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A new age
After a long bull run in European real estate markets, almost uninterrupted by Covid-19, we may be on the cusp of a ‘third age’ for the asset class. The ‘first age’ was the period up to the 1980s, when there were no reliable indices and little cross-border investment. The second age is from the late 1980s to the present day in which global indices are standard and real estate has become a financial product via structures such as mortgage-backed securities. The third age looks set to be one in which achieving net zero emissions becomes the defining factor governing usability, ability to let and profitability.
Of course, the ‘normal rules’ will still apply - the balance of supply and demand, the ability of tenants to pay rent, depreciation and obsolescence, and even the ‘wow’ factor which makes a tenant want to occupy a building. However, of the three themes emerging for 2022, only one is a ‘traditional’ factor - inflation. The others are game-changing features of the market which will require completely new ways of assessing the asset class. Each brings costs, risks, and opportunities, but the impact of getting them wrong could be significant.
1. The inflation dragon
The dragon of inflation, having been slayed by central banks in decades past, is threatening to rear its head again. If that happens, real estate may keep pace and therefore provide a useful hedge. When prices rise in the general economy, companies’ revenues (in nominal if not ‘real’ terms) tend to rise and rents do too. In continental Europe in particular, virtually all leases are automatically indexed in line with inflation (usually CPI) which can give investors additional comfort.
Two factors, however, make it dangerous to assume all properties benefit in such scenario. First, if open market rents in a particular location don’t rise along with ‘indexed’ rents, tenants will simply vacate a building when the lease expires to take advantage of cheaper rents elsewhere. Second, property has historically kept pace with moderate price rises, but if inflation spirals out of control (e.g. 10 per cent or more), property tends to be less correlated. Investing in good buildings with high environmental standards in markets that aren’t oversupplied and letting to tenants with sustainable business models will be crucial to withstanding persistent inflation, even if rents in general are rising.
2. Changing use of buildings
Real estate professionals used to talk in near-certainties about certain aspects of the market: what made something prime as opposed to secondary, whether certain cities were always ‘in demand’ from certain types of companies (e.g. financial services in London); or how much investment a building might need to be upgraded in future (e.g. the lifespan of air conditioning units).
This was partly because society tended to use buildings in the same way - we all worked in offices, goods were manufactured in warehouses, we bought things in shops. In recent years, we have bought ever more online and less in the high street, and large warehouses at motorway junctions have effectively become the ‘new retail’. Now the question is how far offices will be affected by new hybrid working patterns post Covid-19. Will these shifts in behaviour create permanently lower structural demand?
Similarly, the ever-increasing use of technology, not just for shopping but for communicating, saving and ‘zooming’ from home, increases the need for more, and more efficient, datacentres close to cities to ensure reliable speeds. We’re all getting older - we need more and different types of leisure to keep us fit, different types of living and care in old age, and more healthcare facilities.
None of these trends is new (even ‘working from home’ was growing at a rate of 4-5 per cent per year before the pandemic), but the trends are rapidly accelerating as the world adjusts to a post-pandemic state. It takes time to buy and sell property, so there is an urgent need to start diversifying portfolios now, to ensure exposure matches a modern economy where people and businesses use buildings in very different ways to the past. Indeed, real estate investment trusts are showing the way in which the subsector make-up may change for private sector funds (see charts).
3. Net zero
Real estate is central to achieving the Paris Climate Accord targets designed to limit global warming to 1.5 degrees. The ‘easy wins’ to reduce emissions - installing efficient lighting, adding smart meters to manage energy use better, or recycling waste - are marginal, and the sector must now navigate not only removing gas boilers, but also working out what to replace them with.
The best real estate fund managers have historically been brilliant negotiators and experts in contract law. In essence, the landlord’s obligation has been to provide a building, and a tenant’s to pay the rent, with the relationship entirely based on the lease agreement. But things are changing.
What if the tenant is a careless polluter of the environment? Should the landlord care and can they even do anything if the tenant is meeting their obligations under the lease agreement? What about the tenant who is ‘clean’ themselves, but deals with a munitions company or a coal miner in its supply chain?
Historically, these areas were nothing to do with the landlord. Now they are becoming central to whether the building is a successful investment or not because investors are starting to demand that the ‘impact’ (environmental but also social) is measured, monitored and improved. The path to net zero needs to be demonstrated with clear improvements every year, not just as a distant policy aspiration.
It is therefore becoming acceptable to engage with tenants about their environmental activities, policies, or targets, irrespective of their obligations under the lease. Most net zero targets have been set for 2035, 2040 or later, but these mask the urgency of the action needed now.
With the risk of buildings becoming ‘stranded’ in the future (e.g. if they don’t meet stricter ‘green’ regulations and are not permitted to be let out to tenants), investors cannot afford to wait.
Despite cost and technology challenges, continuing to be successful tomorrow means starting to reposition holdings today, both for the low-carbon transition, and in the nearer term to cope with inflation and changing building use.