Renos Booth, Isabel Gossling and Kris McPhail from our real estate long income team discuss the importance of selectivity to uncover opportunities and how new buyers can fill the void left by DB pension schemes.
Read this article to understand:
- What sticky inflation means for real-estate long-income portfolios
- The opportunities for selective investors
- How long-term structural themes are playing out
Sticky inflation and a challenging labour market are impacting real estate sectors in different ways. While investors get some protection from inflation-linked rents in real estate long income, they should look out for areas where stresses might emerge, brought on by evolving factors like elevated interest rates and longer-term structural changes in the market.
In this Q&A, Renos Booth (RB), Kris McPhail (KM) and Isabel Gossling (IG) from our real-estate long income (RELI) team explain how, despite the current challenges, being selective on sectors and quality can uncover opportunities.
How have inflation and higher interest rates impacted real estate over the summer?
RB: Inflation has been much stickier than anyone anticipated. Investors can benefit from inflation-linked rental agreements in most cases, albeit with caps in some cases, and this provides some shelter. In Europe, most cashflows are inflation-linked and uncapped, which is helpful in a more inflationary environment.
However, rates are not far off the peak reached last September, which is presenting challenges. Higher rates have improved the funding positions of defined-benefit (DB) pension schemes, some of which are now choosing to de-risk and accelerate their path to buy out or buy in, leading to redemptions. On the flipside, we are being asked to identify and originate similar assets for insurance clients for bulk purchase annuities, and that market remains competitive.
KM: To illustrate, between June and September, five-year swaps went from 4.5 to 4.9 per cent. Similarly, ten-year gilt yields have gone from 4.2 to 4.6 per cent. Over the quarter, the increase in rates has impacted investor sentiment and resulted in pricing and values falling in certain sectors, particularly offices and retail, where the underlying fundamentals are not as strong as, for example, in distribution or student accommodation.
RB: The other thing to note about inflation and rate hikes is that we are yet to see the distress fully come through. It will play out differently in different sectors. For example, the supermarket sector was flavour of the month through the pandemic but is now struggling to pass inflationary pressures onto consumers, whether energy or labour costs. Some supermarket retailers have reported significant declines in EBITDA over the last year, creating an interesting pivot from an investor perspective, from strong appetite to caution.
KM: There is an important read across in other industries, too. In construction, several contractors are filing for administration for the same reasons. That will start to impact the financial viability of new development as construction costs rise due to a lack of contractors. This could drive rents and land values higher in certain sectors, such as distribution, where there is a lack of supply of sites.
RB: The current pressure on the construction industry is intense and, in the UK, Brexit has also played a role. Companies are struggling to find workers with the right expertise, and the sector now needs to address issues with lightweight precast concrete as well. It is part of the broader challenge for real estate.
What do these challenges mean for RELI portfolios?
RB: Although nothing is guaranteed, these conditions are what RELI is designed to protect against, historically being less volatile than other real estate strategies. Focusing on stronger, investment-grade credits helps the properties generate contracted, long-term income streams that are uninterrupted through recessions, COVID and so on.
Nevertheless, we expect to see more defaults in the market because of the macroeconomic environment. The cost of debt is increasing and that will feed into the overall viability of corporate entities. Rating agency Moody's has increased the probability of default from around three per cent to almost five per cent for sub-investment grade by the first quarter of 2024 – that’s a big difference. Even within investment grade, we expect to see downgrades as companies come under more pressure.
Public-sector entities are being challenged as well (Birmingham City Council recently served a Section 114 notice showing problems balancing its budget), but that is a clear reminder these entities are supported by the state. Local authorities cannot legally become insolvent. The fact they are more likely to ultimately receive support from the government is another reason we have focused on them as tenants. However, it remains prudent to ensure an appropriate level of diversification to avoid being overexposed to any single counterparty, asset or sector.
KM: In addition, the default rate of weaker tenant credits is likely to be higher. There is a squeeze on discretionary spending by consumers, which is likely to continue. In this environment, it is important to maintain a portfolio of strong tenant credits with a good rent collection record.
We have also been exiting investments let on shorter leases where the investment’s return will be closely aligned to the capital value performance of the real estate market. This is not compelling in the current environment, particularly in sectors such as offices where there are headwinds from an occupier and obsolescence perspective.
IG: Since June, market values in Europe have shown early signs of stabilising at the prime end, and we have seen a marginal improvement in financing availability, but activity and capital raising remain subdued. We do not expect this to pick up materially in the fourth quarter, as most investment decisions are on hold until next year.
Are discounts available in the secondary market?
RB: The fact DB schemes have improved funding levels and are therefore de-risking has created an imbalance between supply and demand. That is reflected in the level of discounts available on the secondary market, and we are seeing some investors, particularly local-government pension scheme (LGPS) clients, looking to take advantage.
KM: In the UK, there have been some willing sellers of secondary units at significant discounts of up to ten per cent on the net asset value (NAV), which offers a great opportunity for incoming investors. When you consider that investors coming into the long-income market through the primary route have historically paid a premium, the overall discount available today is significant. It is a once-in-a-cycle opportunity for investors.
IG: European long income went into this cycle relatively attractively priced and with a higher yield profile than prime real estate. Therefore, the rise in yields has had proportionally less impact on capital values.
What we haven't seen in Europe is capital returning to the market in any meaningful quantum. Transaction volumes are still around half what they were year-on-year, with value not yet sufficient to drive a meaningful return for investors.
Which sectors and geographies have been most resilient?
IG: The life sciences sector has been particularly resilient. Established European science parks with a good tenant mix have held up well, as have well located and operated hotels and student accommodation. We also like build-to-rent because of the structural and persistent shortage of residential accommodation in major cities like Dublin.
On the other hand, offices have been more vulnerable. There is greater polarisation as the market is caught in a post-pandemic hangover. It is becoming much more expensive to reposition and upgrade assets with environmental, social and governance (ESG) considerations in mind as well, so investors are very selective. Within the office sector, the ultra-prime end of the market is less impacted.
RB: As we discussed in June, we expect a K-shaped recovery across most sectors, benefitting prime assets (See Demand, diversification and discounts: Where next for real estate long income?). Buyers are opportunistic and will seek to play the recovery and take advantage of any distressed situations. We know from previous cycles that prime assets are the first to recover, with secondary and tertiary assets gradually finding their level. There will also be a dispersion between stronger and weaker credits and more sustainable real estate versus that requiring higher transition costs.
Which of the structural changes brought about by COVID are likely to intensify?
KM: A lot of the fairy tales around COVID have not materialised. As mentioned, everyone thinks supermarket retailers were doing great during COVID. But in reality, costs were high, profits were pretty much flat, and supermarkets are now struggling with a large real-estate base and high fixed costs.
The office sector is seeing the biggest structural change, as flexible working is probably here to stay. But an even more important issue for offices is the obsolescence risk and ESG factors that real estate investors need to consider. Office space has a lot of mechanical and electrical equipment that requires updating and decarbonising, with huge associated costs.
RB: What COVID has done is accelerate that structural change. Being in the right place and having the best workplaces and amenities has always been a requirement to attract and retain the best talent. That is still true today but has been accelerated by COVID.
