Savills Investment Management on navigating cyclicality

This article is sponsored by Savills Investment Management. It appeared in the Investor Perspective 2019 supplement with the March 2019 issue of PERE magazine.

One of the established truths of real estate investing is the cycle. No bull market in property is ever eternal, and despite the excellent run the sector has enjoyed in recent years, investors are squinting nervously toward the horizon, trying to identify the point at which the cycle will turn. That has already begun to shape their behavior, observes Giuseppe Oriani, European chief executive at Savills Investment Management, with managers being asked to engineer defensive strategies and take increasing pains in allocating capital to investment opportunities that offer enduring value.

PERE: What are the most critical concerns facing global private real estate investors in 2019?

Giuseppe Oriani: The number of uncertainties at the macro level is a topic that we are now frequently addressing in our meetings with investor clients. One of the big considerations is the perception that interest rates, which have been at a low level in recent years, have begun to change course. How rapidly and to what extent they rise remains to be seen, but central banks in Europe are winding up their quantitative easing programs and there are other indications that interest rates may be increasingly volatile. The UK is the largest real estate market in Europe, so how Brexit will be resolved is a concern in terms of its effect on investments there, and also the spillover effects on other geographies. The currency volatility Brexit has prompted has led to some investors sitting on their hands and delaying investment decisions. There is also the threat of a trade war between the US and China. That could have implications for the growth of economies. The backdrop to those factors is a situation in which people are asking if we are now coming toward the end of a cycle and facing the replacement of the prolonged economic recovery that we have experienced since the global financial crisis with a progressive slowdown.

PERE: How are capital allocators changing their investment approach to alleviate those concerns?

GO: Investors want to feel even more supported in their decision-making. They want to be able to entrust investment managers with an additional level of delegation to ensure that, through selection and the ability to identify mitigants to these risks, they can construct investment strategies that provide a safe harbor for their capital. We do not anticipate a dramatic shift in investor preferences, but we will certainly see a significant move toward making a more careful selection of assets.

The universe of investors is very diversified so managers need to be a good port of call for different strategies. Some investors like a level of delegation, others like to retain a degree of supervision and interaction with the manager. That said, we have seen some investors moving away from traditional fund structures toward a mandate structure where they are sole investors with the ability to have a larger input on governance and decision-making. There is still a lot of fundraising activity, however, and funds suit the investors that are more inclined to delegate selecting investments to an investment manager.

Those investors looking to mitigate risk may focus more tightly on core assets. They are less likely to be affected by the market volatility generated by macro events, and by investing in long-let real estate investors can look to ride out the bumps that might be generated by any potential downturn in the market. Investors are also increasingly looking at asset types that are more defensive in nature: infrastructure and forms of real estate that are less exposed to macroeconomic trends, perhaps because they are linked to the need for social infrastructure, such as homes for elderly people, or student housing in those markets where that sector is still comparatively underdeveloped. In addition, when the market is showing an element of volatility, debt financing collateralized by prime real estate represents a very attractive opportunity. Investing selectively in whole loans, senior debt and mezzanine finance provides a good complementary strategy to investing in the equity portion. Once again, the key to success is to be particularly selective about the underlying assets. It is the collateral that determines the quality of the underlying investment.

PERE: What real estate sectors will offer good opportunities in 2019?

GO: Demand for new forms of residential space for rent is emerging in some geographies because of greater mobility and changing working practices, so multifamily is an asset class that is attracting a lot of investor interest. Logistics is a very sought-after asset class on the grounds that there is a clear structural shift in that industry driving the demand for the big logistics buildings that serve as infrastructure for the operators and last-mile facilities that enable efficient delivery of goods to end consumers. A lot of investor interest is currently focused on that area because the evolution of formats in logistics and retail markets is ongoing, and that creates opportunity to cash in on those trends.

By contrast there is an element of aversion and prudency in retail real estate markets. We are less averse to retail than some, but we are much more selective than we were prior to the shift in the market provoked by the growth of e-commerce. We think you still need to consider carefully which of the various different categories retail assets fall into when judging their attractiveness. Some segments have much more intrinsic value protection and resilience than others, whether that is because it is prime high-street retail, or because it offers a better experience to consumers by including elements like entertainment within a more holistic experience.

Investing in the office market is also an increasingly selective process. Investors are keen to focus not on countries, but on those cities that have the capacity to attract corporate occupiers and residents over the long term. Our research department calls them “dynamic cities.” Well-connected high-quality offices adapted to the business practices of modern occupiers and situated in the right locations in those cities are still particularly attractive. The office market in London is still an area of interest for many of our investors, and so are markets in Paris, the main German cities, the Netherlands, Warsaw and Milan.

PERE: Results from our Investor Perspectives survey show that, compared to other asset classes, a higher proportion of investors in private real estate expect their performance to fall below benchmark. Also, a higher number of investors plan to decrease their target allocation to private real estate compared to other alternative asset classes. Are you seeing this reflected?

GO: We see an element of caution, but not a decreasing propensity to invest in real estate at this stage. Instead, there is a propensity to invest in anything which is more defensive. If interest rates were to go up that would affect the performance of real estate investments because there would be a decrease in the advantages that leverage has brought to boosting returns. Higher rates may also lead to the repricing of certain assets. That element is in play, but it is not currently affecting investor decision-making, and I am not concerned that there will be an immediate increase in interest rates. Central banks in Europe have shown caution over the potential detrimental effect that a rise in interest rates could have on the growth of European economies. I remain convinced that real estate will represent an area of continued great interest for investors in the year ahead, but on a very selective basis because most of the plays that were derived from cap rate compression and economic recovery have now come to an end.