This article is sponsored by Invesco Real Estate.
The diversity of real estate as an asset class remains one of its greatest strengths. Alongside office, retail and industrial assets, residential real estate can potentially provide strong returns for institutional investors, particularly if they are looking to enhance their long-term portfolio diversification.
Invesco Real Estate, the global real estate investment management company, works directly with contractors and developers and is eager to use its experienced team to help clients navigate recent market challenges in the residential investment market, whether they stem from regulatory changes or from the covid-19 pandemic.
John German, managing director of residential investments at the firm, considers some of the key trends and outstanding opportunities in the market.
How has the residential market developed in EMEA and the UK?
We have seen continued growth in investor appetite for residential investments across both EMEA and the UK. The largest sector continues to be rental residential, but we are also seeing strong activity in the purpose-built student accommodation (PBSA), senior living and co-living markets. These subsectors were challenged by the covid-19 pandemic, particularly the micro-apartment co-living space, but even here we are starting to see renewed activity.
If you look at residential as an asset class, it is probably the second-most traded in Europe after logistics. As mentioned, the pandemic did have an impact, but generally the value of residential assets remained flat. This was largely because rent collection was maintained at an incredibly high level compared with the majority of other asset classes.
Beyond the pandemic, there has also been a growing number of investors looking to establish portfolios across a variety of markets beyond the established ones. So, it is an asset class that continues to attract investor interest, and we see no reduction in investor appetite – be that domestic or international.
Are you seeing any difference in the levels of residential investment between cities in EMEA?
Domestic investors will continue to invest across the entire spectrum of their respective markets. If we take a smaller market such as Denmark, international investors are largely comfortable sticking to the major cities – Copenhagen and Aarhus, for example.
The same is true of other markets. If you look at Spain, international investors may be happy to invest in Madrid, Barcelona or Valencia, but then beyond those the interest starts to thin out. This is a general theme. As you look at investment in smaller cities, which have smaller markets and potentially less liquidity, you start to see less interest – albeit with slightly higher capitalization rates.
This is perhaps not so surprising if you assess the balance of risk and return. The key question to ask is how tradable your asset in a tier-two or tier-three city is going to be; it is always easy to buy something, but it is not always easy to sell it. Plus, in terms of the differential between capitalization rates, for some markets we are starting to see very little difference, particularly for stabilized assets.
One market where you perhaps see a little more activity in tier-two cities is student housing. There are certainly strong universities outside capital cities and if the fundamentals of the university are strong and there is sufficient demand for PBSA, we are seeing significant investor activity.
How are current price increases impacting the funding of residential developments and affecting overall residential strategies?
Price rises are certainly having an effect on new developments. It isn’t necessarily making investments unsustainable, but it may mean a change of strategy. Having a partner that shares in this heightened construction cost risk is very important.
New developments can still take place, but the strategy may now be to review the market in a few years after completion. The great benefit of residential is that it gives you two options – you can sell the asset or lease it. You potentially have greater flexibility and optionality.
Choosing the right partner is important to mitigate price increases. We always look for an alignment of interests. We are seeing a slight move away from forward funding towards joint ventures.
For some projects, the developer’s profit is not delivered at the end of the development but at a later date and is predicated on the asset performing well. Will there be a bigger risk premium for residential development projects? That hasn’t materialized yet, but it is certainly something we are continuing to monitor.
Other developments that we are keeping an eye on include changes to tax and interest rates, and how these are changing in various markets. If we look again at Denmark, they recently introduced a mark-to-market tax on residential investments and also announced a change to how property tax will be calculated on an annualized basis for residential investment. This will have an impact on returns.
There also seems to be an understanding that governments will have to pay for the cost of covid over the last two years and the only way they can do this is through taxation. We are not seeing material increases in taxation across the board so fortunately it is not making investments uneconomic yet.
Interest rates may present a bigger challenge, and one that is not particular to the residential market. They impact any sector that needs to borrow to enhance returns. Also, as interest rates rise, this may put pressure on bond pricing and could lead to outward yield shifts, although we haven’t seen this yet.
How are deals being structured today to avoid construction cost risk?
For the most part, deals are simply not being done. Depending on which market you are in, the concept of a fixed-price bill contract does not necessarily mean you won’t have construction cost increases.
As soon as you become a landowner in Italy, for example, you have some degree of liability for increased construction costs – it is a function of the law in that market.
You can’t completely avoid construction cost risk, but you can mitigate it by working with contractors that are thinking about methodologies of construction that don’t necessarily replicate what has happened before. It is beneficial to work with partners who are more creative about where they are sourcing their product and, perhaps, accept that they may have to buy domestically at a slightly higher cost but from a more reliable supply chain.
In terms of joint ventures, we may also see more deals where the developer is further incentivized to keep construction costs down. Ultimately, although we are still witnessing deals being completed, fewer people are prepared to take construction cost risks at the moment.
What are the current similarities and differences across the EMEA region when investing in residential and its subsectors?
Every market is different. What works in one country won’t necessarily work in another. In the UK, for example, we are seeing the emergence of a multitude of amenities in residential buildings. In Germany, however, building tenants have to pay for building staff themselves, so you are likely to see a pushback when developers want to introduce, say, a concierge to a residential property. National regulations and requirements will dictate how assets are created, built and managed.
If we compare residential with other real estate assets, it is performing better than some and not as well as others. In recent years, some asset classes, like hotels, have been hit hard by the impact of covid-19 and now potentially the war in the Ukraine, so residential outperformed those.
Overall, residential may have underperformed against asset classes that you would classify as “hot” but has consistently been “warm.” It’s a diversifier: a defensive, counter-cyclical asset class. On a medium to long-term basis, residential is probably one of the best asset classes you could consider.
How do you expect the market to develop from here?
We see residential as an important component of our offer to our investor base. It delivers some compelling opportunities as part of a balanced portfolio. We are continually seeing the market evolve, with different areas opening up. Rental residential isn’t going away.
It is worth noting that residential, unlike other forms of real estate, is operational. You are operating for the tenant, so it is a lot more hands-on than other real estate asset classes.
The operations side is going to become an increasing focus area for us in the next few years. We brought in an operational director two years ago to bolster what we can offer our residential investors. Having the internal resources to understand residential operations is key to strong market performance. We are also seeing global investors moving into other markets. These investors generally have deeper pockets.
With everything going on in relation to interest rates and inflationary pressure, I think it is going to be hard to justify the continued compression of capitalization rates. And we are going to see the continuing growth of emerging markets, probably around tier-one locations.
Leveraging local knowledge
Investing creatively can unlock opportunities that may not occur to others.
Leveraging its local knowledge, one of Invesco Real Estate’s recent residential investment strategies looks to be a little more creative in terms of how it assesses new opportunities. The company has a small investment in a German town with a population of less than 20,000 called Wolfratshausen.
“The main advantage of Wolfratshausen, from an investment point of view, is that it is located on the S-Bahn, making it possible to be in the center of Munich in approximately 40 minutes. This means that the physical real estate is in a tier-three city in terms of size, but it is more accurate to think of the investment as being part of a tier-one catchment area,” says Invesco’s John German.
“Our residential investment in the French border town of Bossey, a 20-minute drive from Geneva, relies on similar principles. This is the benefit of local knowledge – leveraging the returns of a tier-one city, while investing in what is, conceptually, a tier-three market.”