Alternative property sectors can offer investors higher risk-adjusted returns, greater diversification and lower volatility. Daniel Bowden and Joanna Turner explain
In this period of heightened global market uncertainty, investor risk aversion has climbed to high levels. In Europe, this has led most commercial real estate investors to defer investment, or only acquire prime assets in ‘safe haven' markets. But investing in alternative real estate assets could provide investors with higher risk-adjusted returns than they could achieve on traditional real estate assets, while providing additional diversification benefits and, for some of them, lower volatility of returns. A key differentiator is the weak correlation of the occupational demand drivers with those of the traditional real estate sectors.
The alternative real estate market encompasses many types of assets, ranging from student accommodation to healthcare and automotive assets. In Europe, the sectors are highly fragmented and still in their infancy as investable asset classes, often with low levels of liquidity and transparency.
In effect, investors are receiving a liquidity/transparency premium, although this could be eroded (with a commensurate uplift in value) as data availability and market intelligence improves. One example of this is the newly introduced Investment Property Databank (IPD) UK Healthcare index, which shows that the sector outperformed the all-commercial property index by 7.1% per annum over the five years from 2007.
In terms of pricing, there is a weak positive correlation between the yields of office and retail investments and those of care homes and student accommodation. Although yields in all of these sectors have been falling since the fourth quarter of 2009, there is still a yield premium of around 60-70bps for UK care homes and student accommodation, office and retail assets.
In continental Europe, yields for these types of alternative assets are typically around 150bps higher than comparable assets in the UK. These spreads reflect not only lower levels of liquidity and transparency, but also a premium for investors' perceptions of the depth of the tenant occupier market and obsolescence. There are clearly risks associated with investing in these sectors, but we believe that current yields are priced at an attractive premium to the mainstream sectors.
Demand for student housing in the UK has increased with the strong growth in student numbers that has been fuelled by a demographic bubble, a structural change in the economy, increasing participation rates and weak prospects in the jobs market. In 1979, only 12% of British school leavers entered tertiary education. By 2010, that figure had reached 45%.
There are now over 2.3m students in tertiary education in Britain, slightly more than in France or Germany, which have larger populations. From September 2012, the UK tuition fees cap will rise. This means the growth in student numbers from undergraduates could fall as prospective students are deterred from studying. Nevertheless, demand for university places is expected to remain robust due to the continuing weak jobs market and the perception of better career prospects for graduates compared with non-graduates when they leave university.
A greater risk in the short to medium term is the expected decline in the student-aged population. The demographic bubble is set to reverse as ‘baby busters' move out of traditional studying ages (18-25 years), and the number of people aged 18-20 years in the UK is forecast to fall from 2.1m in 2010 to 1.8m in 2020. While key university cities such as London, Oxford and Cambridge should experience continued growth in demand from foreign students, third-tier universities and associated facilities may see falling numbers.
Overall, nearly 700,000 university applications were received in the UK in 2010. In comparison, universities provided just 150,000 bed places. There are significant regional differences; London is particularly under-supplied with bed places, while some regional cities have adequate supply. Outside of the UK, in university cities across Europe, supply is limited, the quality is generally poor and the supply of investment-grade student accommodation is still in its infancy. As universities throughout Europe face funding cuts, they appear to be increasingly reluctant or unable to fund the provision of new or upgraded student accommodation.
In these key markets, where supply is restricted and demand is robust, there is an opportunity to take advantage of this supply-demand imbalance, either through development or investment in purpose-built student accommodation in major university cities in the UK and continental Europe, particularly France and Germany.
In contrast, the healthcare property sector is predominantly driven by an increase in the needs of an ageing population in Europe and subsequent increased spending on healthcare. Between 2004 and 2009, average healthcare spending in Europe rose at approximately 6% pa compared with 2% pa for CPI inflation. Between 2010 and 2020, the number of people aged over 65 years is forecast to increase by 18%, and the number of the very old-aged by 24%.
While we expect increased patient demand for healthcare facilities and care home beds, the public sector in the UK is increasingly being squeezed as a result of austerity measures. This is forcing local authorities to cut costs by reducing healthcare expenditure, even closing hospitals. The primary healthcare sector is expected to be more resilient as the focus of future government healthcare policy is expected to remain on local community services. But there is a risk that future changes in public healthcare policy could reduce the supply of public healthcare assets.
Although these policies vary across Europe, most governments are under similar pressures to reduce costs. This could have a two-fold effect on the market: an increase in sale and leaseback opportunities of healthcare properties let to public authorities and medical staff; and an increase in the development and supply of healthcare provided by the private sector.
There are signs that investors are increasingly aware of the potential benefits of investing in alternative sectors. While the UK market has been active for some time, France, Belgium and Germany have recently been receiving active interest from institutional investors.
A recurrent theme of attractive alternative investment sectors is resilient occupier demand. By adhering to an investment strategy that focuses on this aspect it is possible to acquire mis-priced assets with robust income streams, long leases and at significant premiums to core assets with similar characteristics. The investment spectrum can be further expanded to include overlooked assets such as police stations (long-term leases to the government) and even certain types of automotive assets (benefiting from planning protection).
But all this comes with a caveat: while there is good evidence that excellent risk-adjusted returns are available, achieving this result is unlikely to come via simply taking advantage of positive market effects. Our experience has shown that investment in these sectors requires, first, an intimate knowledge of the tenant's business and the market within which it exists, which is then combined with traditional real estate investment expertise required in mainstream sectors.
Due to its still emerging nature as an institutional asset class, investors are receiving a liquidity-transparency premium, but this premium should be eroded over time, as the sector becomes more in demand from institutional investors and transparency improves. In addition, the potential for higher returns than those achievable on mainstream property assets combined with portfolio diversification benefits should lead to greater demand from institutional investors for alternative real estate assets.
Until this occurs, asset mis-pricing is likely to persist, although the risk-adjusted returns appear to be attractive for the experienced investor.
Daniel Bowden is fund manager of the Alternative Property Income Venture, and Joanna Turner is senior property analyst at AXA Real Estate