“Demographic trends are reshaping the way we use real estate today, leading to new opportunities in the sector.”
What are the fundamental reasons for investors to consider direct real estate investing at the current time?
The first reason making real estate investing particularly appealing in today’s environment is that the market can offer interesting entry points at times of volatility in the property sector. Where some asset owners see reason for concern and decide to exit certain markets at all costs, we see a hidden opportunity to benefit from attractive below-market entry pricing driven by non-rational decisions to sell.
The second reason is real estate’s ability to generate market-independent returns. Especially in times when stocks trade sideways, real estate is a valuable source of diversification thanks to its low correlation to traditional asset classes. In effect, real estate can deliver compelling risk-adjusted returns irrespective of market moves and across cycles, as its performance is driven mainly by two components: current income of 3-7% cash-on-cash annually, and alpha generation through active asset management.
Today we are probably at a turning point in real estate investing. With capitalisation rates (net operating income divided by current market value) having compressed, pushing up the prices of assets, value-creation strategies are ever more compelling. Value-add can be created through improving a real estate asset from a bricks and mortar perspective, or by improving the asset’s use and operational efficiency, i.e. “sweating” the asset more. For instance, adapting an office space to address the changing needs of modern tech companies or reducing a building’s energy consumption. Private real estate benefits from the luxury of time: its long-term investment horizon allows for intrinsic value creation independent of market swings.
A last reason to consider investing in real estate is downside protection. Tangible assets retain a residual value over time – the “bricks & mortar” component. Even in times of volatility, property will maintain a latent value, and even more so if the quality of the asset and the location are good. Moreover, real estate serves as an inflation hedge (albeit imperfect), as rents tend to be indexed against consumer price inflation.
You also believe that the European context is particularly favourable for real estate…
We still have low interest rates in Europe, with the current spread of property yields over 10-year government bonds near all-time highs. This makes European real estate particularly attractive compared to other asset classes. While an increase in interest rates could weigh on property yields, we believe it would take a hike of at least 150 basis points before there is any real move in capitalisation (cap) rates. Given the current political instability in Europe, we do not expect to see that anytime soon.
Meanwhile, the underlying fundamentals are supportive. One important factor in Europe’s favour is that, except pockets like Dublin, London and key German cities, there has been limited rental growth in Europe overall since 2008. In the aftermath of the global financial crisis, there has been an unwillingness to lend or to invest in development projects. Hence, compared with the US, there has been little new construction of new real estate in Europe or renewal of existing stock during the past decade. So now, as economies recover, with unemployment falling, demand has been outstripping supply in many locations. In Europe overall, office occupancy has reached 93%, and in some places around 95%, which makes office availability a structural issue. There is presently a positive imbalance between demand and supply, meaning there is significant scope for rental growth in some markets. Then there is the question of what size and type of offices one builds to meet the changing needs.
In what areas do you think direct real estate investing can create value in Europe?
Europe is not as advanced in the economic cycle as the US, and base rates have not risen yet, meaning the opportunities for value creation in Europe are immense, whether in terms of refurbishment, building additional space or turning smaller assets into portfolios for institutional investors. Overall, institutionalisation—the running of real estate assets by professional managers—is still at an early stage in Europe (under 5% of private rented accommodation in the UK is managed professionally, for example).
Demographic trends are reshaping the way we use real estate today, leading to new opportunities in the sector. For example, household formation is evolving: millennials today are contributing to the growth in single households as opposed to family ones; while when it comes to home ownership, they prefer to rent rather than buy. These trends will increasingly be felt in many European markets, giving rise to a need for modern, for-rent homes designed for single young professionals. At the other end of the spectrum, there is a growing need for specialised senior housing stock to accommodate Europe’s ageing population, as well as student housing to host increasing numbers of inbound international students.
In the office sector, the flexible workspace model is still at a nascent stage in continental Europe when compared to the US. As European technological hubs are emerging, there is an interesting opportunity to modernise the Old World’s office stock for tech occupiers. In retail, growth in new logistic hubs has trailed the shift in consumption patterns. Traditional retail, suffering in the US because of overbuild, is still growing in parts of Europe. Instore sales are growing in some locations, and well-sited shopping centres, perhaps with some repurposing, still hold potential.
Are there any particular markets in Europe grabbing your attention?
Some markets in Europe (Ireland and Spain, for example) are red hot and we expect short-term volatility, especially as economic growth starts to waver. But irrespective of our macro view, there are micro opportunities given how opaque real estate is. We are engaged in a ‘truffle hunt’, meaning that we are looking for deals that allow for “better than market” risk-adjusted returns. But that requires a well-trained nose in the form of origination capacity—in other words people based in local markets who can dig up off-market transactions.
Can technology and governance trends also be vectors of growth in direct real estate?
Real estate is one of the last industries to be disrupted by tech innovation. But proptech, a set of cross-industry technologies that is changing the way we research, rent, buy and manage property, is set to have a significant impact. Take the example of energy consumption: today, proptech solutions are allowing for an in-depth analysis of real estate assets’ environmental performance, making it possible for asset managers to become efficient, responsible investors. And when it comes to ESG (environmental, social and governance) investing, what differentiates real estate from other asset classes is that a responsible investment approach has an immediately tangible and measurable impact on the social well-being of the property’s tenants and surrounding communities.
With direct real estate investing very much in vogue, what more can Pictet bring to the table that its rivals can’t?
While direct real estate is a new initiative, Pictet has been investing in real estate since 2007. Our real estate team has decades of experience and has handled about USD30 billion in real estate transactions in the past eight years. What places us in a uniquely favourable position in real estate is our on-the-ground presence that allows us to go ‘truffle hunting’. Pictet has offices in 18 gateway cities in Europe, including 6 with dedicated real estate investment professionals. This allows us to really know and understand the peculiarities of each individual market, while many other direct real estate teams work almost exclusively out of London.