This article is sponsored by Macquarie Infrastructure and Real Assets
Six months ago, barring a few anxieties over the lateness of the cycle and a possibly disorderly Brexit, most investors were bullish about the resilience and growth prospects of European real estate markets. Since then, covid-19 has shaken confidence and undermined certainty. Yet with interest rates and bond yields almost certain to remain at historic lows for the foreseeable future, the asset class still offers a compelling story for institutional investors like German-based Hannover Re, one of the world’s largest reinsurance groups. The firm’s chief investment officer Gerald Segler discusses the response of investors in the region to a new set of risks, together with the European co-heads of real estate at Macquarie Infrastructure and Real Assets’ (MIRA) Florian Winkle and Christian Goebel.
The impact of covid-19
Gerald Segler: Because other asset classes are currently low-yielding, real estate is making a higher contribution to the total return of assets within Hannover Re’s portfolio than the size of the allocation to real estate would first indicate. With this in mind, the pandemic will have a significant impact on real estate because it has increased the overall level of market volatility as well as accelerated existing trends in some sub-sectors.
Christian Goebel: There’s no sign that interest rates are going to rise in the near future, and real assets, in particular real estate, should benefit further from that. We can see how some of the largest investors, which already went through significant increases in their real estate allocations over the past years, are looking for additional exposure in this sector. Before the pandemic hit there was an increasing tendency toward adopting higher-risk core-plus and value-add strategies to generate higher returns, but in the near future investors will probably be more cautious.
GS: In the short term, I don’t expect European investors to increase their allocations to distressed, opportunistic and value-added strategies within the real estate space. Given the continued low returns available in fixed income, the relative return spread with existing core real estates has been maintained or even increased, which relieves a bit of the pressure on investors to hunt for yield for a certain time. Combined with the fundamental uncertainties of covid, and the support provided to markets by government stimulus packages, that will deter investors from all-in behavior these days. For institutional investors in the insurance and reinsurance industry, everything is a relative play, so they don’t currently need to increase their allocations to real estate or push into the distressed spectrum because the relative payment for credit risks is intact. Moreover, the relative increase in returns is not high enough to be attractive due to the underlying capital charges that insurers face when investing in high-risk assets. In the near future, allocations to real estate will remain steady, but in the longer term, institutional investors will be pushed into equity-type asset classes or real estate much more, and allocations in three to five years will be higher.
Florian Winkle: What we’re currently seeing in the real estate market is a high level of liquidity combined with generally positive views on value and risk-adjusted returns on a relative basis. A lot of core investors like to keep the risk level within their portfolios fairly stable, in part because real estate is seen as a substitute for fixed income. Meanwhile, the relative evaluation of risk within property sectors has changed as a result of the pandemic. A few years ago, hospitality was more attractive, so investors were happy to take more risk in that segment. Now, they want to take risk in data centers or logistics, but the total value of logistics investments is often smaller. And because of the denominator effect caused by falling stock markets, some investors are having to reduce their exposure to real estate, which also lowers their allocations to high-yielding assets.
Future of the office market
GS: Economic activity is decelerating alongside the organizational changes forced on the office sector by covid-19, and those factors could lead to less demand. In the short term, existing rental contracts and government support packages will provide some stability, so the period of economic vulnerability that we will see over the next 18 months may not lead to problems. However, in two to five years the sector could see major reorganizations that will impact demand. The decentralized working solutions and structures currently adopted by most businesses will have a greater effect on reshaping the office market the longer the pandemic goes on. We will not necessarily see a sharp fall in demand for office space, but we will need to examine whether office assets are suited to future demand in the light of changing working practices, and therefore active management of office blocks will become much more important.
CG: Investors will continue to invest into the office market but likely become even more selective in their choice of asset managers. One thing that we think will make an increasing difference is boots on the ground: investors will likely focus on managers that are properly represented in the different markets in which they are invested and will expect active asset management. Undoubtedly, there will be changes to investment strategies. Because of the difficulty of bringing staff into big office towers in London or Paris, we expect occupiers to spread more into secondary locations to create a more diverse employee base. This would impact target market selections.
GS: Not all regions will experience the same effects. In urban centers, for example major cities in Asia, it is much more difficult for people to work from home than in Scandinavia for instance. This means in cities where living space is very limited and expensive like London, New York or Shanghai, office assets will not face too much of a difficult time. Smaller secondary cities will possibly be more affected by new working practices in the longer run.
FW: There are several factors driving change in the office segment. First, how people will want to work in the future. What are their preferences in terms of work-life balance and home working? Is that possible in areas where apartment sizes are small? Will they be forced to go into the office? Second, the pandemic is a catalyst for digitalization, and we expect that will have a massive impact on how businesses employ people. Third, there is infrastructure and transportation. How can people get to their offices? That impacts which office buildings are successful. What will be the layout of the office building of the future? Due to covid-19, aspects like health and safety are also becoming more important.
Finding value in logistics and retail
GS: Investors need to be a bit cautious when considering investing into the logistic real estate sector. Most of them are jumping on the bandwagon in the present circumstances and as a result yields are falling. While it seems to be the most stable real estate sector at the moment – and there are definitely dynamics at work that will accelerate demand in the sector – investors should ask themselves whether the pricing of assets represents the inherent risk. Simultaneously, many investors are running away from the retail sector, however there are some parts of it that will of course continue to succeed in the future – for instance, we expect event retailing to come back after the pandemic crisis. Logistics is in high demand and retail in high supply, so investors need to be more creative and pick and choose carefully, rather than avoiding certain sectors altogether.
CG: Going into counter-cyclical opportunities like retail is on the minds of many investors, but the difficulty at this time is finding the right space and the right sellers. A lot of investors in Europe have increasingly focused on logistics because they see the potential for rental growth. There is about six times more logistics space per capita in the US than in Europe and many investors therefore believe there will be significant scope for further demand in Europe. E-commerce should continue to grow, including in aspects where Europe is lagging behind, for instance online grocery sales. When you look at last-touch or last-mile logistics in particular, the investment rationale is that rents will continue to grow and therefore pricing can still be justified.
Geopolitical turmoil and Brexit
GS: The disruption to international trade caused by protectionist policies, the pandemic and Brexit will probably not have too many negative impacts on the real estate sector. It may lead to business activities that have been outsourced to Asia over recent years returning now to Europe. While economic activity may be slower, that will be offset in the real estate sector by the need to create greater capacities closer to home. In some regards, deglobalization and Brexit require an even higher level of flexibility from business and asset managers to enable them to ride out the geopolitical waves. When we are investing internationally, our undertaking now places more focus on the flexibility of management and the product manufacturing than it did before.
FW: Before the pandemic our expectation was that London was probably not going to correct as much as some other markets where we have seen a lot of growth over the past several years, because it had already been through some pain. But now we see the impact of covid-19 on the UK in combination with Brexit, it is unclear what the London office market will look like at the end of this year and the beginning of 2021.
GS: Because of Brexit we have seen a lot of people moving from London to Frankfurt and Paris. German real estate is really benefiting from that shift. Meanwhile, we are cautious about the market in cities affected by covid-19 where falls could be steeper than expected. In general, despite the tremendous monetary and fiscal help that has been provided by central banks and governments, we do not expect Europe to see a V-shaped recovery. The path will likely be longer and more gradual.