The view from the boardroom on the seventh floor of Savills’ London headquarters, just off Regent Street, takes in the UK’s sprawling capital. It offers an easy prompt for thoughts about the city’s future role in a rapidly-changing European and global marketplace.
Savills Investment Management, the real estate investment management business of the FTSE-listed property services firm, is playing host for the annual PERE European roundtable, which saw five property executives participate: Savills’ own chief investment officer Kiran Patel; Jonathan Harris, head of European real estate at capital advisory firm Macquarie Capital; Rob Rackind, partner at the real estate division of global alternative investments firm EQT; David Kirkby, chief executive of the European business of Cromwell Property Group; and Brian Niles, head of European investment bank Morgan Stanley’s real estate unit, Morgan Stanley Real Estate Investing. Like the events’ participants in the past, these men have gathered to discuss the current state of the continent’s private equity real estate market.
The subjects of Brexit, and geopolitics in general, have dominated real estate conversations in Europe since last summer and continue to do so given the spate of parliamentary elections on the horizon. Despite this, the discussion at PERE’s roundtable quickly turns to two other key topics that the group agrees could dominate the conversation between private real estate capital and its management over the coming years: occupiers and demographics.
It is, however, impossible to avoid an initial broad debate about the impact of last summer’s referendum in the UK and the wider issue of instability and uncertainty in the European property market – even if this table is largely unconcerned. “Everywhere you look there is geopolitical risk,” says Harris. “But if you are a Chinese investor, then you’re used to systemic sovereign risk of a different kind. To the Chinese, Europe looks like a relatively benign place.
“If you look at other asset classes – equities are looking fully priced and bonds don’t look like great value right now. So I have a lot of conviction that the investor community, globally, is still under-allocated to alternatives, including real estate, and will be for a long time to come.”
For Kirkby, essentially a value-add player, the first issue to deal with following last summer’s referendum is pricing. “We had three deals fall down due to Brexit, but we got them reinstated before the end of the calendar year and achieved the original pricing,” he says. “The market was extremely volatile, but then came back extremely quickly.”
Niles says the impact, particularly in the London market, has been sector and location-specific. “Deal volumes and liquidity are less. If you are looking to sell an office in the City today, you’re not going to get the same price as you would have achieved 12 months ago.”
Harris doesn’t entirely agree, citing London’s One Leadenhall building which is expected to realize its asking price. “Look at the pricing on Leadenhall; it’s pretty firm, it may have dipped down but it came back. It’s just a different kind of capital.”
Rackind says the reliance on the “different capital” that Harris refers to could lead the UK real estate market down a difficult path. “We are kidding ourselves in the UK about the strength of our local market, where values have held up largely because of Asian capital. What has changed is the depth of capital. Before you would have 10 bids, now you have two.”
He adds that his real estate team was involved in advising on the sale of a large office asset last year to Asian capital, 120 Holborn, in London’s mid-town, for €230 million. The US capital offering, he adds, was 10-15 percent lower. “So once that Asian capital goes, we’ll be on very thin ice,” he says.
Not that Asian money is showing any signs of losing interest. Just as this issue was going to press, another real estate investment manager, TH Real Estate, sold a west London office asset, One Kingdom Street, to a little-known Hong Kong buyer for around £230 million.
Patel has also seen changes in the market. “I think the overall cost of capital is different,” he says. “Expectations are also different, as are hold periods. If you are trying to get into the market on a three to five-year play, it’s a hard bet to justify. But if you’re a 15 to 20-year player, then there are different costs of capital and you can park yourself in London for the duration.”
Niles concludes the topic by reflecting that the real focus should be on London’s occupational scene: “The reality is that if you look at London, growth from financial occupiers is limited. So if I had to lease one million square feet in an office tower in the City or Canary Wharf, I don’t care if Asian capital is coming, I would feel concerned.”
Occupiers and demographics
The group agrees that the industry is currently in the process of re-evaluating the way it offers space in line with occupiers’ changing working, living and traveling habits. In order to keep pace with these changing dynamics, a fresh look at new data and trends is required, says Rackind.
“The key is understanding both occupier and demographic trends,” he adds. “If you don’t, you are going to end up buying buildings in fringe or regional locations, thinking you have achieved a nice yield with a bit of re-let risk. But actually you are going to end up with a vacant building for a long time.“
With financial companies no longer the ‘Holy Grail’ they once were, tech companies, such as Google, are the new must-have renters for any dynamic, forward-thinking working spaces. As such, traditional uses of, for example, office space could change significantly as early as two decades from now.
Niles highlights that many cities around Europe and the world have seen new hubs pop up, which are providing new opportunities for institutional capital. “Look at King’s Cross in London. Twenty years ago, you wouldn’t have dreamed of buying there, but now it’s a hub, Google is moving there and it is a desirable location for investors and occupiers. The opposite is also true – what is deemed core today may not necessarily be deemed core in the future,” he says.
Patel concurs stating that cities, with transport hubs and amenities, are going to be the winners. “When I started, Canary Wharf, Stratford, Paddington and King’s Cross didn’t exist,” he says. “Cities are getting bigger because they’re a draw, so you have to look at the winning cities. Clearly, when you are in the heart of the city, a lot of space gets converted to other uses, but it’s going to survive. So where you make money today is around the fringes.”
Another trend which has caught the eye of the real estate sector, and particularly Kirkby, is the growth of co-working firms such as WeWork and RubberDesk.
“I didn’t understand the business model, so I used it as ‘person off the street’,” says Kirkby. “It was fantastic, it exceeded my expectations. People had their dogs in the office, there were businesses networking and integrating. I would rent to a WeWork in a heartbeat. I’m a value-add manager, so if they were to go, I’ll just take the building as they are well located, as the model is about amenity. It’s full of people and all the tenants don’t want to go.”
Rackind and Patel were more reticent about the workspace-sharing concept. In fact, Rackind says EQT rejected an opportunity to lease 120 Holborn to WeWork 18 months ago. “Ultimately, we passed on it. Along with our investors we were 50-50 on it. We kept asking ourselves, ‘Are they going to survive in five years? Is that institutionally acceptable?’”
Patel is also focused on the business models of co-working office operators. “You have to look at the financial strength of your tenant. They are not making money, so it’s hard justify,” he says. “What substance is there behind the business to pay that rent? If it is continually taking on debt, it is more of a concern.”
Niles, however, is more inclined to agree with Kirkby, although he favors a different sector. “We are involved in an office development in Notting Hill Gate. Would we take on some non-traditional tenants? Absolutely, although it is very location-specific,” he says. “But thinking about changing occupier needs and technology impact us, I think residential is the area that is least impacted as people will always need a place to live.”
In late 2016, Michael Gross, the vice-chairman of WeWork, which is valued at $16.9 billion, announced his firm was in the process of creating a real estate investment vehicle that would acquire assets for the business, and its co-living sister firm WeLive. Gross, speaking at New York’s Cornell Real Estate Conference, said: “The moment WeWork comes into a building, you’re creating value.”
It is put to the roundtable that if such a fund was launched, namely the operating partner working directly with institutional capital and becoming the fiduciary, what would the reaction be from traditional fund managers?
Harris says his immediate reaction is caution, though he did concede there was a potential route to making such a real estate vehicle work. “When you have a growth company of limited profitability, it is likely a leap of faith for investors. What I could see happening is firms like this turning themselves into a REIT, or employing a hybrid fund model, because that is potentially a path to a more sustainable and scalable business model.”
Niles believes occupiers pursuing a real estate management path could be a case of muddled thinking. “If they want to continue growing, and those types of companies get valued on growth, they can’t get bogged down trying to become a real estate company,” he says. “They cannot become a capital-intensive business. It needs to be the opposite, they need to be light.”
The conversation then turns to PERE’s editorial heartland – discussions between investors and money managers, and how the investor community sees the lie of the land at the moment. Harris believes one of the key themes arising at present is manageability. “The bigger end of the LP community globally has certainly been reducing the number of managers they work with, so they can focus on, and leverage their GP relationships,” says Harris. “I think it’s an interesting Darwinian aspect of the investment management industry, a form of consolidation.”
“The consolidation trend is real,” concurs Niles. “Managers are, in return for winning business, willing to get more creative and commercial because they see where that trend is going and once the train leaves the station they want to be on board.”
For Rackind, the answer is simple. “The smaller managers are getting squeezed out and the bigger firms are getting bigger. LPs wants to put more money out, in bigger tickets, into more strategies, but with fewer managers because that’s where they are receiving preferential treatment.”
But is such a trend a positive or negative thing for the industry? Niles suggests there is a form of ‘ecosystem,’ which has inherent checks and balances. “The big guys do get bigger, but that prevents them from exploiting smaller opportunities in the market which will fall to others.”
However, Kirkby highlights one potential negative outcome with which firms need to be wary. “We are definitely seeing the emergence of a couple of really big capital sources that are supporting us,” he says. “My concern is that you must have enough of those big guys so you have some diversification, and if one switches off, you’re still able to invest.”
Patel says the key is to look at the evolution of the European real estate market. “In 2000, how many managers were there? How many have actually grown? The regulatory environment is huge now and clients, having learned from the crisis, want like-minded investors, from the same country, so they can benefit from the same tax structures and legal frameworks.
“Our German clients want KVGs regardless. If we go to Italy, they want an SGR. The same applies in France. But you’ve got to have those licenses to operate, which is a heavy regulatory burden.”
A further investor trend picked up by the group is the number of private equity firms now operating in the lower part of the risk-reward spectrum. “Around 18 months ago, they were targeting an IRR of 18 percent,” says Kirkby. “But now we are talking 12s. They have come down the spectrum late cycle and are willing to take on different risk to get the return.”
Last year’s PERE 50, which highlighted the biggest capital raisers in real estate, revealed that eight of the top 10 firms now offer core strategies, a departure from the freewheeling post-financial crisis years. “There are two reasons for this,” says Harris. “One is an entrenched decline in opportunistic returns. The other is that firms, which traditionally offered high return strategies, are now promoting core or core-plus products to further scale their business.” For Rackind, investing in core real estate requires a completely different mindset to that of other risk strategies. “If I was an investor, I’d rather the investment manager came down on his return expectations for an opportunistic or value-add strategy, than a core or core-plus buyer going up the curve to get the return, because core or core-plus buyers do not really understand what it takes to manage out value-add or opportunistic risk.
“My view is that core buying is macro, whereas value-add is micro. Two completely different strategies which should be reflected in completely different returns.”
Patel says he thinks the reasoning is connected to diversification. “Traditionally, opportunistic businesses are trading businesses,” he says. “You are buying something and either correcting it or working it, and then you are out. You can’t sustain 15 percent or 20 percent over 10 years, so you end up trading it and trying to work the cycle.”
Harris suggests that a further theme is ‘develop-to-core,’ particularly in response to the low interest rate environment, which, he says, requires some developmental risk to hold the asset. “You have to have a specialist partner who knows what they are doing. In my mind, PRS and multifamily are the biggest destinations for that type of capital, especially in the US.”
Nigh on two hours with these five men is enough to be clear that their chief concern is how demographic and technological changes will impact their real estate investments, in the future and today. There is a regional geopolitical storm brewing around them – just as there is for their American counterparts – but you would not know that to sit with them. Whether right or wrong, they are focused first and foremost on the forces impacting those who would occupy the buildings they buy and not on those who might regulate how they do it.
Partner & co-founder
EQT Real Estate
Rob Rackind is partner and co-head of EQT Real Estate, the real estate investment strategy of global alternative investments firm EQT. Rackind has more than 20 years’ experience in the European real estate industry, including working for Wainbridge, where he was co-founder.
Chief investment officer
Savills Investment Management
Kiran Patel, who has 27 years’ experience in the real estate world, joined Savills Investment Management in 2012 after spending over 11 years at AXA Real Estate, where he was global head of business development and research.
Cromwell Property Group
David Kirkby’s real estate career in funds management goes back to 1991 when he was fund manager at Lend Lease Group working in Australia, Asia and Europe before joining Valad in March 2008 as head of funds management. He was appointed chief investment officer in 2013.
Head of real estate, Europe
Morgan Stanley Real Estate Investing
Brian Niles is head of Europe for Morgan Stanley Real Estate Investing and is a member of the firm’s global investment committee. Prior to joining Morgan Stanley in 2006, Niles worked for nine years at Goldman Sachs.
Head of real estate, Europe
Jonathan Harris heads Macquarie Capital’s real estate business in Europe. Harris joined the firm in 1996 and has more than 25 years’ experience in the industry. Prior to joining Macquarie, Harris worked for five years in the London and Melbourne offices of Arthur Andersen.