Finding value in challenging times
28 / 10 / 22 - 6 minute read
In a volatile market showing deeply negative year-to-date returns (see chart 1), an increasing proportion of investors are considering an incursion into alternative asset classes, including real estate.
This is good news for real estate investment managers but, in order to succeed, a manager of the future needs to be three things: the portfolio designer of choice, the landlord of choice and, last but not least, the employer of choice.
Finding value – portfolio of choice
Clear convictions about the medium- and long-term are critical to underpinning your investment strategy. Whilst there are many polarising factors between geographies, sectors and individual assets, there remain plenty of opportunities to generate returns on investment even when the short-term outlook is bleak. It is this adherence to medium- and long-term convictions on real estate market trends and fundamentals which will prevent dashes to follow the herd based on short-term influences.
We believe there are four fundamental trends which will support allocations to real estate in the medium and long term: demographics, urbanisation, digitalisation, and decarbonisation. Demographic trends, such as evolving age pyramids, affect how people ‘consume’ real estate, driving demand for emerging subsectors such as student housing and senior living. In parallel, urbanisation trends will underpin where the demand will rise and fall within urban areas.
Tech and digitalisation trends, such as the rise of e-commerce and hybrid/remote work, bring about the need for last-mile logistics, data centres, and tech-enabled buildings. Finally, decarbonisation is closely linked to ESG trends and impact investments that are more important than ever. With the looming threat of climate change, we have a firm conviction that these principles will underpin value and liquidity in the future. Therefore, the way forward for managers is to be the portfolio designer of choice.
Securing the income – landlord of choice
The next major task for investment managers will be to secure resilient portfolio income. Except for a relatively brief period during the global financial crisis, yields over the past 20 years have mostly travelled downwards. However, given where pricing is today and where interest rates are headed, we shouldn’t expect yield compression to be the primary driver of returns. Willingness and ability to pay for space will drive the returns in the future. NOI (net operating income) is now king.
Even more important, however, is another NOI – net of inflation, that is. real NOI. The past couple of decades were characterised by low inflation, but this time it won’t be so simple for income returns to surpass inflation. Our research on pan-European offices over the past 20+ years shows that real income does, in fact, decline during periods of high inflation, and capital values are more stable.
This makes intuitive sense: business and household incomes get squeezed in periods of spikes in inflation, making it difficult for tenants to absorb much higher rents. A key challenge for investment managers will be to measure and track the affordability of rent in their portfolios and the wider markets.
Higher yielding strategies
The search for real returns will push many investors towards higher-yielding strategies. Landlords will also be under significant pressure to attract high-quality tenants meaning a greater focus on tenant care is needed. Understanding how tenants use the space leased to serve their current and future needs will be invaluable for landlords.
Tech solutions can assist asset managers in this way. PATRIZIA increasingly leverages data intelligence to evaluate the quality of a property’s location. As part of our work in this area, we developed the Amenities 15-Minute Magnet algorithm, which measures the distance to nearby amenities and scores a location according to its attractiveness in terms of seven human activities: commuting, living, caring, working, educating, supplying, and enjoying. The information provided by the algorithm influences our investment and management decisions.
Investment managers face the difficult task of balancing the need for higher nominal returns, with challenges to affordability and increasing demands from tenants. It is, therefore, critical to be the landlord of choice.
An income and growth investment philosophy
We believe one of the most successful investment philosophies for this new norm is the principle of income and growth, in which income is at the heart of the returns. Income is driven by occupier demand. The more attractive a property is from the perspective of potential tenants, the more likely it will be let at a high(er) rent on a long-term basis.
In addition to the data intelligence at our disposal, analysing the external environment and drawing upon local expertise is crucial to our strategy.
As an example, when we embarked on our big hub logistics strategy in the early 2010s, we had built the conviction that occupier and investor demand would increase over time. France is a great case study. We had seen that the market had been oversupplied the prior 10 years by overly relaxed planning regulations and easy development and that it was starting to show signs of recovery. Most importantly, the occupier demand was healthy. Our strategy then was to acquire existing assets showing moderate vacancy (up to 40%) in the main hubs on the logistics corridor (Dorsale) linking Lille, Paris, Lyon and Marseille. Thanks to experienced boots on the ground, we managed to bring the assets to full occupancy and drive returns through income. Capital growth followed in the footsteps of income.
This example demonstrates the need for both ‘boots on the ground’ and an ability to understand the ‘bigger picture.'
Chart 1
Negative performance across equities and bonds in 2022 year-to-date (YTD)
Employer of choice
Investment managers can only overcome the challenges mentioned above with the right people. Ultimately, people are behind the decisions that make or break an investment strategy. Attracting, retaining and developing human capital is the most important driver of success.
It is a significant challenge. What first began as the ‘great resignation’ is turning into the ‘great reshuffle’ – rather than leave the workforce, employees are increasingly switching jobs or their occupations altogether. A study published in MIT Sloan Management Review analysed the attrition rates of MIT’s Culture 500 – a sample comprising some of the largest companies in the US. The results highlight the importance of workplace practices and culture. Toxic corporate culture (for example, failure to promote diversity, equity and inclusion) was found to be up to 10 times more relevant than compensation as a predictor of employee turnover. Other significant sources of attrition were job insecurity and reorganisation, too high levels of innovation (associated with employee burnout), failure to recognise employee performance and a poor response to Covid-19.
The demands of employees are also shifting. A Deloitte survey found that good work/life balance, learning and development opportunities, fair compensation, positive workplace culture, a sense of meaning derived from work and flexible working models were all important reasons for Gen Zs and millennials to continue working at their current organisation. Additionally, the previous MIT study found that lateral career opportunities, remote work arrangements, company-sponsored social events and predictable schedules led to higher employee retention rates.
Managers must be agile to the needs of their people. Our advice: strive to be the employer of choice!
