Market data underlines the disparities institutional investors face when assessing where to make real estate investments.

The Savills prime world cities rental index recorded an average increase of 0.5% in the first half of 2021, which follows a fall of 1.8% through 2020 as global restrictions on travel reduced demand for corporate relocations. Kuala Lumpur saw prime rents decline by more than 8%, Hong Kong and New York by more than 4%, and prime rents also fell in Cape Town, Madrid, Paris, Shanghai, Los Angeles, San Francisco and Amsterdam.

However, investment in housing was up significantly in the Americas (+33%) and EMEA (+23%) during Q3 2021, according to global property consultancy JLL’s November 2021 global real estate perspective. Meanwhile, global commercial real estate services and investment firm CBRE's figures for Q3 2021 show that global retail rents and global retail capital values were down by 3.9% in the year to Q3 2021 yet had both increased 0.2% from the previous quarter. Global office rents were down 1.3% for the year to Q3 2021, but also showed 0.2% improvement from the previous quarter. Global office capital values rose slightly by 1.6% in the year to Q3 2021.

"The attractiveness of the industrial space sector reflects the ongoing structural shift in consumer purchasing habits toward online" This mildly positive trend is underlined in the November JLL data, which shows that third quarter global leasing volumes were 39% higher than Q3 2020 – but still 25% lower than Q3 2019. According to JLL, real estate capital markets continued their recovery in Q3. Global transaction volumes for the first nine months of 2021 totalled US$292bn – up 77% from the same period in 2020 – driven mainly by the Americas and EMEA economies, with US$219bn of that investment going into residential.

JLL suggests “diminishing operational uncertainty and rising institutional allocations are bolstering liquidity in the commercial real estate markets”. The sheer breadth of the sector means healthcare, life science, residential and industrial real estate are effective defensive assets and complement retail and leisure properties, which are more geared towards economic recovery.

It also allows investors to capture secular trends, such as the growth of logistics and the focus on sustainable investing. “This is currently reflected by the excellent returns of warehouses and offices focused on providing high quality working space with a low carbon footprint,” explains Francisca Fariña Fischer, head of real estate international at Credit Suisse Asset Management.

This is backed up by data from the US-based National Council of Real Estate Investment Fiduciaries (NCREIF), which shows that the industrial (primarily warehouse) sector returned 13.3% in the final quarter of 2021.

Hedging benefits

Paul Kennedy, a managing director within JP Morgan Asset Management’s real estate team, refers to compelling expected total returns, diversification and inflation hedging benefits as well as yield when asked why the real estate sector is appealing to institutional investors, despite the illiquidity of the asset class. Paul reckons the attractiveness of the asset class is enhanced by mispricing at the sector level, as market level returns don’t reflect strong performance anticipated from logistics and ongoing weakness from retail or include enhanced alpha potential in the office sector.

Industrial space remains the most attractive sector, even though values have soared over recent quarters, says Martha Sewald Peyton, global head of real assets research at Aegon Asset Management. Total return on industrial properties in the NCREIF National Property Index in 2021 was 43.3%.

“The attractiveness of this sector reflects the ongoing structural shift in consumer purchasing habits toward online, with warehouse distribution space yet to catch up with demand,” she says. “In addition, ongoing supply chain disruption has demonstrated that ‘just in time’ inventory management is inadequate.”

Oli Creasey MCSI, head of property research at Quilter Cheviot, strikes a more cautious note, suggesting that real estate’s value as an inflation hedge has been somewhat overstated. “A good example to consider would be the events of 2007 to 2009, a period when inflation had very little to do with property values,” he says.

Property values at that time were impacted by the global financial crisis. Too much debt was loaned against the value of properties, which helped to inflate prices. Once debt became unavailable – either for new buyers or people remortgaging – prices had to come down as a result. Falling prices made banks even more reluctant to lend and the cycle perpetuated.

“Of course, that is a relatively short period of time and over a longer period there is a correlation that can be observed. Even so, it is far from perfect, and we would caution investors against thinking that property investment will always protect you against inflation rises.”

Access for smaller investors

Oli says there are routes for investors with smaller investment portfolios to access property markets too. “One option is open-ended property funds, which give direct exposure to property but where the key concern is liquidity,” he says. "The Legal & General UK Property Fund is a good example.

“The alternative is closed-ended real estate investment trusts (REIT) shares (or funds investing in REITs), which are more liquid, but also volatile as share prices can deviate from the underlying property value depending on market sentiment. The abrdn ASI UK Real Estate Share Fund would be one such option for investors looking for UK exposure.”

In addition, Creasey points to so-called ‘hybrid’ funds, which combine direct and indirect exposure to reduce these risks. He adds: “The BMO Property Growth & Income Fund has a long and strong track record, and the recently launched TIME: Property Long Income & Growth fund has a similar but not identical investment profile”.

Niche interests

In terms of specific market segments, Martin Zdravkov, lead portfolio manager at asset management company DWS, points out that in the UK, affordable housing comes with the underlying premise that rents are below the mid-market point. “Our view is that responsible residential (defined as medium scale multi-family projects in vibrant commuter locations where rents are below 30% of the occupier’s net income) offers similarly compelling investment characteristics without the regulatory burden, limited control, or embedded reliance on uncertain reversion to market as is the case with shared ownership or rent-to-buy.”

Brewin Dolphin, like Aegon, favours the industrials/logistics sector, says senior analyst Shakhista Mukhamedova, who adds: “In terms of geography, we like to have exposure to large global cities mostly in developed markets with strong economic growth, sophisticated infrastructure, and large talent pools.”

JP Morgan is optimistic on the logistics and residential sectors and, while office returns are expected to be in line with the all-sector average, the firm sees opportunities at the higher-quality end of the market. “We remain cautious on the retail sector and expect the ongoing roll out of ecommerce to lead to impaired capital values and obsolescence risks,” says Paul Kennedy. “Residential remains a sector of focus, although largely for diversification reasons rather than return expectations. At country level our projections don’t highlight any clear opportunities or risks, although we currently have a mild preference for the UK.”

"In some cases, the creditworthiness of tenants does not quite match the pricing of the asset" Oli agrees that many sectors within the property market look attractive, noting that, although industrials and logistics have been strong for some time, supply and demand fundamentals within that market have created a favourable environment which should persist. “For the past few years, the retail market has been on the other side of that trade and has been weak as a result,” he says. “However, recent evidence suggests that this market has turned a corner and may even have overshot on the way down, meaning the short-term prospects are becoming far better.”

As a result, Quilter Cheviot believes there are some bargains to be had in the retail market in certain subsectors. The firm is also surprisingly upbeat on office space, noting that, although properties are currently used far less than they were pre-pandemic, potential buyers of office buildings remain keen at least in the short term. “The so-called long income sector has gathered considerable new interest in recent times, with buyers looking for properties with leases of 20 years or more, often with inflation linked rental uplifts,” says Oli.

The current attraction to these assets is fairly obvious – inflation linked, and with a considerable yield spread to long-dated bonds, he adds. “However, our concern is that while the leases look good on paper, they are reliant on the quality of the countersigned tenant and their ability to consistently pay rent for the next 20-plus years. In some cases, the creditworthiness of tenants does not quite match the pricing of the asset.”

In September 2021, the US government stated its intention to limit the sale of certain residential property types to large investors, possibly spooked by data cited in the announcement suggesting that real estate investors purchased almost 68,000 US homes in the second quarter of 2021, the highest quarterly figure on record.

Investor concerns

When asked if institutional investors are concerned about restrictions on the acquisition of residential property in the US or other markets, Oli says it would be a surprise to see the US government prevent institutional buyers from accessing the residential market, adding that it would not be universally accepted and would be unlikely to have the desired effect.

“The threat of rent regulation is another ‘known unknown’ and emphasises the need to look at the sector holistically, lean on the macro drivers behind higher penetration of rental accommodation not only in residential but also in other sectors such as student and senior living, and diversify away from single jurisdictions which carry unwarranted idiosyncratic risks,” says Martin Zdravkov.

These macro drivers include demographic trends, urbanisation and affordability constraints, explains Martin, who notes that a single country strategy carries tail end political and regulatory risks (such as rent controls or new taxation methods) which can be diversified away through a geographically broader strategy focused on macro themes that transcend national borders.

For those with shares in REITs, 2021 was a great yearPaul says that JP Morgan doesn’t anticipate any impediments to investment in the sector by institutional capital to be introduced in Europe, while Peter Hobbs, managing director of private markets at Bfinance, says the chronic shortage of residential real estate worldwide means it is unlikely that large sources of capital will be restricted from providing solutions.

Precise returns will depend on how the investor accesses the property market. Oli notes that for those with shares in REITs, 2021 was a great year with net asset value discounts unwinding and shares providing excellent returns that have outperformed other sub-sectors of the equity market, whereas direct buyers will have seen more muted returns (for example, the iShares UK Property UCITS ETF returned +28%).

JP Morgan remains optimistic that a shift to a portfolio that incorporates more alternatives (including real estate) should support short-term returns, and expects the disruption associated with both ecommerce and a potential shift to hybrid working to enhance alpha potential for investors able to take advantage of changes in occupier and investor demand.

Perhaps equally important is the potential for property net operating incomes to grow as economic recovery continues. “Such growth may also embed inflation protection as leases turn, creating potential to pass on rising costs of operation,” says Martha Sewald Peyton, adding that properties with net leases automatically pass on rising costs to tenants.

Looking ahead, Credit Suisse predicts that with “interest rates expected to rise modestly and the global economic recovery set to continue, the environment remains supportive for real estate investments”. The bank expects the listed real estate markets to deliver “positive mid-single digit returns in 2022”, driven by growth in the US, the UK (where it expects the London office market to rebound strongly) and the Swiss rental apartment sector. It also forecasts further falls in retail and lower quality office space values.