Private Real Estate – Desperately seeking Diversification?

It’s clear that private real estate has been in focus with allocators for some time.  For much of the last five years, institutional investors have been keen to build private markets allocations to augment performance.  Real estate has been a major part of that shift.  The attractive blend of current yield allied with the potential to grow income and create value through active management continues to appeal to investors who have been starved of yield and concerned with record high equity valuation.

Indeed, the relative attractiveness of real estate looks set to grow, as in recent months, the surge in CPI has re-invigorated the sectors appeal as a potential source of diversification during periods of rising inflation expectations.  In Europe, the correlation between inflation and property returns has historically been driven by the nature of real estate cashflows.  European leases are generally index-linked, creating a direct pass-through effect from CPI to rents.  Equally, the ability to grow rents by exploiting demand and supply imbalances is also central to the appeal of the sector when prices rise. 

We believe it is possible to boost the benefit of this effect by focussing on sectors where there are strong cyclical and secular demand tailwinds and where supply is likely to remain constrained due to low vacancy and limited development activity.  There are a handful of sectors where such demand/supply imbalances are likely to persist.   The most scalable opportunities include:

Last-mile urban logistics assets

Demand from ecommerce users for last mile sites continues to massively outstrip the supply of good quality logistics assets located close to the consumer.  Rents are rising dramatically, and the shortages are so acute that demand is spilling over, fuelling significant repurposing activity in uses such as retail parks.

High quality ESG oriented office in innovation centres

The return to the office in Europe has been more positive than many expected. Although the effects of the pandemic-induced demand shock are still visible in elevated vacancy rates, this is concentrated among lower quality stock – grade A space remains in short supply. In fact, we think capacity constraints and rising costs in the construction sector mean that Covid’s shock to supply, not demand, will be the defining feature of European office markets in the coming years.

In the key innovation hubs where demand is growing rapidly and supply is constrained, this has the potential to drive rental growth for well located, properly amenitised assets with high energy ratings.  We can already see evidence of this in our portfolio in London, Birmingham, Dublin, and Barcelona.  Increasingly, it also seems likely that, given the lack of new supply and less construction activity, rising demand will spill-over from Grade A into a broader range of good quality, certified ESG assets.

Living strategies focussed on key demographic niches

Across a range of different sub-sectors, we observe a continuing mismatch between demand and supply in the living sector:  multi-family remains under-supplied across Europe and rents continue to track ahead of inflation; the aged living sector is poorly provisioned, and the demographic and wealth dynamics are extremely compelling; the student housing sector remains highly fragmented and is primed for significant growth.

We believe that by balancing these strategies carefully, an investor looking to maximise risk adjusted returns during a period of rising inflation risk will be well placed. Building allocation to these tailwind-oriented themes at a point of acute supply constraint while the cost of fixed rate debt remains low, seems like an attractive and simple way to maximise diversification, and reduce correlation to other asset classes.  Such diversification may prove to be increasingly valuable over the coming five years.

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