Those looking for an example of how economic uncertainty is gripping the world should look no further than property. Investors with exposure to these markets have been offered completely different outlooks.
The first is that those with allocations to bricks and mortar may need to adapt to a global economy in turmoil. This has led forecaster Oxford Economics to revise its expectations for global property returns downward.
Another view is that property remains attractive, with bricks and mortar set to outperform other asset classes – even if returns remain just short of double digits.
The two outlooks could in fact be the same, just viewed through a different lens, depending on if you are a half-glass-empty or half-glass-full person.
If we take the more positive picture as an interpretation of the asset class going forward, where in the property universe should investors be looking for those all-important opportunities?
Doug Clark, head of research and solutions at the BT Pension Scheme (BTPS), identifies clear headwinds for the sector, not least the impact of Covid and wider secular trends – be that working-from-home or the shift to online shopping – but he also sees opportunities, which he describes as four-fold.
First, higher borrowing costs have made lending money against real estate attractive. Second, offices with strong ESG and environmental credentials are in high demand from tenants.
Third, the significant repricing in retail is leading to selective assets offering value. Fourth, demand for well located, quality residential property is strong, given affordability challenges.
Louise Warden, head of real estate at Local Pensions Partnership Investments (LPPI), similarly supports the proposition that property remains attractive. And importantly, should perform well given the inflationary environment.
“We are seeing some negative impacts from the rise in rates on borrowing costs and cap rates, but those sectors where rental growth can be achieved should provide some resilience,” she says.
And although Warden says no sub-sector remains immune to the economic environment, during the medium term, LPPI expects well-located, “prime logistics” assets to perform, given strong tenant demand. “We also expect less cyclical assets, such as those in the living sectors, and alternative real estate assets, such as life sciences, to provide resilience within our portfolio,” she says.
The investor appeal of property, Warden says, should also be on those with green credentials. “Assets which have strong sustainability credentials are attractive across all sectors, but with offices seeing a particular bifurcation in tenant demand, rents and take-up over secondary space as corporates seek more efficient space in line with their net-zero commitments and in a drive to attract and retain talent.”
Safe as houses
Christophe Montcerisier, head of real estate debt at BNP Paribas Asset Management, offers what he says are “compelling reasons” for considering an allocation to commercial real estate debt ahead of other opportunities.
The first is that commercial real estate debt funds offer indirect inflation-linked income streams typically 100-160 basis points higher than public-market debt with a similar credit worthiness: an obvious attraction in these inflationary times. “The span of a commercial real estate debt fund investment is typically 10 years, which suits long-term investors such as pension funds,” he says.
Here he asserts that rising interest rates are not a danger, as loans are set and adjusted in line with changes to the base rate. “As with other mortgage-type products, there is a 0% floor on interest payable, which means that negative yields are not possible. Negative yields are a reality for a lot of publicly traded paper so we can say there is extra value these days in the illiquidity premium,” he says.
In addition, he adds: “Commercial real estate debt is fully collateralised. That is one strength of investing in bricks and mortar. Senior debt holders have first-ranking mortgages.” Montcerisier says loan-to-value ratios have been falling, providing, he suggests, another source of comfort, because it means the equity borrower has more “skin in the game”.
Finally, there is diversification by ultimate revenue. “It is common for funds to have exposure to more than 2,000 tenants, situated in hundreds of properties in different jurisdictions,” he says. “Investors can take comfort that their income – typically distributed quarterly – comes from a greater variety of underly- ing sources than many other forms of debt,” Montcerisier adds.
Setting out the Oxford Economics view, real estate economics associate director Christopher Babatope offers some advice on how investors may need to modify their approach. “In the near term, property investors will likely need to shift their focus towards assets with solid levels of rental uplift potential and income growth,” he says. “The past few years have seen total returns largely driven by elevated levels of capital appreciation, driven by yield compression.”
Babatope believes that in most instances, yields are likely to soften over the near term – as the cost of capital rises and average credit spreads increase. “This will create additional near-term uncertainty for commercial real estate performance. “That said, our five-year forecast for commercial real estate sees all-property direct returns outpacing those of bonds, real estate investment trusts and wider equities market.”
Babatope adds that while near-term uncertainty will impact all sectors, “occupier fundamentals” for growth segments, for example, urban industrial assets and residential, remain positive. “Broadly speaking, focusing your attention on selective assets within these sectors, and diverting your attention away from sectors facing structural headwinds – traditional offices and retail – will help to produce stronger returns,” he says. This represents Oxford Economics view at the national level and there are nuances.
“While the office sector appears weak from a top-level perspective, flight-to-quality trends mean prime, new developments in core sub-markets continue to perform well,” Babatope says.
Looking ahead, he adds: “With a deteriorating economic outlook and rapid monetary policy tightening likely to continue over the near term, we expect that the speed of execution of lending and overall transaction levels will remain slower and lower than in recent history.
“The buy-sell spread will likely remain wide and volatile over the coming quarters, but we firmly believe there are still positive market transactions that can be made within commercial real estate,” Babatope says.
There are a number of reasons why property is attractive for pension funds, as highlighted by Doug Clark at BTPS, who reveals the importance of property in the fund’s portfolio, which represents just under 10% of its assets.
“From a strategic perspective, the income profile, inflation-inkage and portfolio diversification are the primary characteristics that we find attractive,” Clark adds. “Our portfolio is increasingly focused on relatively core, income orientated property investments – debt and equity – that help generate cashflows to meet our ongoing pension payments.”
His fund sees property as an important investment opportunity at the present time. “In the current environment we feel certain areas within real estate offer attractive and diversifying opportunities for the scheme, particularly to generate resilient, inflation protected income.”
The attraction of property is typically as a long-term investment. A point made by James Agar, head of long income at PIC Capital, who, as a pension insurer, have a relatively low appetite for risk and timeframes that run over decades.
“This dynamic requires an investment strategy that is carefully constructed to provide cashflows that match all future pensions payments,” he says. “One of the best ways to do this is by investing in the long-term assets that the country needs, such as urban regeneration, social housing and build-to-rent,” Agar adds.
Property and society
Here, property as an effective investment morphs into a real benefit for society as a whole, boosting the social pillar within ESG investment.
“We are always looking to maximise our cash-flow matching and sourcing private debt investments enables us to sculpt the cashflows more precisely,” Agar says. “Because bonds have set maturities,” he adds, “we source private debt investments to ensure we have the right cashflows to match our pension payments every year. These investments are a great example of how we balance PIC’s purpose of paying our current and future policyholders with creating social value within our portfolio.”
PIC’s investment in Miller’s Quay on the Wirral is a perfect example, Agar says, where, alongside Peel L&P and Wirral Metropolitan Borough Council, the insurer is developing more than 500 homes, a fifth of which will be affordable. “This investment is part of the wider Wirral Waters regeneration project to transform 500-acres of brownfield former-dockland into a thriving new community, which will create 20,000 permanent jobs and is one of the largest regeneration projects in the UK,” Agar says.
Property investment, in the style of Build Back Better, has then a clear wider societal benefit that will stretch well into the future long after the soundbite has been forgotten.
“The infrastructure PIC finances also stimulate local economies, providing much needed investment and job opportunities,” Agar says. “Our investments often have an agglomeration effect and act as a catalyst for wider regeneration, breathing new life into communities by unlocking investment in the long-term.” Another important example in this regard is where PIC
invested £130m to fund the construction of Manchester-based New Victoria – its first build-to-rent project – in 2020. “Over the course of the development more than £40m has gone directly into Greater Manchester’s economy through local employment, businesses and material sourcing,” Agar adds.
The S pillar of ESG can then underpin much property investment, as long as it fits a specific society focus. Inevitably, property also pays an important part in the environmental element of ESG.
In this way Clark shares and encourages the ESG benefits of property investment. “The asset class offers great opportunities to embed sustainability in a way that can be more tangible and easier to evidence than in equities or fixed income,” he says. “This is important to BTPS given its strong focus on sustainable investment and our 2035 net zero emissions ambition.”
As part of this, BTPS has embedded a net-zero target in the objectives of its primary real estate manager and have seen strong year-on-year decarbonisation from its portfolio over the past few years.
In addition, and as further evidence of its society focus, the scheme has exposure to city-centre developments in Manchester, Leeds and Birmingham, where engagement with local communities, education and councils creates positive social benefits.
“A lot of environmental and social benefits can be achieved from property in a way that’s clearly aligned with generating attractive investment returns,” Clark says.
So even in the most of testing of times, property can offer investors a multitude of opportunities, mixed with a variety of benefits.