This article is sponsored by PATRIZIA
PATRIZIA has been investing in European residential real estate since the business was founded 36 years ago. The pan-European investment manager’s funds and mandates include €11.5 billion of property in the sector, and it has transacted €12 billion of living space over the past six years.
“Residential came solid into the crisis and will probably emerge even stronger,” predicts the firm’s head of investment strategy and research, Mahdi Mokrane. He tells PERE that any truly diversified core real estate portfolio in Europe must include residential.
“The sector offers a range of asset types and return profiles: you can do forward funding and get a risk-adjusted return premium, or you can buy into a fund of existing assets and have stability and a very decent income yield on day one with a really good spread versus anything else that is fixed-income and secure.”
How resilient has the residential asset class in Europe been during the pandemic?
Residential has done exactly what it said on the tin. Investors have traditionally backed residential to access stable, predictable income and capital preservation with some form of inflation indexation over a cycle. Rent collection across our residential portfolios between February and May was surprisingly resilient and we collected over 97 percent of the rent due, while tenant turnover was much lower than usual because of lockdown measures.
We focus on housing for middle-income tenants in attractive cities, and those investments have been particularly resilient because the rent represents a reasonably low proportion of the tenants’ overall income and therefore remains affordable. Meanwhile, the investment market for residential property has held up fairly well.
Deals that were already engaged and underwritten were generally completed, and we have managed to acquire and sell assets throughout even the most stringent period of the lockdown. It has mainly been larger deals that have closed, though. There are fewer small deals being done.
Most development sites reopened pretty quickly after a four to six-week delay and providers of development finance have showed themselves willing to abide by terms that were already agreed. Going forward, development finance will be more difficult to obtain, particularly for property types seen as less resilient. Residential development is probably least affected, but it will also be impacted to some degree.
Where will European residential property sit within the real estate portfolios of global institutional investors going forward?
Institutional residential assets in Europe have proved to be relatively more resilient than the US multifamily sector, which has wobbled in the early days of covid-19. Rent collection in Europe is probably 10-15 percentage points above US levels. The pandemic’s impact on unemployment in the US has been massive, while in many European countries the current and expected effect on the job market is far less dramatic, particularly in Northern Europe where the bulk of our portfolio sits, so households are better able to meet their rental liabilities.
Most residential investments in Europe are financed by banks, and only a minority by other lending platforms such as non-listed or private debt funds or conduits such as CLOs, which are more commonly used in the US, and where we have seen some of those alternative debt conduits temporarily shut off. Because the institutional residential investment market in Europe remains stable, an increasing number of investors are considering moving part of core allocations that have traditionally been invested in commercial real estate into residential, to create a more diverse mix of exposure.
We are also seeing investors looking at residential as a bond-substitute. If you look as far back as the 1990s the net operating income generated by a square meter of residential space in Europe has remained remarkably upward sloping and stable compared with offices, retail and even logistics. A diversified residential portfolio could be viewed as a good fixed income substitute with a higher yield spread. It offers a 250-300 basis point premium compared with an average 10-year government bond yield.
In the US that spread is much thinner because the economy there has arguably been stronger, so long-dated bond yields flattened and even started increasing in the past few years. In addition, the compression of residential real estate investment yields has been steeper in the US since the global financial crisis.
Project 130, Copenhagen
Few would consider the summer of 2020 the most auspicious time to deliver a turnkey residential development to the market. However, the Project 130 apartment block in Copenhagen illustrates the resilience of the leasing market for rented residential in some European locations, even in the face of the pandemic.
“The seafront project of 76 apartments, located midway between the city center and airport, was forward-funded by PATRIZIA’s flagship pan-European Living Cities Residential Fund. Tenants have continued to sign up based on virtual tours of the building and it is around 50 percent let ahead of completion,” says Mokrane.
“You might think it was the worst possible timing, but the leasing progress is comparable to what we have seen in the past. The asset will be a long-term hold for our flagship core open-ended vehicle, which aims to provide stable income in strong micros-locations that also offer long-term capital growth prospects.”
Which residential property types have fared best in the pandemic?
Multifamily residential stands out as the main asset class within the living sector for investable stock, liquidity of markets and diversity of players, but in terms of resilience, senior housing comes close. There will be some uncertainty in the wider economy, but the healthcare and retirement homes sectors will be defensive because they benefit from strong secular demographic trends.
What challenges will investors in European residential markets face?
With over 500 million inhabitants, Europe is a larger market than the US by population, but only about a quarter of the housing stock is suitable for institutional investment and regulations and market dynamics are very local. Every investor needs to work with a manager that has people on the ground. It is very much a specialist market, sometimes more complex and detailed than commercial property investment.
Another challenge is centered on affordability and regulation. Rent control measures have recently created some headwinds in Berlin for example. That has had a minimal impact on our revenue streams, however, because we target assets where the rent is very affordable for the tenant.
A key goal for investment houses across Europe is to better communicate to governments and local authorities that by investing we are improving the existing stock and providing new housing to the market at sustainable rental levels. The main difficulty, though, is sourcing good quality assets in the cities that you like.
Advita portfolio, Germany
PATRIZIA’s acquisition of the Advita portfolio of seven German senior living assets was lined up before the coronavirus crisis, but Mokrane says that the investor had no intention of allowing the pandemic to derail the deal.
“These are high-quality assets let for 20-years to a very good operator. Some senior care operators that were not well-prepared have struggled with covid-19, and we would be very wary of those situations, but Advita has a pristine reputation, even in this severely abnormal episode,” says Mokrane.
He adds: “The portfolio, which consists of one completed asset and six developments which allow for a future proof asset to be designed for assisted living, day care, dementia patients and intensive care. It fits very well for our clients who are looking for stable and steadily rising cashflows.”
Where will we see the best post-covid investment opportunities?
Probably in strategy mixing well-located assets in the best mid-market cities combined with selective forward fundings. Before the pandemic development, finance was relatively cheap, abundant, and available at generous loan-to-value ratios.
Developers were competing for land and some probably stretched their balance sheets to secure a pipeline of projects. Now, development finance will be scarcer, and developers’ existing lenders may be looking to de-risk.
Meanwhile, demand from home buyers is likely to be lower in locations where unemployment rates have increased, so developers may be looking for institutional capital partners to whom they can sell part or all of their projects. We see this as a really good phase of the market for our funds to team up with developers and manufacture core products in the locations that we favor.
To identify cities where we can find value for both standing investments and forward fundings, we use data-driven tools to analyze factors including economic performance, demographics, innovation, and connectivity, as well as ranking them according to liquidity.
This allows us to identify and categorize the most appealing opportunities: powerful cities such as London, Paris, Munich and Dublin; innovative cities like Luxembourg and Amsterdam; affordable cities that can be very rich in terms of income per inhabitant, but where residential rents and prices are relatively affordable, for example Aarhus or Eindhoven; and cities like Leipzig and Salzburg which are liquid relative to their sizes, and which may not immediately come to mind as first-tier destinations, but are very liquid from an institutional point of view.