At a time of heightened market uncertainty and volatility, what strategies should investors in European real estate be taking? Indraneel Karlekar, global head of research at Principal Real Estate Investors, gives his views.
As the macroeconomic environment shifts dramatically, with further interest rate hikes in the offing and a recession looming on the horizon, large investment managers are reviewing their game plans and assessing how to navigate the many headwinds.
One such firm is Principal Real Estate Investors, which manages close to €6 bn of property assets in Europe and over €105 bn worldwide on behalf of institutional asset manager Principal Global Investors. Its advice to investors for the next 12-18 months is: focus on ‘resilient asset classes’ and ‘income-oriented investment strategies’.
During a visit to Amsterdam in late June, the firm’s global head of research & portfolio strategies, Indraneel Karlekar, detailed what that means in practice. ‘In the current inflationary environment, where geopolitics is colliding with tightening monetary policies, investors should focus on stability of income,’ he told PropertyEU. ‘Global economic growth will slow so we recommend investors focus on sustainable and resilient investment drivers as anchors to their investment portfolios.’
Karlekar listed industrial and logistics warehouses, data centres, science parks and laboratory space, care homes and (affordable) housing as property types all underpinned by ‘resilient demand drivers’ and therefore able to provide valuable income streams in the face of adversity. These drivers, which Principal refers to as DIGITAL (Demographics, Infrastructure, Globalization, and Innovation & Technology) themes, have accelerated in recent years, propelling the growth of formerly niche, or non-traditional, property types and pushing them into the mainstream.
Although the industrial and logistics sector has been booming for several years and may arguably see yield compression come to an end after prices tightened further during the pandemic, it remains firmly on Principal’s radar. Said Karlekar: ‘Industrial falls within the framework of our “digital” strategies because we think long term there are some very compelling attributes to the property type. It’s structurally driven, the trends that have propelled it to where it is today such as e-commerce are not going to go away.’
While acknowledging there were differences within Europe in terms of e-commerce adoption and economic outlook, the bottom line is that it remains a solid investment bet, noted Karlekar. ‘Some markets which have really embraced the e-commerce surge and are more advanced in terms of adoption might see NOI [net operating income] soften a little because of the economic slowdown. But other countries where e-commerce penetration is still nascent are not likely to see the same kind of weakness,’ he said. ‘How you access those opportunities is going to be interesting. Buying core industrial assets at low yields becomes less attractive when your cost of debt has gone up significantly, so I think people will be redoing their total return calculations.’
Industrial development
Principal is also keen on ground-up industrial development in Europe, where it has a portfolio totalling over £1 bn (€1.2 bn) and nine projects under construction or committed to across Germany, the UK and Spain. ‘We’ve been doing it for the last five-six years in Europe on behalf of some big separate account clients. We think there’s a real advantage to development, as the yield on cost is higher than your stabilised cost - but obviously developing in Europe is a lot more complex than in the US due to regulatory and zoning requirements,’ said Karlekar.
Data centres are another high-conviction theme, despite high barriers to entry, tight supply and growing land and energy issues in Europe (see below). The asset class is an example of the niche, or alternative property types which Principal believes are worth pursuing due to their structural resilience and ability to outperform cyclically challenged sectors. Life sciences real estate, encompassing specialised laboratory space, is another. The firm says long-term analysis of such segments in the listed sector - which embraced them earlier than the private markets - demonstrates their long-term resilience.
In the residential sector, the firm favours single family rental (SFR) and multifamily housing (MFH) – ‘although affordability has become a very big issue across the world’- as well as care homes. Said Karlekar: We’ve been investing in care homes for a while, particularly in Germany where we have quite a large senior living portfolio. The story there is structural – an ageing and rich population, plus the state has an important role to play, so we like that strategy.’
Principal is also examining student housing, but is ‘still working through how to access that market’ in Europe. ‘We haven’t stepped into the space yet because there’s already quite a large, well established set of operators that have done really well. For us the challenge is to find the edge, so it’s a market we are still investigating,’ Karlekar explained.
Recession on the cards
Turning to the prospect of a recession in Europe and the US, the head of strategy said: ‘I wouldn’t be surprised if it happens over the next 12-18 months – all the conditions are in place, rates are rising, energy prices are elevated, consumers are getting hurt by high inflation, and the labour market is seeing signs of weakness.'
He added: ‘I think in some ways the question has now moved more to: what sort of recession is it going to be, and how long is it going to last?’
Some European markets will get hit more than others, he noted. ‘Germany, for example, is very exposed because of its high dependence on Russian energy but also because of its large manufacturing base.’
For real estate investors, said Karlekar, it will come down to looking at which property types are affected most by the downturn. ‘I don’t think anybody really expects a GFC type of recession. We don’t have the same sort of issues that were there 14 years ago, such as high leverage, oversupply, inflated rent growth.’ He quipped: ‘It almost feels like it’s a recession being orchestrated by central banks to let some of the air out [of the economy]’.
Interest rate hikes
On the subject of rising interest rates, Karlekar said higher rates per se were ‘not necessarily a headwind’ to real estate, noting that historically the asset class had performed well amid a tightening environment. The impact on private values ‘shouldn’t be that bad’ as long as investors continue to focus on strong income streams. ‘Of course private values are not untouchable, and as a result of the slowdown and the recession we will likely see some values correct, but the lower volatility of private real estate and the steadiness of the income stream should help to offset the hit – and the ability to capture some of the inflation in rent resets will be an important part of that.’
Whether or not the European Central Bank adheres to a sustained programme of interest rate increases remains to be seen, according to Karlekar. ‘We’ve seen one hike already, and the second one is forecast for the fall depending on how quickly the European economy weakens - but who knows, we may not even need it? I wouldn’t be surprised if in the winter the ECB says: we’ve done two hikes and that’s enough for now.’
Summing up, Karlekar predicted that private real estate should weather the coming period of turbulence relatively well. ‘Investors looking across their book of assets will say: if it’s anything public it’s probably going to be very volatile, if it’s fixed income there’s probably going to be damage to the portfolio, so within alternatives/real assets, real estate is not a bad place to be!’
Plugging into data centres
Advances in technology coupled with a surge in data consumption – particularly during the pandemic which saw an abrupt shift to remote working and significant growth in streaming subscriptions – have catapulted data centres into the spotlight. These often vast buildings, which store digital information, process orders and handle shipping and supply chain logistics, are attracting increasing investor interest in Europe due to the long-term, structural tailwinds supporting the sector.
Principal Real Estate, which earlier this year completed the first close of its inaugural European data centre fund with a higher than expected equity raise of €155 mln, is a strong proponent of the sector’s ‘defensive’ characteristics. It lists growing demand, triple net lease contracts and the potential for fixed or indexed rental uplifts, as well as high tenant retention as some of the benefits of the segment.
But there are also downsides, it warns, relating to supply side constraints, power shortages across Europe and moves by local authorities – notably in the Netherlands and Ireland – to restrict zoning permits and curtail new development.
To access this increasingly tight market, investors are therefore having to consider a range of opportunities from core to opportunistic or value-add assets ‘which require capex to get them up to speed’, the firm notes. Other strategies include moving from Tier 1 to Tier 2 and Tier 3 markets such as Barcelona, Milan and Manchester, focusing on smaller assets rather than hyperscalers, developing ground-up data centre assets pre-let to operators, and acquiring stakes in data centre operating companies.
