PATRIZIA: The importance of an active approach

This article is sponsored by PATRIZIA

According to Paul Hampton, head of international funds at PATRIZIA, it is simply not feasible to be a passive owner of real estate today. Properties require proactive management, and as economies around the world transition toward a new cycle, this has never been truer.

He discusses how recent trends have reshaped the investment landscape. As a new market environment cements itself, asset managers will need to display all their knowledge and experience. If they can, there remains plenty to be excited about in the value-add space.

From a macro perspective, what are some of the key trends that are making value-add strategies attractive as we enter a new property cycle?

In many ways, the events of the past two to three years, starting with the pandemic, have served as trend accelerators. The fundamentals of urbanization, demographic and technological change will all continue to shape the way we live, work and play. From a real estate investment standpoint, two major drivers of change are leverage and decarbonization.

The extent to which borrowing costs have increased has been nothing short of dramatic – in some cases interest burdens have trebled if not quadrupled, wiping out cashflows. And although there is an expectation that rates will start to fall back from as early as Q4 2023, it would be brave to expect a reversion to anything close to what we had been used to pre-2021. I also remain somewhat bearish as to whether inflation really will be under control by the end of 2023.

Decarbonization is the other agent of change – something that has been bubbling away in Europe for quite some time. It has been suggested that across Europe, circa €7 trillion is needed to decarbonize residential and commercial real estate. This will obviously place a huge burden on real estate owners and occupiers alike and values will need to respond.

From a timing perspective, why should investors commit to higher-risk strategies now, instead of waiting 12 to 18 months for the market to stabilize?

Now is the time to have capital ready to deploy – but the answer to the question of when is more nuanced. One of the charms of European real estate is that it is not homogenous; it is not uniform. Different country markets move at different speeds – take the UK, where we saw one of the most dramatic declines in the MSCI Index in the last few months of 2022. As in 2009-10, it was very different across continental Europe.

At an asset level, higher risk investments or properties with transitional business plans have been hit hard – and rightly so, as risk is re-priced. Indeed, we are seeing a wider reset of the return spread between core and value-add, and this is likely to continue through this year and into 2024.

Notwithstanding the rational correction that is underway, we are also starting to see early signs of over-reaction and being ready to take advantage of that to match liquidity needs is going to be important to anyone seeking out-sized returns.

In today’s market and based on your experience, how would you approach portfolio construction to drive maximum value for investors?

I believe we will see a reversion to old-school portfolio construction approaches, a greater reliance on standing investments and income, and overall, an acknowledgement that diversification and risk offsetting have their place.

“One of the charms of European real estate is that it is not homogenous; it is not uniform”

This doesn’t mean embracing a risk-off approach, but rather it means embracing an approach where higher returning, appreciation-driven business plans are complemented by lower returning, NOI-driven plans.

Focusing on office as an asset class, what are some of the trends you are seeing in the sector and how might these play out in a value-add strategy for 2023 and beyond?

I think the office market in Europe right now is fascinating. A lot of opinion has perhaps been influenced by the incredibly negative market in North America, where we are seeing high vacancy rates and the sustained impact of working from home. The office market across Europe is much more nuanced.

Unquestionably, some of those US themes are visible here – working from home has certainly had an impact. But in some European markets, such as Denmark or the Netherlands, working from home is not a new thing. Demographics are also fundamentally different in many parts of Europe.

Also pertinent to this is the fact that we are still seeing a war for talent in Europe. Businesses must provide top-quality space, which extends beyond amenities. The carbon footprint of an office space is now of huge importance to recruitment and talent retention.
On the supply side, there are also fundamental differences when compared with the US. In Europe, by and large, office stock is very old, so there are limitations around where we are witnessing any new demand being directed.

Particularly in the current climate and the high volatility environment, what do you think will be the key differentiators for a successful team?

Experience will be the key foundation for success. A team that has worked through several cycles and has learned from past mistakes and its successes will go a long way.
However, the past doesn’t teach us everything about the future – indeed we are still grappling with fundamental, unprecedented changes across the traditional property sectors, let alone alternatives. We are doing this in a marketplace which offers few clues as to the precise direction of travel, where there are multiple plausible futures. A successful team will therefore need to be able to accommodate for this; to test various scenarios and debate accordingly.

In your experience, when you get all these ingredients right, what is the ultimate benefit for investors in a value-add strategy?

Ultimately, investors want to ensure that they are being paid for the risk that they are taking – and I am excited that this should be eminently achievable in the current environment. However, a key benefit is also the positive impact that they can have on the communities in which they invest. It is easy to sometimes forget that what is at the heart of value-add is betterment; the rectification of management problems and, often, the modernization and reimagination of old and underutilized properties.

Capturing innovation

In Berlin, PATRIZIA pursued an innovative approach to deal origination through a process of walking the streets and cataloguing buildings with value growth and ESG-enhancement potential.

Paul Hampton: A former furniture factory, 117 Warschauer Straße was acquired in Q3 2016 and completely redeveloped and brought back to life, prior to being re-tenanted to global sportswear group, NIKE, as its German HQ. Sold in Q1 2021, the project realized a 64 percent pa IRR and 3.6x multiple.

In the UK, the TEP VII fund pursued a strategy of aggregating community based, convenience-retail parks on the basis of their attractive NOI-driven return potential, coupled with the prospect of value enhancement through tenant repositioning, light capex and future market movement.

Acquired in Q4 2020 for under £360 ($447; €408) per square foot, Crayford Retail Park, London, represented an attractive holding based on its urban location, tenant line-up, modest rental levels and alternative use value. Since purchase, the investment has generated an unleveraged NOI yield on cost averaging 7 percent.