This article is sponsored by Savills Investment Management.
Private real estate has had a good run in recent years, providing strong relative performance for investors, which continue to target higher allocations and seek to deploy more capital in the sector. The global economy has been in an extended late cycle and concerns over a coming downturn have become more pointed. But Black Swan events notwithstanding, there is still plenty of cause for optimism. PERE’s Mark Cooper talks to Alex Jeffrey, global chief executive of Savills Investment Management, about the outlook for real estate in 2020, and the evolving needs and demands of investors.
How do you expect the global economy to perform in 2020 and how will this affect real estate?
We are in the midst of a slowdown in the global economy, which has been happening for some time and, of course, real estate is tied closely to the wider economy. The economic outlook is more muted than we have experienced in the past decade, and that will affect occupational markets, particularly in the office sector. This has the potential to hit rents and therefore returns. So, investors are right to be concerned. Of course, there are a number of risks out there – financial, political, military and ecological – that could impact real estate markets. Some risks have a cyclical impact, as we are seeing most recently with the novel coronavirus outbreak. Other risks, like climate change, have a structural impact.
These risks are not necessarily all negative for real estate, because the low interest rate environment is persisting. And the more investors expect that to continue, the more capital will be diverted into alternative sectors such as real estate, which have performed well. Investors rightly regard real estate as a good diversifier and return enhancer.
We also see the emergence of real estate sectors, such as multifamily residential, healthcare and student accommodation, which are more insulated from the wider economy and which have more structural drivers. Multifamily, for example, accounts for around 20 percent of US institutions’ real estate portfolios, and is attracting interest elsewhere. In some respects, it is also counter-cyclical as people are more inclined to rent in a downturn. So, we are tracking the sector across the key markets and are quite heavily involved in Japanese residential, which has become an established institutional sector.
The PERE Investor Perspectives Survey shows many investors consider themselves under-allocated to real estate and are keen to invest more. Is there a risk inherent in the glut of capital targeting the sector?
Investors need to understand that in the absence of a positive shock, returns will generally be lower than in the past. But those returns may well be better than those generated from investing in other asset classes, so this needs to be looked at on a relative basis. The spread over the risk-free rate in most countries is still attractive and significantly above the previous peak in the cycle. There is room for that spread to fall further and therefore for returns to continue to be attractive on a relative basis when compared with other asset classes.
There appears to be more interest in value-add and opportunistic strategies, and appetite for investing opportunistically in real estate debt. What is driving these preferences?
Investors are looking for potentially more risk and higher returns, probably because core returns have come down. We would be quite cautious about how wise that is given the more subdued economic outlook. Value-add strategies still work in certain selected markets, where managers have strong access to off market deals at attractive pricing, and in markets with a beneficial imbalance of demand and supply. Generally, however, value-add and opportunistic strategies normally require quite strong economic and employment growth to exceed their target, so investors need to be selective about how they access those types of strategies. From the investors we have spoken to, it is clear risk appetite depends on their existing book. Investors that have established a well-diversified base of core assets will at a later stage look to invest in more higher-risk strategies or more sector-specific bets.
We are also seeing a significant uptick in interest in real estate debt. This is obviously a relatively newer way to access real estate, because traditionally banks have done a lot of that lending. It is an attractive way for investors to obtain good risk-adjusted returns, because it gives downside protection, which is reassuring in a late-cycle environment. It is a structural shift as well as a cyclical one, in that it is a fairly recent emerging sector for non-bank players.
ESG issues dominated discussions at Davos this year, but the PERE Investor Perspectives Survey indicates that this topic is not yet at the top of investors’ list of concerns. Does this match your experience?
ESG is moving up the agenda for investors, especially for those in Europe. However, it is starting to spread into mature markets elsewhere, including Asia. It has long been the case that we and other managers have focused on environmental factors such as energy efficiency and the overall carbon footprint of our portfolios given that the built environment accounts for 40 percent or more of global emissions. Benchmarks such as GRESB and the UN PRI are being increasingly used and the focus is now broadening to social factors, such as the contribution investments make to the local community.
Consultants such as Mercer now require an ESG rating in addition to an investment rating when they are underwriting managers’ offerings. That is only going to increase. We will get questions not only about how we manage our assets, but also, quite rightly, about how we manage our own businesses responsibly. My sense is that investors looking at this in a sophisticated way will increasingly regard it as aligned with the search for attractive returns. In the past, ESG was regarded as a cost whereas now, there is an increasing realization that such measures are likely to enhance returns over time, both in terms of income and capital value.
This has been partially driven by the growing focus of governments on reducing carbon emissions. We should expect more regulation and differential taxes for the best and worst performing assets from an ESG standpoint.
What is the outlook for European real estate this year, and is Brexit still a dominant issue?
Brexit is very much UK-specific, and while investors are aware there is still a risk of a hard Brexit at the end of 2020, our sense is that it has slipped off the top of the list of concerns about investing in the UK. Investors are somewhat relieved we have a more stable political environment in the UK with a business-friendly government that is also focused on infrastructure investment over the coming years. So, we are seeing an uptick in interest in the UK as a result.
The wider concern about Europe is that growth is expected to be quite subdued in the next 12 to 24 months. However, there has not been a significant amount of development, so vacancy levels, especially in the office sector, are at historic lows in many cities in Europe.
What are the attractions of Asia-Pacific, which is once more the preferred emerging market region for real estate investors in the Investor Perspectives Survey?
It does seem that Asia is affected more than other regions by cyclical risks – think of the effects of the SARS outbreak, for example. This fact should not be downplayed and must be considered as a risk compared to other regions. Having said that, investors are keen to get into Asia because they like the potential long-term structural growth potential and the diversification it offers. There are very robust fundamentals with regard to urbanization, the rising middle class in countries like China, India and Indonesia, and that these countries can still expect a shift toward service sector output and therefore structural employment growth in the office sector as in more developed markets. There is now also an emerging core sector in Asia. There is a much bigger potential portfolio to go for established investment grade assets across the region, which was not there a decade ago.
Under the microscope
Alex Jeffrey highlights the key areas of a manager’s business coming under more intense scrutiny in investor due diligence
Fees are an ongoing topic and there is pressure on fees, but experienced investors look at this in a sophisticated way. They are more concerned about potential returns after fees than just absolute fees. Investors are also expecting managers to be more creative about how they share risk and reward. There is a lot of discussion about the balance between base fees and performance fees, so the manager is aligned with the investors to a high degree.
We see more pressure coming from investors in other areas. For example, more detailed questioning on operational due diligence. Looking back five years or more, investor due diligence would focus more on a manager’s real estate skills. Obviously that is still the case, but there is now a far more wide-ranging analysis of the operational side of a manager’s business, including the overall approach to risk management, the compliance framework, IT and cybersecurity and the whole investment process. Quite rightly, investors want to make sure there is a very robust infrastructure around the investment and asset management teams.
Eye on the team
There are also more questions about the make-up of the team, especially with regard to diversity and inclusion. How do we go about recruiting and retaining people? What is the culture of the organization? We get much more broad-ranging and searching questions than used to be the case.
For smaller managers, it is getting increasingly difficult to demonstrate to large institutional clients that they have the infrastructure needed with regard to risk management, compliance, technology and ESG. There will still be a place for sector-specific niche players, but if they are successful they will often be drawn into tying up with larger players. So, there is an inevitable process of consolidation going on, partly driven by the march of compliance requirements, but also by the other operational due diligence investors need. But it is in investors’ interests for that consolidation to happen because if you can spread the fixed costs of, for example compliance, risk and ESG over a larger pool of assets, then – all other things being equal – fees should come down, too.