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Europe GC: The fund manager's perspective

The impact of rapid advances in technology and secular changes in demographics has become inescapable in the once closeted world of real estate.

PERE gave participants in the property investment industry an opportunity to dive into these important developments during its recent two-day conference in London. Developers, investors and technologists joined to share insights and debate the challenges and opportunities arising out of these far-reaching trends.

Over the past decade, the arrival of networked technology has begun to make an indelible impact in the way we design, develop and interact with our built environment. The rapid rise of e-commerce is undermining the physical retail environment, some would argue fatally. Large-scale warehousing and logistics is assuming the role of fulfillment for the retail industry, direct to the consumer’s doorstep in 24 hours. Meanwhile, the rise of freelancers and small businesses, often networked with co-workers over long distances, is driving the rise of collaborative and innovative work spaces that are changing the face of the office sector. And lastly, changes in household formation as well as marriage and child-bearing practices are leading to important changes in residential design and utilization.

The reaction of institutional investors to these arguably unsettling developments has included a mixture of fear and frustration combined with resignation. It has also included, however, the occasional glimmer of optimism in the possibility of harnessing these changes toward creating greater returns for pensioners, annuitants and other stakeholders.

Of all the property types, residential appears to be the safest bet. But investors must make peace with the need to embrace a different unit mix in response to smaller households. With tenants on tight budgets seeking greater flexibility, investors are confronted with the need to offer shorter leases, extra services and amenities to their properties – all of which increase operational risk.

Logistics also seems a safer option – witness increased transaction volumes and the unbroken series of lower cap rates achieved in the sector. But the picture here is not without its complications. Tenant specifications continue to evolve, reflecting the changing needs of fulfillment, with tenant improvements potentially exceeding the raw value of the building. And then there is the big risk: as e-commerce delivery cycles collapse, safe out-of-town locations are superseded by competitors offering a venue promising better access to end-customers. Price appears a secondary consideration for such tenants.

The dangers in the retail sector are now widely accepted by investors. Some at our recent conference continued to express confidence in so-called ‘fortress centers,’ although, even here, the barbarians seem to be very much at the gate. On the other extreme, perhaps, many institutions espouse the benefits of retail venues rich in entertainment and food and beverage, particularly with in-town locations. While this might seem to offer defensive characteristics, such centers are characterized by operational and tenant credit risk, a far cry from the super-secure retail centers of yesteryear.

Office, the mainstay of many institutional portfolios, seems next in line to receive a make-over due to changes in technology and demographics. Tenants are becoming smaller, more focused on flexibility in lease terms and desirous of heavier amenities. Locational loyalty is shifting, if not outright evaporating, as tenants focus on locations that offer an attractive environment and eschew traditional CBD coordinates.

The net result of this is that real estate is becoming a more operationally-focused asset class, and with reduced rental stability, while providers are becoming more shy in extending cheap credit. In short, real estate is looking more like an equity and less like a fixed income surrogate. And with that reappraisal of risk, some investors are re-thinking property’s role in the multi-asset class portfolio. But surely there is a silver lining in this otherwise dour portrait? With lower gearing levels does not real estate drop its noose-like tie to the vagaries of the interest rate and credit markets? And doesn’t the greater operational leverage inherent in a service-based model for landlords offer the greater opportunity for equity-style returns for the asset class?

Of course, investors will need to be even more focused on management value-add in the sectors and partners they select for co-investment. But perhaps this will prove a small price to pay for achieving greater risk-adjusted returns in the future.