Savills IM on why capital is still attracted to real estate

Property continues to appeal to investors, but there is less appetite for risk and good stock is getting harder to find, say Alex Jeffrey and Kiran Patel

This article is sponsored by Savills Investment Management 

The turbulence caused by covid-19 is by no means over and real estate is still reeling. Nevertheless, investors recognize that even compressed property returns are attractive in the continued very low interest rate environment, while supply is in check in most markets around the world. PERE’s Mark Cooper talks to Savills Investment Management’s global chief executive Alex Jeffrey and deputy chief executive and global chief investment officer Kiran Patel about the most attractive sectors and markets, and what investors are looking for from private real estate in 2021.

What is the overall outlook for real estate and how does it stand up against rival asset classes?

Kiran Patel

Kiran Patel: The ramifications of covid will not disappear very quickly. Covid was a huge demand shock, not just real estate but for all industries. But compared with the global financial crisis, real estate is in a much better position. We don’t have that huge indebtedness and if you look at the supply side of the equation, vacancy rates are much lower than their pre-GFC equivalents. Significantly, the demand shock has been very uneven, with hospitality and some retail the hardest hit, and logistics still performing.

How are the markets in Europe and Asia faring, and where do investors favor at the moment?

Alex Jeffrey: Overall, there seems to be a slightly greater preference for staying in your own backyard, but we’re also seeing an uptick in interest in the Asia-Pacific region from investors. We did an investor survey as part of our 2021 outlook publication and found that, for pan-regional strategies, Asia-Pacific was favored by 22 percent of investors compared with 14 percent for Europe and 8 percent for pan-America strategies. One of the reasons investors are more focused on Asia now is clearly a sense that the various countries have dealt with the pandemic crisis more effectively. Investors believe this region will recover more quickly and in a more robust way than other parts of the world.

And Savills IM is rebalancing toward Asia. Obviously, our home territory will always be the UK and Europe, but we’re looking to shift the center of gravity of the organization. We are mainly dealing with the more developed markets, such as Singapore, Korea, Australia and Japan, and that chimes with where investors tell us they want to allocate capital. Singapore in particular has seen an uptick in interest. It’s drawing investments from global tech occupiers that see it as a neutral ground in the US-China rivalry.

KP: Asia’s resilience has been backed up by transaction data, which show volumes to Q3 last year down 17 percent, compared with around 40 percent in the US and Europe. Broadly speaking, there is a north-south divide in Europe, with Northern Europe and Germany faring better and thus attracting investor interest. Southern Europe has been pretty badly hit and you can see that with the unemployment numbers rising even faster in Spain and Italy, and you can put France in that category, too. The UK has its own nuances – the effects of Brexit, which is still causing European investors to be cautious on UK property, and also being relatively overbuilt in retail as a consequence of a looser planning regime.

Which sectors are hot and which not for investors?

Alex Jeffrey

AJ: We’re seeing a lot of capital for multifamily residential, which has performed throughout the cycle in those markets where it is established. We’ve seen the emergence of a number of UK-focused and recently pan-European residential funds, usually focused on build-to-rent because of a shortage of viable existing assets. We’ve been very active in residential in Japan over a number of years, which is an established investment market for that sector, especially in Tokyo, where a 38 million metropolitan population gives unrivalled depth. We’ve just announced the launch of a new fund seeded with some attractive assets in Tokyo and we would like to do more in residential in Europe.

Fundamentally, we’re still believers in the office as an asset class. When we talk to occupiers, we find that companies and their employees want to go back to the offices when they have the opportunity to do so, but maybe not full time. People are looking for social interaction within their work environment and want to feel part of the organization. And there are things that you simply can’t do with everybody sitting in remote locations.

KP: We shouldn’t forget that the office sector is one of the biggest in terms of capital invested. Offices are also crucial to the life of city centers and office clusters are crucial for businesses. That means there’s a lot of vested interest from investors, occupiers and governments. If you claim the office is dead, then what does that say about city centers? There are short-term headwinds to be sure, but overall supply is low so I think we’ll work through it.

Talking of not writing sectors off, I also don’t believe high-street shopping is dead; we just need to work out how much retail we need and the right price for it. And not all retail is the same – we’ve seen a big increase in a demand for convenience retailing and we’ve launched a pan-European fund targeting daily goods retail. That offers a good cash-on-cash, index-linked income stream. We also see food operators wanting to do more sale and leasebacks in order to reinvest in their existing properties.

AJ: Retail is also different in Asia where, in general, it’s not facing quite such serious challenges as in Europe and the US. However, this may be just a timing factor, as online retailing, in most markets, has not penetrated as much as in Europe. However, in markets such as Singapore, the mall plays an important social role in the community. They tend to be surrounded by residential and effectively represent the town center. A number have already been repurposed, with more Food & Beverage and more community facilities such as libraries, healthcare and education.

We see continued demand for logistics, but there’s concern about pricing being distorted. Big box distribution warehouses in prime locations across Europe are reaching yield levels that we’ve never seen before.

So, you’ve got to assume a fair degree of rental growth to make those numbers stack up in some cases. And we would be somewhat skeptical that you’re actually going to see that rental growth when you consider the amount of development that’s happening in some locations.

How can a manager add value in this current tight real estate market?

Kiran Patel: There’s no one area, but this is an asset class where basis points matter in every step. And you have to add value at all levels, looking for marginal increments in everything. That starts with transaction negotiations; for example, how swiftly you can move and how much due diligence you can do up front.

Financing and your relationship with banks is also crucial as squeezing a few basis points helps your margin. Also working with local asset managers, knowing the nuances of local markets and being highly reactive is key. And finally, you have to be up to date with ESG and technology trends.

Are you seeing changes in the way investors seek exposure to real estate?

AJ: Debt is a different and very interesting way for investors to gain exposure to real estate and we do find it attracts greater interest during times of economic stress, because there’s greater downside protection. During the crises – and that’s certainly the case this time – banks tend to pull back and focus on their closest main clients and on lower risk assets. This opens up opportunities for alternative lenders. Typically, you see during these times margins start to widen and LTVs start to fall, so for a given level of risk, the potential returns become more attractive.

KP: When you’re in a recession or coming out of a recession, the top end of the capital stack, the preferred equity and mezz space, is where you’ll see more demand to begin with. That is partly to deal with distress.

Do you expect significant distress and are investors keen to participate, or is the bulk of demand for the core space?

KP: Most of the clients we’re talking to would still prefer to be at the lower end of the risk spectrum. So, for them, core-plus, maybe with a touch of value-add, because they’re also needing a little bit of return. Distress we feel is a bit further down the line and it’s more likely to be sector orientated. For example, we’re unlikely to see any distress in residential or logistics; most of it is going to be in retail and hospitality, but it’s hard to tell whether there is sufficient price discount to reflect that ongoing risk.

AJ: Downside protection is probably the prominent driver at the moment, which is why there’s a lot of interest in core investing and debt. However, investors will have an eye to the recovery and seek some exposure to the upside.

Is there any sign of an end to the wave of capital heading for real estate?

KP: Despite the upheaval of last year, capital was still raised and the amount of dry powder globally is around $350 billion, although a lot of that is targeting the US. With $7.8 trillion of stimulus thrown into the global financial system, interest rates are staying low. We have around $18 trillion of bonds yielding below zero; we have bonds expiring and that capital chasing yield. It’s no surprise that asset allocators are turning to an inflation-backed income-producing asset class. The challenge for all of us is finding a home for this capital at an acceptable price and stock is getting harder to find.

What is the outlook for returns?

KP: When you go through a massive economic demand shock, occupiers’ profitability gets hit. So, in the short term, we will have to deal with the headwinds. However, we don’t have the structural flaws of huge indebtedness or huge overbuilding we had going into the GFC. So, there’s still a chance we could get positive returns in 2021, which will be attractive relative to fixed income. A decade ago, core returns were somewhere between 6 and 7 percent; now they’re 3-4 percent. But in a negative interest rate environment, this seems fair.

AJ: There’s going to be a broad spectrum of returns between real estate sectors. You might expect very encouraging returns for logistics in 2021, but it’s hard to see the same for retail over any time period and offices will be somewhere in the middle.


Priority items

Investors and managers are ever more mindful of the vital role ESG and diversity and inclusion play in investment performance

Alex Jeffrey: ESG remains a major trend, which is pretty much part of the day-to-day for people in real estate now, and that’s often linked with technology, which has given us the ability to measure and improve environmental performance. The ‘S’ in ESG has arguably been neglected but thankfully now coming to the fore. Our assets need to play an impactful role in their local communities. Studies now also show that ESG performance is not something you sacrifice returns for, but a precondition for decent returns. The returns gap between the best and worst ESG performance will widen.

Something I’m personally passionate about, and which the real estate industry has traditionally not done brilliantly on, is diversity and inclusion. Again, we have data now and all the evidence points to the fact that a diverse team, where people feel welcomed in their roles, delivers better investment performance for clients and delivers business performance. We’re focused on it in terms of our recruitment processes and appraisal and promotion processes to ensure that we have the most diverse and engaged team we possibly can.