May 2017

REAL ESTATE: Seeking out special properties

Real-estateCompetition in the property sector and a shortage of available buildings are leading investors to more specialist real estate funds, writes Nicholas Pratt.

Global investment in real estate is forecast to hit €1.3 trillion later this year. Investors will flock into the sector in search of income and diversification and there will be new sources of cross-border capital, according to ‘The Atlas Summary 2017’, a report produced by real estate research firm Cushman & Wakefield.

The total of newly-raised capital allocated to real estate markets is actually down for the first time since 2011, but this is more a result of a fall in available debt and investment activity in general, says Cushman’s regional head of research, Elisabeth Troni.

“The cycle for real estate is still strong,” she says.

Perhaps the most important finding from the report is that there is still more capital targeting real estate than there is real estate to buy. This is especially evident in core property assets, such as commercial real estate in major Western cities, which continue to be attractive to big investors, as shown by the recent purchase of London’s Leadenhall Building (nicknamed ‘the Cheesegrater’) for £1.15 billion (€1.7 billion) by a Chinese property tycoon.

With debt levels down globally and lenders providing credit against a narrower range of asset types, investors are facing greater competition for core assets and this is reflected in changing strategies.

It suggests there is more investor interest beyond the so-called core – in other words, more interest in emerging markets or ‘tier two’ markets in leading countries, and a growth in new styles of investing.

“Chief among these newer asset classes,” the report states, “will be those with a residential focus, particularly looking at affordable and rented space including themes such as shared services and retirement homes. In other segments, data centres, urban logistics and leisure are set to see growing interest.”

For real estate managers, they should carefully select the markets in which they want to compete, says Troni. “There is a growing interest in specialised knowledge in this market but it can be a niche category – nursing homes, logistics warehouses.”

These specialist funds tend not to be pan-European but single-country strategies, as shown by the growth of residential/private rental sector funds, which are proving popular with European investors. There are also some collective investment schemes where investment has been pooled in order to get access to large assets like shopping centres, which would have otherwise been inaccessible. 

Meanwhile investors need to have focus and patience but also be flexible and ready to move, says Troni. “You can always find mispriced assets as a market matures and we see the interest in real estate as a long-term trend due to the growing interest in alternatives and real estate’s status as an alternative within alternatives.”

FINDING PROPERTIES
The competition for property is supported by the testimony of real estate asset managers. “Our hardest job is finding assets,” says Tony Brown, global chief investment officer at M&G Real Estate. “As soon as we do find one, we are competing with others.”

The fact that yields have compressed across the board, combined with a desperate demand for income among investors, has made real estate returns more attractive and the search for decent properties a greater challenge than ever, he adds. “This is especially true in the UK, where there is a housing shortage. An investor can capitalise on those underlying economics and supplier/demand dynamics.”

Another trend exacerbating the competition for core properties is that people want to invest in major cities, says James Thornton, chief executive of Mayfair Capital, a UK-based real estate investment manager. “A growing demand for work/life balance means that people are looking for amenities. This has resulted in more investment in city centres such as the likes of London, Leeds, Manchester and Birmingham and less in out-of-town business parks.”

The competition for city-centre commercial properties has forced managers to be more imaginative in their search for assets, says Thornton. He cites a recent example of an investment made in the Gloucestershire town of Cheltenham, which is suffering from an acute undersupply of offices as a result of permitted development rights enabling the conversion of offices to residential use without the need for planning.

Cheltenham is home to the UK’s intelligence centre GCHQ, which is currently on a recruitment drive. As a result, the town is also developing a reputation as a hub for cyber-security providers and professionals, hence the growing demand for office and residential space, Thornton says.

Other real estate fund managers see greater interest in global property portfolios. “This makes sense when you compare it with other asset classes,” says Simon Redman, global head of product management for Invesco Real Estate. “To go global gives you greater diversification.”

Selecting countries involves various criteria, says Redman. “Some countries we would exclude completely because their market is too small or too immature with too little certainty around ownership. Otherwise we look at returns, location and investors’ appetite.

“The key trend is the number of investors looking for income, and real estate provides a stable income and net returns between 4% to 8%,” he adds. “We think that’s compelling. There are a number of strategies designed to meet this demand – the UK private rental sector and European hotels to name two.”

As well as more imaginative direct property purchases and geographical diversity, there are a growing number of specialist real estate funds emerging, measured by MSCI’s recently published AREF/IPD UK Quarterly Property Fund Index for the first quarter of 2017.

INDIRECT EXPOSURE
For some investor groups, investing in sub-sectors of the market indirectly is the most appropriate way of gaining exposure and taking advantage of specialist fund management expertise.

The growth of e-commerce and online retailing is also fuelling continuing demand for large logistics, which can be bought through specialist funds or real estate investment trusts (Reits). In London, around 20% of land for logistics properties has been lost to the residential sector so there is less available land but more demand from a smaller number of large providers, such as Amazon.

Other examples include shopping centre funds, the Unite UK Student Accommodation Fund and the Airport Industrial Property Unit Trust Fund.

The growth of specialist real estate funds will mean that managers must be well-resourced and known for their expertise, says M&G’s Brown. “It is a private market so you have to know the brokers and the intermediaries. It is preferable to buy off-market and avoid the competition but you need people on the ground and a reputation as a credible counterparty. That makes a big difference in building trust between buyers and sellers.”

The competition for core properties and the emergence of more specialist funds will also give managers a chance to prove themselves, says Chris Urwin, head of global research, real estate, at Aviva Investors. “Investors are looking to put money with experts that can make conviction calls. They want more for their money and they expect their managers to be active and able to make conviction calls.”

After all, it is difficult to be truly passive in this type of market or to allocate in accordance with a benchmark, says Urwin. Instead managers must be embedded with architects and developers, making good deals and adding value to those investments.

This has led to a preference for partnering and joint ventures between managers and investors where each side holds 50% of the asset which continues to be actively managed by the manager, says Urwin. “Investors like the fact that the managers have some skin in the game and the respective interests are aligned.”

DRY POWER
Another consequence of the competition for properties, and the difficulty in delivering the same kind of returns that real estate investors have seen in the past three years, is a build-up of capital, says Urwin.

“There is a lot of dry powder struggling to find properties to invest in. Most real estate investors are aware of the last cycle and are reluctant to bid too aggressively for assets. They are also averse to income risk and not highly motivated by opportunistic investments. So it is best that they remain patient.”

Thankfully, the risk factors of past property cycles (cheap debt, loose lending and excessive development) are not flagging any concern at present. But one potential issue is around a future loss of liquidity and the wider implications, says Urwin. “There is a lot of it across markets at the moment but when that starts to reverse, the cost of capital goes up as does the cost of property. What would help is an increase in the general economy to support rising prices.”

Managers are also observant of economic and geopolitical risks, coupled with the prospect of reflation in a post-quantitative easing world and the uncertainty of whether this will lead to normalising of yields or a five-to-ten-year period of financial repression.

The prevailing message from managers to investors, though, is to be patient in the current competitive environment and wait for the right investment.

©2017 funds europe