Future-proofing European real estate

Institutional investors in European real estate need to assess what these trends mean for their portfolios. The thesis of PATRIZIA is that the market is on the cusp of major changes.

The United States, a real estate market that has undergone tremendous changes over the last decade, heralds the transformations we expect in Europe. The same megatrends are evident and, although there is a lag, there is no reason they would not lead to the same effects, albeit with local nuances.

To back this thesis, we combined data from the National Council of Real Estate Investment Fiduciaries (a US industry data collection of private real estate holdings) and the National Association of Real Estate Investment Trusts (an association that represents equity real estate investment trusts, mortgage REITs, REITs traded on major stock exchanges, public non-listed REITs and private REITs). The aim was to measure growth in assets under management for traditional property types in the United States, irrespective of whether they are owned by a REIT, a separate account manager or directly by an investor. We found that residential, industrial and logistics drove growth at the last decade’s back end, not office or retail.

That implies retail and office assets, which still account for the bulk of typical institutional real estate portfolios in Europe, will become less dominant given the trends in e-commerce and remote working. Retail exposure has been shrinking in Europe for the last decade anyway. Office performance will be all about anticipating how the working-from-home model will affect the office markets and assets.

Instead, residential and logistics are gaining importance in institutional portfolios. We also see a broadening of the real estate asset class that will help investors tailor and diversify real estate exposures. The US experienced spectacular growth of alternative property types over the last decade. Alternative property assets have grown to now represent a cumulative asset value of over US$1 trillion or 43% of the invested real estate stock.

In Europe, the alternatives market is a tenth the size, but megatrends favour its development. These property types fall loosely into four categories: healthcare and well-being, living alternatives, supply chain, and tech and digital. All are powered by different trends and drivers, some of which are correlated and others not, making them attractive from a portfolio construction and diversification perspective.

In terms of the best risk-adjusted returns, scalability and diversification potential in Europe, we believe healthcare and alternative living are particularly attractive. Investor acceptance is higher because such properties are adjacent to investments that investors probably have exposure to (say residential for example).

In terms of alternative living, investors readily appreciate that, while the dynamics may be slightly different to residential, they are not difficult to understand. One does not need to be a specialist to benefit from these trends. Senior living, or best-aged living, is very scalable on a European basis, even though some cities may be more attractive than others. Our research has found that metropolitan areas in Germany, Netherlands and the UK offer the best prospects.

We also see the knowledge economy as a driver. Student housing has been an afterthought in most of Continental Europe. Many popular university towns lack enough purpose-built student accommodation. However, this is changing and rapidly becoming an asset class. In terms of scalability, it ranks second in our estimation behind best-age living.

And then there is co-living, which is attractive as it offers a solution to the problem of housing affordability in the most expensive housing markets in Europe. We see co-living as an opportunity but only in the primary, more attractive cities. However, it is a smaller, less scalable segment than best-aged living or student housing.

It will likely take more time for wide acceptance around more tech-oriented property types to move from alternative to established property types. For digital, the execution is trickier for most investors and managers as the operations are specialised. There are questions around technology changes that could quickly render assets obsolete, and the energy footprint also raises questions. We see a huge potential for investment opportunities in infrastructure around energy and technology from a risk-adjusted return angle.

To create a future-proof European portfolio, it pays to step back and see how a similar portfolio developed in the US. Today, a future-proof US portfolio presents a quite diversified picture compared to 20 years ago, having been shaped by demographics, urbanisation, and tech and digital forces.

The inspiration for the push into alternative property types were cell towers and data centres. After the GFC, demand in the United States emerged for tech-driven real estate and stable income. This could be achieved by investing in property with strong tailwinds and able to offer a yield premium for an extended period.

Cell towers, for example, were one such type as ten years ago, society was undergoing a dramatic change from 3G to 4G communications (and now 5G). Ageing populations have also been a real estate driver. There is demand for senior living from couples or individuals who need to downsize to smaller, more manageable houses but do not want to go into a traditional nursing home. They are still quite active, and they are looking for a community offering ample shared spaces to catch up with friends and neighbours, while also using age-specific services.

We believe the same drivers will inspire growth in Europe in similar alternative asset as they become more attractive to investors. However, alternative assets classes are unlikely to be exactly in the same property types as in the United States.

In the United States, you can quickly scale a strategy, whereas, in Europe, each market is quite different from a market structure (who owns what) and a regulatory standpoint. Most alternative property types are highly operational in nature and need platform investments to achieve scale and efficiencies. They are complex; they need special talent and skill sets to access the product and then manage the properties and de-risk them.

It starts with who owns those assets today, and who will be the tenant and occupier in the future. That may vary country by country or even city by city, so you need people on the ground to map out the opportunities and scale investments. Regulation can also vary from country to country for, say, nursing homes, data centres, or cell towers.

For investors seeking to create a future-proof European portfolio, the challenge will be finding an access route to alternative assets. Unlike the US, these routes do not currently exist through the listed sector. This means choosing a partner who can provide, source and develop the product effectively. This is critical as many alternative niche property types need to be built or go through active asset repositioning.

Managing alternative property assets can also be significantly more complicated than with traditional real estate and, in most instances, requires specialised skills. This means investors can be better off by investing in a combination of operating companies (OpCos) and property companies (PropCos), hence benefitting from the vertical integration the vertical integration of specialised expertise in relevant areas.

When we looked at practical strategies to access the assets on behalf of clients, we concluded that the solution means blending OpCos and PropCos. This means hiring talent and bringing the OpCo expertise internally or partnering through a joint venture with a best-in-class OpCo.

Another reason to use a blend of operating and property companies is that it allows investors to control cash flows better, maximising and stabilising the cash flows and de-risking the investment.

Alternative assets are excellent investments and offer diversification. They have a low correlation with traditional property types and contribute to the de-risking of portfolios, but there are key operational challenges.

However, at PATRIZIA we should not invest in a niche that will stay a niche forever. We want to invest in a niche that has the potential to be scaled and become a mainstream property type. We think this is the case for alternative living sectors such as senior and student housing as well as digital infrastructure real estate.

We believe that in 10-15 years, it will be as easy for the average investor to invest into, say, senior housing or data centres as it is today to invest in an office asset in Munich, London or Paris. By then, property and facility management services will have been extended to cope with expanding demand and these successful niches will have become mainstream. Our aim is to be ahead of the curve.