50 years of real estate – 5 lessons learned, and what we think comes next
50 years of real estate – 5 lessons learned, and what we think comes next
In many ways, 1971 was a momentous year. Companies like Disney World Florida, FedEx and Starbucks opened their doors. It was the year the UK replaced shillings and pence with a decimal currency. It was also a golden era for music. ‘American Pie’ by Don McLean, ‘Imagine’ by John Lennon, ‘Stairway to Heaven’ by Led Zeppelin were all released.
In the early 70s, modern institutional real estate investment was still taking its first tentative steps. UK pension funds owned property company shares, but did not generally invest in “bricks and mortar”. Schroders’ first real estate fund, such as they are known today, was launched in 1971.
As we celebrate 50 years of real estate management, we look at how the industry has grown and changed, what we’ve learned and ask what comes next.
Lesson 1 - Investors are not at the mercy of the economic growth cycle
Traditionally real estate has been viewed as a cyclical asset class, with rents and returns driven by the economic cycle. Logic therefore dictates that investing for returns is all about timing. This may, to some extent, hold true when looking high level at the market as a whole. However, it does not hold true at the individual asset, nor even sector level.
One need only look at the big divergence between industrial and retail real estate returns since 2015. Occupier demand is not simply a function of GDP growth; long-term structural forces are also critical.
Industrial is not the only example. More recently a number of niche property types – from convenience stores to data centres and – have experienced long-term structural changes in demographics, social norms and technology. They have also proven relatively defensive through the GDP declines caused by Covid-19 disruptions.
By the same token, shops and shopping centre vacancies are rising as shoppers move online. Existing retailers are either failing or closing stores, while investing more in their websites and supply chains. Similarly, the switch to hybrid working and the growing emphasis on energy efficiency and staff wellbeing is cutting the demand for older, secondary offices.
So one lesson is to follow structural trends. No matter how good an investor is at stock picking, or market timing, it is a lot easier to swim with the tide than against it.
Lesson 2 - Investors need to adopt a “hospitality” mindset
Until the recent past, building owners only communicated with their tenants when strictly necessary. The old saying went that “every phone call could trigger a maintenance question”. Negotiations were regarded as a zero-sum game; someone only won when the other lost.
The lease stated the amount of rent the tenant had to pay, irrespective of whether their business was a success or a failure. No allowances were made for variances in the type or amount of space needed. Services were largely limited to the rent of the square meterage, with tenant paying for a standard fit out.
Recent developments have reminded the industry that in fact all real estate is operational. The payments of rent are hugely dependent on the success of the business.
Some investors still wish to keep their tenants at arm’s length. But a growing number now recognise that there is more to be gained by entering into a regular dialogue and building a constructive relationship. Doing so can ensure the building can actually be an enabler to the success of the tenants’ businesses. This is a full change of attitude. This change of heart reflects two main factors:
- First, even before Covid-19, an “individualising” consumer meant that the world was becoming less predictable. Businesses were having to adapt more quickly to technology and other structural changes. The growth in serviced offices and on-demand warehousing has, in part, been driven by occupiers’ desire for flexibility.
Landlords engaging proactively to provide this flexibility – both in services and contract terms - can ensure their asset is an effective part of the tenants’ business operations. As a result, it is more likely to collect a higher rent and, importantly, less likely to become obsolete.
- Second, the growing focus on sustainability and health means that landlords and tenants now have a clear common interest in optimising the use of buildings. The built environment accounts for 40% of global CO2 emissions, mainly due to cooling, heating and lighting homes and commercial buildings.
Cutting energy usage, generating clean electricity on site, conserving water, reducing waste and adapting buildings to cope with extreme weather will become ever more important. The pandemic has also highlighted the need to improve staff health and well being. Things like upgrading air conditioning, providing quiet areas, enabling people to control heating and lighting and adding cycle stores have become priorities. Employees are more likely to return to the office and contribute to the business culture when the right services and support are on offer.
We believe that investors who adopt this “hospitality” mindset – treating each building as a business by itself and offering the right services and support to tenants - will achieve superior performance. This is true both of financial returns and ESG objectives. Minimising waste and finding the best contract model for both landlord and tenant is mutually beneficial. Investors who continue to keep tenants at arm’s length will be left with stranded assets.
Lesson 3 - Ignore the supply side at your peril
Rent levels reflect the balance between the demand and supply of space. Responses to demand are often delayed given time to completion in construction. This means so-called “pork cycles” have always been a feature of real estate and other capital intensive industries, such as semi-conductors, or container ships.
Pork cycles refer to the dynamic of rising investment when prices are high, but the effects of which are not seen until a new generation of livestock arrives. It is a similar production lag as appears in real estate development.
All other things being equal, pork cycles obviously have had less of a detrimental impact on rents in supply-constrained office markets such as central Paris, New York and the West End of London. These markets have delivered stronger rental growth and higher returns than more developer-led markets like La Defense, Atlanta, Frankfurt and the City of London.
That said, the risk of building booms and an over-supply of space has reduced since the Global Financial Crisis (“GFC”). According to Property Market Analysis, total office completions in Amsterdam, Berlin, Brussels, Frankfurt, Hamburg, London, Madrid, Munich, Paris and Stockholm were a third lower in the ten years to 2020 than in the previous decade.
One of the few silver linings of the GFC was that banks’ capital adequacy rules were tightened and banks are now much more reluctant to lend on speculative building projects. At the same time, potential profits on developments have to be offset against the opportunity cost of zero income and liquidity during the construction phase. The lower level of new building in the 2010s resulted in low vacancy rates in many densely populated urban areas. This helps explain why office rents are expected to fall less as a immediate result of the Covid-19, than in previous recessions.
Looking ahead, the need to cut the carbon emissions generated during the manufacture of cement and steel is likely to further limit new construction and encourage more conversions and refurbishments of existing buildings.
It would, however, be wrong to conclude that investors should simply avoid development altogether. Long-term structural trends (e.g. ageing population, individualism) and new schemes can generate their own long-term demand, once occupiers become familiar with the concept. In addition, new buildings can play a major part in regenerating rundown areas. While initial returns may be modest, some urban renewal projects have delivered strong performance when measured over a 10- or 15-year horizon.
“If you build it, they will come” is a high risk strategy, but developments which lean into a structural shift or trend can pay off significantly.
Lesson 4 - Occupier markets are local, investment markets are global
One of the biggest changes in real estate markets over the last 50 years has been the growth in cross-border investment, both for portfolio diversification and access to attractive risk-adjusted opportunities.
In 1971, virtually all real estate was owned by domestic investors. International investment was severely constrained by exchange controls, and in some countries laws either banned foreign owners or heavily penalised them. By contrast, today most of those investment barriers have gone. The introduction of the euro in 1999 gave a further boost to cross-border deals in Europe.
Over the last five years, international investors have bought €1.25 trillion of real estate around the world, accounting for 30% of transactions. The exact sources of capital ebb and flow over time. It might be sovereign wealth funds out of the Middle East one year, Asian investors the next. But this growth in international capital is likely to continue as investors look to diversify real estate holdings away from home markets.
In general, the greater diversity of investors with varying rates of capital has meant that real estate has become more liquid, particularly in “gateway” cities such as London and Paris. However, there is a happy balance between domestic and foreign capital to look out for. Some smaller investment markets, which rely heavily on foreign capital – such as Polish shopping centres or Italian logistics - froze during the eurozone sovereign debt crisis of 2010-2013.
Furthermore, there is the inevitable paradox that some of the diversification benefits have reduced as movements in real estate yields have gradually become more synchronised across cities. The average correlation between prime office yields in major European cities rose from 0.2 between 1982-2000 to 0.6 between 2001-2020 (source Property Market Analysis).
The same is not necessarily true for rents, which remain subject to local demand and supply pressures. As we have specifically seen during the pandemic, rents are also heavily influenced by local regulation. It will be interesting to see whether these local regulatory influences will have a bigger impact on capital markets going forward.
Lesson 5 - Investors can either have real estate returns, or liquidity, but not both
Real estate has moved a long way from an industry which 50 years ago was dominated by local partnerships of surveyors and where deals relied on the “old boy network”. The growth in cross-border real estate investment has helped to significantly increase liquidity and transparency over the last 50 years. A number of other changes, often inter-related, have also played a part, including:
- The creation of large publicly, listed agents offering multiple services internationally
- The launch of multi-national funds
- New professional standards
- The growth of sale and leaseback deals which has liberated large amounts of real estate from owner-occupation
- The big increase in real estate data and research, which has aided transparency.
Recent innovations such as big data, or blockchain, which promises to reduce the amount of time (and travel) involved in due diligence, should further increase liquidity.
Yet, while real estate has become more liquid, it is still a physical and heterogenous asset class. It will therefore never be as liquid as equities and bonds, which can be traded electronically.
One of the lessons of the last fifty years is that attempts to offer both real estate returns and instant liquidity (e.g. open-ended funds with immediate redemptions, derivatives), work in a bull market, but typically unravel when real estate values start to fall.
The German open ended fund industry suffered an existential crisis between 2008-2013 with a wave of redemptions and forced sales as a result. But the open ended industry has since re-invented itself following a series of reforms, including minimum investment periods, structured redemption windows and improved transparency to investors. Portfolio size and composition, the quality the assets and governance make a very important difference.
REITs are often referred to as a good hybrid. On the one hand REITs can deliver returns similar to the underlying real estate market if they are held for two or three years and have modest leverage. Although the correlation between the MSCI UK Monthly Total Return Index and the FTSE EPRA NAREIT UK REIT Total Return Index is almost 1 over a three-year holding period, it falls dramatically if measured over a three-month period.
In the short-term REITs are subject to general stock market fluctuations, thereby diluting some of the diversification benefits of investing in real estate and they do not offer the same control and ability to add value as “bricks and mortar” assets.
The physical attributes which make real estate attractive also contribute to its illiquidity. They are two sides of the same coin. Anyone who claims to be able to provide the former without the latter is practising modern day alchemy.
Flexibility and variety
The final piece of the puzzle is that institutional investors are far more demanding now than they were half a century ago. A limited allocation to a pool of funds may have sufficed as alternative investment allocation in the past. Institutional investors now need a trusted and innovative partner, one that can think outside the box and “solve” more complex balance sheet allocation questions. Real estate managers therefore need to have a deep understanding of their clients' requirements, extensive experience as well as the resources to truly understand the market. Investors need to understand wider capital markets, and combine the knowledge with top down research capabilities on long-term trends and short term disruptions. In addition, on-the-ground presence and the ability to find and proficiently operate their assets is crucial.
Building on the old to create the new
“Building back better” is a term often used by many politicians these days. We like to think about building on the old to create the new. Flexibility in approach and mindset, in ever changing markets, is key. Those who can learn from the past to find answers to tomorrow’s questions will shape the next 50 years.
Unstructured Learning Time
- Real Estate
- Private Assets
- Market views
- Investment Trusts