As interest rates are rising, property investors will need to go back to basics and derive most of their returns from managing an asset well, rather than from yield compression. This return to basics is likely to benefit those parts of the property market that rely heavily on repositioning assets.
In an environment of falling interest rates, making money from real estate isn’t too hard.
After all, falling interest rates mean a widening of the spread between the cost of capital and the operational income, assuming that rental rates remain steady. As this spread widens and the yield relative to the cost of capital becomes more and more attractive, asset prices are likely to go up, resulting in a ‘compression of yield’.
Let’s illustrate this with an example.
If an office is worth $800,000 and produces a rental income of $80,000 a year, then it has a yield of 10 per cent. When the cost of capital is two per cent and falling, that is an attractive investment case.
As investors line up to buy into such an opportunity, it is likely the price of the asset will go up causing the yield to go down or ‘to compress’.
For example, if the above-mentioned property increases by $100,000 in value to $900,000 and the rental income stays the same, then the yield falls from 10 per cent to 8.9 per cent.
Investors who anticipate interest rates to fall essentially expect asset prices to go up to reflect the widening spread between the rental yield and the cost of capital.
That is the world we have lived in until recently.
Today, we find ourselves in an entirely different environment, where interest rates are relatively high and there are expectations that central banks will lift rates further, despite the recent pause in rate hikes.
If we now think of a scenario where the cost of capital is eight per cent and likely to rise, then a 10 per cent yield looks rather less interesting and is unlikely to cause an increase in property prices on the basis of the spread. Prices might even fall.
Yet, those real estate investors who rely for their performance on repositioning and managing their assets well will have the upper hand over those who simply relied on the falling interest rate environment in such a scenario.
Value-added real estate, a strategy that relies heavily on renovating, repositioning or even repurposing assets, could be a key beneficiary from the current economic environment.
“I can’t remember the last time I was this excited about market conditions!” Paul Hampton, Head of International Funds at PATRIZIA, says in an interview with [i3] Insights.
Real estate is not a perfect bond substitute. It always requires some form of proactive management – and that’s especially the case when markets turn, as they have done
“The thesis for investing in real estate has fundamentally shifted over the past 12 months. We are seeing the basic question of how much value can be added through asset management returning to the fore. This is in stark contrast to the leveraged beta strategy that became so popular over the past 5-7 years, where cost of debt and expected yield compression were the key focus points. Of course, investors pursuing that strategy didn’t really need to be set up to actively manage and didn’t necessarily have the financial resources to do so.
“But real estate is not a perfect bond substitute. It always requires some form of proactive management – and that’s especially the case when markets turn, as they have done. As we come through this transition period, and move into the new cycle, we expect the opportunities emerging to be significant” he says.
Hampton says that not only has the cost of capital increased, but banks are also less willing to lend money as signs of a recession loom large, adding to the pressure on investors who relied heavily on leverage to acquire assets.
“Whilst the cost of debt has increased, the availability of debt has also reduced. It’s these two things combined that have had such a profound impact on pricing. It’s a very exciting time for value-driven funds that have capital and who are able to provide existing property owners with liquidity options where, frankly, they may have run out of money,” he says.
A Case Study in Berlin
Value-added real estate is not rocket science, Hampton says, but it does require teams who understand the market and do thorough research into the changing appetites and needs of tenants.
“At the heart of value-add in real estate is betterment. It is about working with occupiers, talking to the tenants, and identifying the correct purpose and use of a property within its community. It’s about understanding the basics, basics that are often marginalised when capital markets are appreciating,” he says.
“Real estate is created for a purpose and typically that is for an occupier. That could be a public body, it could be private, it could be residence, or it could be for commerce and business. If you can become a master of the occupational markets and you can understand what your end-user wants, then you’re probably not going to go too far wrong,” he says.
Changes to a property can be as simple as renovating and bringing a building up to date with modern conveniences, but it can also involve solving a mismatch between a building’s purpose and the tenants that occupy it.
This can involve re-tenanting a building, changing its usage or introducing environmental efficiencies.
Hampton gives an example of a transaction he is particularly fond of and made back in 2014, involving a portfolio of offices in Berlin, Germany.
At the heart of value-add in real estate is betterment. It is about working with occupiers, talking to the tenants, and identifying the correct purpose and use of a property within its community. It's about understanding the basics, basics that are often marginalised when capital markets are appreciating
The genesis of this transaction lay in an earlier development in the United Kingdom, where technology companies started to move to a certain part of London in the East End for its historic buildings and amenity-rich community vibe, which made the area trendy and attractive to many companies.
“I got very excited about one of the submarkets in London called Shoreditch. And I got excited about it because it was essentially a back-office location that was transitioning into a vibrant, tech-driven live, work play area.” he says.
“The area was characterised by buildings of architectural merit that had originally been used as production, storage and industrial facilities. And they had become attractive to tech occupiers who were completely rejecting the standard City of London glass box office.
“I got excited about it because I could see that the rents were low; they were in the mid £20 per square foot range. And I felt there were opportunities to grow rents through proactive management, through investment. The growth in occupational demand for these buildings at the time was quite extraordinary,” he says.
Unfortunately, Hampton proved to be a little too much of an early mover and had trouble convincing his colleague in the investment acquisition team of his thesis.
Yet, the developments in the market played out exactly as he had anticipated and so when a similar opportunity arose in Berlin, he made his move.
“I was reading about Berlin, a city we have invested in for many years, and I noticed that tech-demand had been growing, in part thanks to venture capital funding which had been coming into the city at scale. Thankfully, my team in Berlin were a lot more receptive to the Shoreditch thesis,” he says.
“We needed to speak to the occupiers to understand the demand picture more clearly and so, together with our team locally, we conducted a series of interviews with a broad range of businesses over a period of several months.
“From that we drew the conclusion that there were a handful of submarkets, primarily in the former eastern part of the city, where most firms wanted to be. Their rationale was simple – their employees wanted to be in dynamic, exciting, live-work-play areas. And they wanted to attract the best employees.
“They wanted to walk or cycle to work. They wanted to operate from a funky building that reflected their corporate identity, and they wanted to be somewhere affordable,” he says.
“Our team did a fantastic job of, what we describe as, ‘walking the streets’ and cataloguing the buildings that fitted the bill. This was a very proactive approach.
Hampton and the team on the ground built a catalogue of buildings that they were interested in acquiring.
“Through that exercise, we ended up acquiring a portfolio of around eight buildings. These were buildings typically of historical value, with some sort of industrial or production usage background leased to a variety of businesses.
“Our approach was to breathe life back into these buildings, through a creative and thoughtful ESG-inspired refurbishment programme. Where the opportunity presented itself, we also looked at increasing massing through add-on development,” he says.
One building in this portfolio was a particular success story, Hampton says.
“This was an old multi-storey furniture factory leased to various tenants on low rents. It was a building that had also been bomb damaged during the war. We saw an exciting opportunity to radically overhaul the property, to bring it up to modern-day standards, to re-lease and then trade.
“We achieved a very significant uplift in the rent compared to the rents that were being paid before the renovation. And then we sold it to a long-term investor. Overall, we delivered back to our investors about three and a half times their original equity investment on that particular building,” he says.
Assessing Valuations
Although prices are changing in the current market environment as stresses are building up for some real estate investors, the volume of transactions is still very low. This makes it difficult to get an accurate idea of the right valuations for properties.
Hampton says investors can look at historical averages to get a sense of what particular assets might be worth, but warns that also this method comes with a number of caveats.
“Looking at pricing trends over the past 5-7 years is not a useful guide in dictating where fair value is going to be moving forwards,” he says.
Investors are acutely aware of the challenges in retail properties, while office spaces are also facing an uncertain future as companies redefine what the future of workplaces will look like.
Hampton believes that many of these developments will take several years to play out.
I think the markets have got quite some way to go yet. Whilst some are starting to look interesting, I expect it will take quite a bit of time before prices and values find their more natural levels
“I think the markets have got quite some way to go yet. Whilst some are starting to look interesting, I expect it will take quite a bit of time before prices and values find their more natural levels,” he says.
“One of the areas that we are watching very, very closely is the extent to which values adjust to reflect the huge cost of de-carbonising. It is the elephant in the room at present and even if some regulation does get delayed, the problem is not going to disappear.
The property industry has come to realise the importance of embracing decarbonisation, but this will be easier to achieve in some markets than in others. European real estate, in particular, faces some key issues.
“Decarbonisation is a global phenomenon, but, of course, much European real estate is old and under-capitalised, so it is arguably more pertinent here. A huge amount of capital is needed to decarbonise and that’s one of the industry’s biggest challenges in the years ahead,” he says.
This article is sponsored by PATRIZIA. As such, the sponsor may suggest topics for consideration, but the Investment Innovation Institute [i3] will have final control over the content.
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[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.