The Alternative Future of European Real Estate
After what seems like a long long hiatus, last week I finally had the chance to speak at a conference again. In person. Or I should say, I had the pleasure. Because who knew that getting in a cab, waiting in line for airport screening and boarding, and all of that in reverse at too early an hour, would ever feel like true joy?
The IPE Conference in Copenhagen felt like the first sunny day in Spring, with almost 300 real estate investors getting together to learn about the post-pandemic state of the European real estate market. And of course to mix, mingle, laugh, and have the occasional drink. COVID-19 felt like something from the distant past, as did some of the direst predictions about the future of the real estate sector.(I made my own predictions in March 2020.)
Indeed, most property types have flourished in the face of the pandemic. First and foremost, the much-discussed logistics sector, benefitting from a dramatic surge in online shopping, but the residential sector also has done quite well, flying high on the tailwinds of very limited construction during the post-GFC years. Not great for tenants, but undersupply is driving up rents for both logistics and residential real estate. Pricing of logistics and multifamily assets has also skyrocketed, in large part thanks to the largesse of the European Central Bank and local governments, lowering the cost of debt and leading to a wall of capital flowing in from institutional investors, eager to earn some form of return on their capital.
The black sheep of the real estate sector, retail and lodging, seem to have weathered the crisis somewhat better than expected. Hotels are slowly filling up again, and there is a very limited number of distressed assets on the market (of course, Blackstone swooped in to take some hospitality REITs private, taking advantage of the dislocation of pricing in the public market). Most types of retail weren’t doing great to begin with, but the pandemic hasn’t led to the total bloodbath that we all expected, with most tenants remaining in business and rental payments starting to pick up again. As long as nobody sells, the pain of capital depreciation can be pushed down the road (of course, not so for listed retail REITs like Unibail Rodamco Westfield, which is still down more than 50% compared to pre-crisis levels, reflecting what valuations in the private market should really look like. But hey, let’s not spoil the party...).
Investors though, have moved on from the retail debacle. And they are also less excited about offices as a core building block of their portfolio. The extent of “the return to the office” will be the ultimate determinant for the long term success of the office sector, and the jury is still out. The real estate sector seems to believe that we will all be back in the office in short order, with limited work from home, but employees may think about this differently. A hybrid form of work, with the majority at home, would lead to a substantial change in the demand for offices. Remember, in real estate, small changes in demand can have a big impact. So, there is a lot of uncertainty about rent growth and the pricing path in the office sector. What seemed to be “core,” or stable assets, now come with potential volatility.
If not office and retail, what else are investors allocating their capital to? Enter the rise of “alternatives.” Think data centers, healthcare, senior housing, medical offices, life science parks, self storage, student housing, cold storage, etc. All of that is bundled together under the banner “alternatives,” but the reality is that all these other property types constitute an increasingly large share, compared to some of the “traditional” property types. A quick look at the composition of the European listed property market shows that retail represents just 7.5% of the total market cap of the FTSE EPRA Index (107 listed property companies). Residential is almost 30% (thank the big German residential owner/operators for that). Healthcare is 3.5%, self storage 2.3%. Diversified is 28%. There are very few data center owners in Europe, but in the U.S., they represent 9% of the FTSE EPRA Nareit Index already, whereas healthcare is at 8.4% and self storage at 6.6%.
Beyond the fact that office and retail have become less attractive from a demand perspective, there’s another thing to note about the attractiveness of “alternative” property types. Their capital expenditure requirements are MUCH lower! As shown below (shoutout to Brian Klinksiek of LaSalle for these numbers), the average capex expenditures as a percentage of net operating income are 20% for office, retail, etc, as compared to just 10.7% for storage, single-family rental and healthcare. That’s a direct and significant return enhancement. (Many of the alternative property types are “triple net,” which means the tenant takes care of equipment and its maintenance.) Looking at NOI forecasts over the next couple of years, the numbers look much more attractive for “alternatives,” with average growth of 5.7% on an annual basis, as compared to what I think is an optimistic 3.7% for traditional property types (traditional includes logistics and multifamily, which likely skews the average).
Looking ahead, when it comes to the securitization, or investability, of commercial real estate, the U.S. seems a forebode of what is to come, with much more capital flowing into non-traditional property types. And for good reason: there are attractive returns to achieve! I’m curious how quickly we’ll change our vocabulary of what is traditional and what is alternative -- what are “alternatives” now are poised to become “traditional” in this decade. That doesn’t mean the end of retail or office, but likely an increase in yield (or lowering of prices) to reflect their increased risk and lower rent growth.