Real estate fund management needs to move with the times, write Andrew Baum and Valentina Shegoyan
House prices in Germany were down an unprecedented 10-15% in 2023. Austrian property and retail giant Signa declared insolvency in November. Other broken property companies which fell over in 2023 include Home REIT and property exchange IPSX in the UK. Meanwhile, the list of distressed owners seeking refinancing deals is growing. For example, it has been reported that the Bank of Ireland has appointed advisers to try to sell the £90m loan secured against 1 Poultry in London, but at the time of writing has had no success.
The inflation shock of 2022-23 driving up interest rates is the trigger for this malaise. It is the final nail in the coffin for real estate investors who have already been busy dealing with COVID’s impact on choosy occupiers, shorter leases, sustainability regulations and increasing operational complexity. All these factors are converging to increase investor risk and undermine property values. Meanwhile the UK Chancellor, Jeremy Hunt, is seeking to direct UK pension funds towards levelling up – so money traditionally invested in shopping centres and London offices is beginning to look at infrastructure and placed-based investing as an alternative. How will real estate investment managers cope with this perfect storm?
Rising interest rates are damaging commercial property values more than residential
As usual, higher interest rates are associated with higher inflation. This is not all bad for residential property, as inflation will usually push rents up, and in the residential market this can happen very quickly and annually. In the office market, however, the inflation-rent link is much less clear as rents are often fixed for three or five-year periods. Hence the rise in bond yields has largely passed through to lower commercial property prices.
Commercial real estate is not protected by demographics
We are seeing major demographic changes, one example being an increase in the average age. This has a largely hidden but huge positive impact on the demand for housing. But the retirement age has not increased, so the demand for commercial space has not been boosted in the same way. We have an accumulated shortage of three to four million homes in England and Wales. No such shortage exists in the office market.
Digital has disrupted commercial property much more than residential
Digital technology innovation has attacked the retail property sector as 30% of all UK sales are now online, boosting the demand for logistics space but hammering shopping centre values. The office market was next in line, as the move to three or fiyr days in the office reduced demand by 20-25%. We have to reduce waste, carbon and energy use in both the residential and commercial property sectors. Governments will have to find ways to incentivise homeowners to insulate their homes and to get rid of gas boilers. No such help will be offered to office investors, who are instead faced with the problem of managing potential stranded assets at a time of inflated materials prices.
Some assets will not justify the expenditure required to deliver what customers require, either because they are in the wrong place or because their design and condition makes refurbishment uneconomic. Asset conversions and repurposing to find the next highest and best use for buildings to justify retrofit capital investments are widely anticipated, with office to residential conversions paving the way. But these conversions are complex (and often impossible) to execute, and the economics of such projects become very challenging in the current interest rate and inflated cost environment.
There has been a shift towards operational real estate
On top of this, we can observe the hotelisation of the office market, meaning the growth of customer choice, the shortening of lease or licence agreements and the provision of services alongside space. The importance of active asset management has increased with a stronger focus on the occupier. Shorter leases mean more occupier management costs for investors, increasing the riskiness of the net cash flow.
The heightened operational risk means that specialist skills are required to manage these real estate assets. Net operating income is much more volatile, as the like of WeWork have introduced office investors to the idea of customer service and associated irrecoverable operating expenses. No longer can landlords sit back and clip the rent on a 25 year lease.
Active operational management means real estate investors need to invest in technology
Demographic, lifestyle and political changes (primarily expressed through the privatisation of former public services) have produced a need for new real estate formats, including private rental, affordable and senior housing, student accommodation, self-storage, co-working, medical centres and data centres. These operationally-intensive residential and social infrastructure sectors are less cyclical and have become increasingly popular with investors.
So investors have to consider very carefully how to work with, or become, operators. This implies developing strong relationships with customers and a deep understanding of the power of technology, especially building management systems and customer relationship apps. Maybe traditional investors can protect themselves from becoming obsolete by investing in tech-enabled customer-focussed operating businesses at the startup stage. This could be a highly productive marriage. After all, necessity is the mother of invention.
