and in the long run owners will find that tenants are concerned about environmental issues. Sometimes it is overlooked in times of market rallies. People can forget about the underlying fundamentals of companies and focus on valuation multiples and dividends.”

Nothing new

“It’s Buggins’ turn – we’ve been here before,” says Don Jordison, managing director of property at Threadneedle. “Property comes into its own in late cycle. It reacted to QE1 and was resistant to QE2’s charms but it can’t withstand the charms of QE3.”

In 2007 the market peaked and values fell 40 per cent not because property was empty but because open-ended funds had to sell assets, he explains. “And from then until mid-2009 values went down like a lift shaft. At the beginning of 2007 people were forced sellers and arguably accepting prices of 20-30 per cent below market levels. By the end of 2009 some had become forced buyers and were paying a premium of 10 per cent.”

On a wider point, Mr Jordison says the default risk of property is overstated as is the lease event risk. “Eighty-five to 90 per cent of properties are re-rented in good times, and since 2008 it has just dropped to 65 per cent,” he says. “But if the risk is overstated, so too is the upside. The fundamentals are not as terrific as people like to think they are.”

Mr Jordinson believes that central London is buoyed by global demand and investors have to compete with oligarchs and sovereign wealth funds. “This does not make sense if what you are trying to achieve for investors is a high stable well diversified income return,” he says. 

The Reits way

Reits (real estate investment trusts) offer investors a potentially high income stream, good portfolio diversification, pound cost averaging and an efficient way to gain exposure to international property – but with a high correlation to equities and varying performances. Investors generally need to hold Reits for up to three years for their correlation to the property market to become evident.

Reits make the same returns over time as direct investment but there is a lot of short-term volatility, says Martin Bernhard, global real estate analyst at Credit Suisse. He prefers private equity vehicles which reflect direct investment more closely but lock investors in for between seven to 10 years, although it is possible to sell in secondary markets.

Most fund managers are predicting 10-15 per cent returns on a 12-month horizon. Historically two thirds of total return have been generated by dividend increases.

Funds that are overweight to large caps could offer some downside protection because large caps are more likely to be run by better managers with stronger balance sheets, access to financing alternatives, and with defined ESG policies.

The big risk for the asset class is interest rate rises. There were mixed signals at the end of May whether the US Federal Reserve will start scaling back their asset purchases in Q4/beginning 2013. This prompted the sell off in recent weeks.

“When interest rates rise, Reits generally have underperformed historically, while direct investments have tended to outperform,” says Mr Bernhard. “I attribute this to the fact that interest rates rise in the good times when markets and the economy are elevated, and demand pushes down vacancies and supports rent levels.”

View from Morningstar – Solid returns

Funds in the Morningstar Property-Indirect Global category invest principally in the securities of real-estate companies, including those of real-estate investment trusts (Reits). Funds in this category may hold a portion of their assets in direct bricks-and-mortar property, but this will typically not exceed 30 per cent of the total portfolio.

The category posted solid returns over the past 12 months (19.8 per cent in euro terms up to May 2013 month-end), buoyed by signs of improvement in the US housing market, as well as a macro environment that proved generally favourable to the real estate sector. The current low-interest rate environment provides Reits with access to historically cheap debt financing, which has led many of them to incrementally improve their fundamentals. At the same time, low rates have continued to fuel investors’ demand for higher yield investments, including real estate funds.

Henderson Horizon Global Property Equities, rated Bronze by Morningstar, was one of the top performers over the past 12 months (up 24.5 per cent). The fund has been managed by Patrick Sumner since January 2005. Mr Sumner heads Henderson’s Global Property team, which boasts significant expertise on the European and Asian real estate markets. For the North American portion of the portfolio, the team relies on external research from Transwestern Securities Management. As is the case for most other offerings in the category, the fund is managed using a synthesis of top-down and bottom-up analysis, paying close attention to the characteristics of individual property markets. The fund’s long-term track record is sound (it has beaten 80 per cent of its peers over five years up to the end of May), yet this was achieved at the expense of higher than average volatility. The fund’s portfolio is in fact fairly concentrated (40 per cent of its assets are in the top 10 holdings), implying a significant amount of stock-specific risk.

Robeco Property Equities, rated Bronze by Morningstar, delivered 18.7 per cent over the same period. The fund is managed by a team of three portfolio managers and one analyst, including team head Folmer Pietersma. Although the team is not one of the largest in the market, we think its stability and cohesiveness compensate for this. Managers identify trends that they believe will be predominant in the property sector for the long term. Current themes include developers in emerging markets, offices and retail premises at prime locations, as well as specialised property such as data centres or laboratories. This is supplemented by bottom-up analysis, focusing on each company’s business model and cash generation. This approach has paid off well for investors: over the past five years up to the end of May 2013, the fund delivered 4.8 per cent versus 3.6 per cent for its average peer, with average volatility.

Delta Lloyd L Global Property, rated Neutral by Morningstar, performed in line with the category over the past 12 months (up 18.3 per cent). Manager Roy van Wechem has been at the helm since 2006, yet his experience in the global real estate sector is fairly limited, having previously run a euro credit fund. The team around him is small by industry standards, as there are no other resources purely dedicated to real estate markets at Delta Lloyd. The fund has been penalised this year penalised by its security selection in the US as well as by its allocation decisions (overweighting Hong Kong and underweighting Japan) and is therefore lagging the category average by 2.8 percentage points year-to-date. Although the fund benefits from reasonable fees, the limited resources available to the fund manager limit our conviction in its long-term potential.

Mara Dobrescu, senior fund analyst, Morningstar France