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Welcome to the ‘equitization’ of private real estate

A shift towards more equity-like return characteristics is on the cards for the asset class, writes Dr Paul Kennedy, managing director, JPMorgan Asset Management

The Covid-19 crisis has led to speculation regarding both temporary and permanent changes to the underpinning factors that drive returns on real estate assets.  We may be amidst an evolution in which more real estate return characteristics start to resemble the return patterns of equities more so than bonds.

Recent events highlight the importance of real estate’s ability to offer ‘bond-like’ returns. Unprecedented purchases of both government and corporate bonds by monetary authorities have kept interest rates low and supported pricing of assets offering long-duration, high quality credit at relatively high yields.

That is not new. Monetary policy support has bolstered real estate pricing consistently since the GFC. Nor is it really about real estate. Rather, it is the asset classes’ ability to provide high quality income based on long-leases, robust demand and controlled supply. But changes to the nature of these returns have implications for the role real estate assets play in multi-asset portfolios.

To this end, Covid-19 has been associated with an extended shut down of most economies, an experiment with home working and an acceleration of the trend towards on-line retailing. Each of these changes may impact the consumption of real estate – specifically lease contracts – drivers of market pricing and characteristics of the asset class.

Kennedy: the ability of parts of the market to offer the stable income returns commonly associated with the higher quality end of the asset class could be reduced.

In the office sector, an increase in home working may result in occupiers reconsidering space requirements and their procurement.  While the jury is out on the impact on aggregate demand, changes to other elements of the traditional leasing model are more certain.

Shorter leases and an increasing requirement for ‘flex’ space are evident, suggesting a greater emphasis on active asset management.  Further, a shift to ‘space as a service’, could lead to higher but more volatile rents, enhanced landlord capital expenditure and greater gross-to-net rental spreads. These effects could erode the bond-like characteristics of real estate income streams.

Trends are similar in retail, where the growth of e-commerce continues to disrupt the economic model of physical retailing. This has multiple implications; shorter leases, higher yields, lower rents and more uncertainty.  And capital expenditure requirements have increased.

The Covid-19 shutdown has led to additional stress on the sector, with landlords typically receiving less than 20 percent of rents due – versus 90 percent-plus for office, logistics and residential assets. Consequently, some landlords have agreed to a temporary shift to turnover based leases.  One consequence may be a shift towards more equity-like return characteristics.

These effects have not been universal, nor necessarily negative.  The logistics sector continues to benefit from the shift to e-commerce, robust demand for a range of distribution facilities, as well as the continued availability of long-duration leases backed by high quality credit and attractive demand drivers.  In addition, the residential sector benefits from the relative stability of demand drivers compared to offices and retail, as well as strong diversification benefits.  Although leases are typically short, underlying cash flows are stable.

Real estate always had the ability to play multiple roles in portfolios, from ‘foundational income’ to higher risk ‘return enhancer.’ Given its inherent diversity, the asset class will retain that optionality.

However, a shift to shorter and more flexible leases and rents linked to occupier turnover will enhance the ability of real estate investors to participate immediately in both the upside and downside of changes to rental markets. This has important implications for both pricing and asset allocation.

There will be positives, particularly as investors seek to offset the impact of low bond yields on overall portfolio returns via exposure to higher yielding versions of the asset class. However, the ability of parts of the market to offer the stable income returns commonly associated with the higher quality end of the asset class could be reduced.

Investors seeking high quality stable income may have to focus on an increasingly narrow subset of the office and retail sectors and rely more heavily on logistics.  This could reinforce recent pricing trends in the asset class, particularly the relative pricing of logistics. These trends may also contribute to an erosion of the historical dominance of offices and retail in ‘core’ real estate portfolios.

Awareness of these trends will help managers develop real estate portfolios that align the needs of investors with the evolving attributes of the asset class; it should also help investors to identify – and profit from – mispricing.