One silver lining of lower transaction volumes and a slower capital raising environment is the opportunity to pause for thought and consider how the shifting tectonic plates of the real estate market may shape the future investment landscape.
There is much to process, not least reconciling medium-term considerations such as a “higher for longer” interest rate environment, geo-political and continued inflationary risk and a different relative value proposition for real estate when compared to fixed income investments, against the longer-term backdrop of capital intensive ESG requirements, stranded asset risk and fundamental, structural changes impacting what we demand from our built environment.
It is in this context that many have begun to question some of the fundamental tenets of real estate investment, such as what constitutes a “core” real estate investment. All real estate strategies, arguably, are on a mission to achieving core status through varying degrees of repositioning and intervention (whether they achieve it during the lifetime of the investment strategy or not), so understanding what constitutes a good core asset and therefore the “end game” is of fundamental importance.
Investments with a core profile are at the lower end of the risk/return spectrum and as such are typically characterised by low leverage and minimal or no development exposure, with a high proportion of return achieved through income. Traditionally, this has been delivered by seeking out assets with longer term leases with “credit tenants” and the ability to pass inflation risk on to tenants, in respect of assets which require minimal capital expenditure or operational intervention. Historically, this has been sought out in the traditional sectors of office, retail and industrial, alongside some residential exposure, as reflected in the European ODCE Index sector allocations, which, even with some rebalancing of portfolios away from office and retail sectors in recent years, continue to comprise 95% office, retail, industrial/logistics and residential assets, as at Q3 2023 (an account is required to access this content).
In the context of the changing economic and structural backdrop, however, views on what constitutes a “good” core asset with the most resilient income streams are evolving. As noted in Macfarlanes’ 2023 Operational Real Estate Report, the growth of alternative sectors in Europe, particularly since the Global Financial Crisis, has demonstrated to the market the virtues of relatively nascent, operational sectors such as student housing, senior living and self-storage. Contrary to previously accepted wisdom, real estate investors have begun to recognise that assets with short leases and a large, granular customer base, when coupled with the right operational expertise, present a stable and resilient tenant base, with the ability to match or exceed inflation in rental growth. Such sectors are often also more closely aligned with long-term, structural trends and present significant growth opportunities, with the majority of such markets still at an early stage in their evolution to maturity in Europe.
This changing perspective has been labelled the “New Core mindset” by LaSalle in their 2024 Global Outlook, who advise:
“…with the reversal of the multi-decade falling interest rate trend, care must be taken to align exposures with structural trends. Core investors should consider adjusting their portfolio allocations to be consistent with (or ahead of) evolving views on what constitutes core, quality real estate; value-add investors should consider creating stock that meets the evolving criterial of core investors through development or repositioning.”
Core managers however have rightly pointed out that such a change will not happen overnight. The European ODCE Index continues to deliver negative performance (-2.55% total return for Q3 2023) with a bid-ask impasse remaining in many markets. Fund managers are likely to continue to be hunkering down for some time, keeping a watchful eye on ICRs and redemption requests. In such a context, it is difficult to ask investors to become familiar with the distinct risk/return proposition presented by operational sectors, however compelling the longer-term picture. Many investors also cite challenges (either borne out of regulation or internal preferences) taking on “operational risk” or having exposure to non-rental income, with some investors feeling it muddies the waters between real estate and private equity allocations.
Investment managers are also likely to require time to adapt to a new core landscape, as such an evolution in the nature of core investments will require not only different sector expertise from portfolio managers but, crucially, that they become adept at securing and overseeing the right operational expertise for their assets. Portfolio managers and investment committees will have to become skilled at analysing EBITDA and challenging NOI projections and carrying out due diligence on operators alongside the bricks and mortar itself. We have already seen evidence of investment managers seeking to provide “vertically integrated” platforms, bringing operational expertise within their own value chain, or ensuring that they have operational expertise at a senior management level. The growth of vertically integrated platforms presents new governance considerations, with investment managers having to be mindful of how they manage conflicts of interest where they are providing operational expertise that is “tied” to assets, but assets are being transferred from one pool of capital to another. An evolving concept of core will also disrupt fee structures, as managers and investors look to ensure that operators, who are often intrinsic to the performance and value of the real estate asset, are appropriately incentivised.
Far from being a sleepy corner of the real estate investment market, it is clear that much work has to be done to reposition both portfolios and investment managers to deliver in the context of a “new core” mindset.