This article is sponsored by PATRIZIA
As is the case across the wider European property sector, the coronavirus pandemic has accelerated existing trends in the residential market, including higher demand for amenities, ESG and digital solutions. Residential, however, has bucked the trend of lower investment volumes despite the difficulties to invest caused by lockdowns.
One reason for this appeal is the resilience European residential has shown amid the pandemic, outperforming even mature multifamily markets like the US. Mahdi Mokrane, PATRIZIA’s head of investment strategy and research, explains why residential has coped well with the crisis and remains an attractive investment proposition.
Since the covid-19 crisis began, how has the European residential sector performed?
We were surprised by how resilient it proved to be, particularly in our portfolio. Before summer 2020, rent collection performance in Europe was 5 to
10 percentage points higher compared to in the US, but the situation did improve in the states afterwards.
This result is due to several aspects. First, affordability: in our European portfolio, the effort rates of our tenants – a measure of affordability where we divide rents by net disposable income – is very robust and has resulted in rent collections of 98-99 percent, similar levels to those we had in 2019 and 2018.
Also, government support for households in Europe enabled tenants to continue to afford their residential leases, even in relatively tight residential markets. Outside of London, we did not observe the same dual phenomenon as in the US where vacancy rates did rise in parts of the country. In New York and parts of San Francisco, for instance, vacancy shot up strongly, whereas in other cities that were arguably more affordable, rent collection held up well and vacancy stayed low.
If you turn now to investment performance, Europe as a whole saw residential in 2020 generate an unleveraged 6.3 percent total return – comprising income plus capital. This is according to MSCI data (similar approach to NCREIF in the US). In the US, the same source tells us that total return was 1.4 percent. I think that’s an echo of the rent collection I mentioned, and its impact on pricing and capital values.
Are investors that have traditionally targeted US multifamily shifting to Europe?
We’ve seen increased interest from Asian investors that have experience in US multifamily and are now looking into Europe in residential but also in other living sectors such as senior living, student and co-living. For core and core-plus, we continue to see appetite from Asia, Canada and Europe.
North American investors, in our experience, tend to prefer higher-returning strategies or platform investing when considering commercial and residential real estate in Europe. So far, we’ve seen them taking interest in operational real estate platforms with the living flavor to it – such as student housing or co-living platforms – or even looking at potential distress in the hospitality and leisure sectors.
For all investors, the European market is appealing for several reasons. Diversification is clearly a driver for many. Investors also see structural changes in the European markets driving demand as well as offering interesting risk-adjusted returns. Given the resilience of the market, they also see residential as a good portfolio stabilizer.
Last year, we wrote a research paper that found that a diversified residential portfolio in Europe is a very good proxy or substitute for fixed income. Residential income has grown steadily since 2000 and outpaced commercial property in both nominal and real terms. Modern residential appeals to tenants of different age groups in Europe’s largest cities, and that is something that many investors – Asian, European or North American – find attractive.
How has covid-19 impacted the different strategies from core to more opportunistic?
For residential, but also for other property types, covid-19 has accelerated trends that were already evident before the pandemic. For instance, our tenants want to be able to communicate with us as landlords and with property managers more frequently and seamlessly, so developing digital solutions to increase communication has been a big plus.
I’ve also seen increasing demand for amenities in and around the buildings. In the past, we had seen a trend to smaller units, but this has reversed somewhat with higher demand for more generous space. Tenant demand is also stronger for balconies, which in many developments we are looking into have become a ‘must-have’ as opposed to a ‘nice-to-have.’
We were already thinking of those amenities before, but we have been active throughout 2020 and 2021 in developing such amenities and considering the implications because this is a commitment for the long term. This is about more generous space, balconies, amenities inside the buildings and even co-working space.
Health and wellbeing, on top of design and energy consumption, is also a factor that is becoming increasingly important in the relationship between landlords and tenants. So, the digital push is not just about communication, but also about how our residential buildings can help sustain and increase the health and wellbeing of our tenants with better air quality systems, more bicycle racks, gardens that tenants can tend to, bookable DIY facilities and on-demand electric vehicles, for example. And that means discussing with our investors, our tenants and developers to co-design sustainable communities for the long term.
Is it time for investors seeking exposure to European residential to build their portfolios with new allocations?
Most investor groups right now would probably say they’re underweight in residential, with a few exceptions, such as the Swiss, Dutch or some German investors. The INREV survey of investor intentions published in January, for instance, shows investors consider they’re underexposed to the living sectors in general, not just multifamily. So, yes, it’s the right time because residential is less cyclical than many other property types and the European market today offers many optimum entry points.
Although this is the right time, we would recommend being patient, selective and creative in capital deployment. When we operate for investors looking to develop-to-core-to-hold, for instance, the expectation is to collect the risk premium of developing and taking the leasing risk in the hope of achieving a stable portfolio for the long term, 10-15 years or longer. For investors with shorter investment horizons, we may be looking to develop and sell blocks of buildings over a shorter time frame, say three to five years.
Has trade activity in Europe returned to normal since covid-19 struck?
Trading real estate is, unfortunately, not like trading on a Bloomberg terminal. You can’t simply press a button and deploy hundreds of millions in seconds. Buying a physical asset means multiple site visits from a number of professionals including transaction leaders, agents, quantity surveyor, asset and property managers.
Some investors would not commit to a transaction if they weren’t able to visit the buildings. Digital data rooms and virtual visits have helped but can’t entirely compensate for travel restrictions. Lockdowns restricted mobility, so covid-19 mechanically pushed down the volume of trade you could execute.
We saw a drop in investment transactions in most property types in 2020. However, residential was one of the exceptions, with the 2020 trade volume in Europe higher than in 2019 and we expect 2021 to accelerate again. In fact, during the first quarter of 2021, more residential was traded than offices, which is traditionally the most traded property type in Europe.
In terms of locations, Germany has been, and is still, one of the most active markets in Europe, with large institutional holdings of residential trading from one investor to another. But the market has diversified and increased in volume almost everywhere.
We’ve seen increased volumes and activity in France, with large portfolios trading hands, and also in the Netherlands. There are active markets in the Nordic countries too. And from a relatively low base, we now see activity, particularly in the develop-to-rent market, in Spain and to a lesser extent in Italy.
What do you expect for the residential market in Europe going forward?
Investors have discovered – or rediscovered – the fantastic merits of adding residential and other living sectors to their portfolios. Today, we are seeing significant competition for assets, which is reflected in keener pricing. This may look like a potential hurdle, but it is not really one for us: it is increased competition from a wider base of investors being attracted to the sector.
I said before that residential is less cyclical in terms of demand-supply than most commercial property types. But the capital market component could be more cyclical given the appetite of investors who could accelerate or decelerate investment allocations in reaction to general capital market movements. But I don’t see investor appetite waning soon for the sector.
Rental regulations could be seen as a potential hurdle. We are not afraid or concerned about regulation, but what we don’t like is unforeseen changes, so we follow developments closely. Sweden, for example, is possibly the most regulated residential market in Europe, but we are happy to invest there.
In October 2020 we bought a residential development project in Malmö for €100 million. It is scheduled to complete end of 2021 and will deliver 427 residential units comprising one- to four-bedroom apartments for rent with plenty of amenities and green space.
It is not just whether a market is highly regulated that may be problematic; it is if the regulations are in a state of flux. We want to make sure we understand the changes and that they support the ultimate social goal, which is to offer better living and affordable prices, rather than complicate this objective.
In terms of sector boosters, we see quite a few. First, structural changes in society mean we are seeing more propensity to rent for households of all age groups.
Second, we have seen that even if a country’s overall population growth is low, population growth and residential demand may still be strong in attractive cities. These are not just the 24-hour cities such as London and Paris, but also what I would call 18- or 15-hour cities, such as Amsterdam, Copenhagen, Hamburg, Manchester, Munich or Stuttgart.
Also, thinking further about the strengths of residential, it can add to a portfolio in a low-yielding environment, and has strong diversification potential.
Finally, for any investor looking at the future and concerned about the current threat of inflation, residential has one of the highest correlations with inflation over a long period of time amongst real estate property types. So, as an inflation hedge, residential is a good ally to have in a portfolio.