Kempen Outlook 2021 The real estate market offers many opportunities to add value

Pre-covid trends to accelerate

There have been some major trends affecting the real estate markets in recent years that have been accelerated by the coronavirus crisis, and this looks set to continue.

Physical retail to continue to suffer
Physical retail was already suffering before coronavirus, but the pandemic has hastened its decline. We now need to start talking about reconversion to other uses as lots of properties are obsolete, and consider how alternative uses of retail buildings can be reflected in the value of assets. 

Reconversion is going to come down to location: if the location is viable for reconversion to residential, owners may get a decent amount of money back. The others are going to have to invest a lot to make their premises more experiential-friendly – possibly making malls as much like showrooms as shopping centres. But we believe the mall remains an important form of entertainment in some more remote areas of less densely populated countries like Canada. 

Essential physical retail such as supermarkets, grocery stores and pharmacies have been extremely resilient thus far, and we don’t expect large value write-downs in the near term. However, we think it’s only a matter of time before online grocery really kicks off. It’s already very well developed in the UK, and we believe it will catch up in continental Europe and beyond soon.

Logistics powers on
Logistics had already been doing well, and this was again accelerated by people working from home and being forced to buy their goods online. Secondary logistics and industrial buildings have attracted interest that wouldn’t have otherwise been there, with yields compressing. These trends are likely to continue throughout next year.

Self-storage benefitting from the 4Ds
Another area that is benefitting even more is self-storage. Demand for self-storage is based very much on life events that we call the 4Ds: debt, divorce, downsizing and death. Unfortunately, all four have increased because of coronavirus. Cash-rich firms like Shurgard, which has a proven platform that operates across Europe, is well placed to benefit from opportunities, as are companies like Big Yellow in the UK. 

Data centres prospering in a digitising world
Data centres are also doing extremely well in this environment. We still see some upside despite what some believe to be stretched valuations as their growth remains spectacular. They’re benefitting from digitisation, e-commerce and working from home, which are all leading to higher demand for data.

Residential still a safe play overall
While many people might be struggling to pay their rent, regulated residential is in our view a safe investment at the moment. German residential, for example, is concentrated in the low- to middle-income section of the population, and it’s a value play that isn’t really driven by market trends. Market trends are important when you re-let the property, but people don’t move out often and they’ll probably move less because of coronavirus. That means rental growth might be low, but there’s very little risk of the market collapsing. The risk is slightly higher in freer markets such as the US and to a certain extent the UK.

Don't forget politics

At Kempen we analyse real estate at the bottom-up level, but it’s still important to consider some top-down factors. For 2021, we’ll be considering the implications of a possible new president in the US and an important election in Germany.

Politics – particularly at the municipal or local level – can be important for property investors because of the possibility of extra regulations on the residential real estate sector or changes to the speed at which development projects can be realised or halted. 

Coronavirus has had a huge impact on blue-collar workers, and they’ve received a lot of government support, but that can’t go on forever. That means politicians could take other actions to support people struggling to keep a roof over their heads.

For example, we’ve already seen rent regulations in Berlin, and a resurgence of political leaders classing residential real estate as a social good like water and clean air. Recently in Ontario in Canada, a rental freeze for 2021 that no one saw coming was introduced.


New trends

Two trends that have emerged after coronavirus are working from home and the question of whether gateway cities are dying a slow death. We’ve got strong views on both. While the pre-coronavirus trends that we discussed above are widely recognised among most specialist property managers, there’s much less consensus about the two trends below. This creates excellent opportunities for us to exploit as active managers. 

Working from home: the death of offices?
When it comes to working from home, we don’t think that offices are dead because they still play a vital role for most companies, even if workers don’t need to go into them every day.

However, we believe it could be the beginning of the end for traditional skyscraper headquarters in major locations. Instead, we believe the hub-and-spoke model, with a smaller central headquarters and several low- to mid-rise offices in more fringe locations on city outskirts, will dominate in the future. 

That’s because coronavirus has shown people can work from home most of the time, and, with people now used to social distancing, they’re unlikely to want to have to make long underground journeys every day to go to an office where they have to get in an elevator to go up 40 floors. Instead, they’ll want to go to a smaller office that they can easily cycle or drive to. Real estate firms like WorkSpace in the UK have high exposure to such mid-sized properties. 

Canary-Wharf-type offices aren’t going to die, but they’re going to be in lower demand, and they’ll need a lot of capex to make them attractive places to work in in the post-coronavirus world. This means they’ll require a higher rate of return, which by definition means prices will have to fall. 

In fact, offices is the area of the market where we see the most diversity of opinions among real estate managers, and therefore the most opportunities to create alpha in 2021. Some are rightly trading at big discounts to NAV because of the risks facing the sector, structural vacancies and the capex that will be needed to bring them up to speed in the post-Covid world. But not all offices are the same. 

Our investment approach is very much on top of all this – we rank individual buildings, and know which REIT holds which building type. At the moment, we see a lot of mispricing because investors have been selling everything off as a group.

The changing definition of the gateway city
We believe 2021 will see a further rise in the success of gateway cities – and that the definition of gateway cities will be expanded to include places that may have traditionally been classified as Tier 2 cities. Examples include Denver and Austin in the US; Rotterdam and Lyon in continental Europe; and Birmingham and Manchester in the UK.

We’ve already seen problems in expensive urban conurbations like New York and San Francisco, where residential towers are suffering and some office blocks only have 10–20% utilisation (even though they have 90% occupancy – people just aren’t going to them). 

Major cities that are still vibrant and have lots going on culturally clearly aren’t going to die, but we believe there’s going to a reshaping of the status quo. In places where the cost of living is abnormally high, like New York and San Francisco in the US, for example, we could see people move away to smaller places like Nashville, Denver or Austin, because they’re significantly cheaper to live in and in some respects provide their residents with a higher quality of life. But they’re still very much urban centres and they’re still part of a group of gateway cities, in our view.  

Of course, many people will want to remain close to big cities like London, but we might see a reshuffling of microlocations. Within London, for example, areas like Kennington and Peckham might become more popular, which fits in with the hub-and-spoke theme. Our investment process enables us to score locations down to the postcode level to help us price buildings accurately. 

ESG – THE YEAR OF S IN REAL ESTATE?

At Kempen we consider ESG criteria in all of our investment decisions. 

The Environmental factor is well known: it goes without saying that real estate firms need to reduce their carbon footprints. Real assets are carbon-intensive, and most of the firms we cover are working towards various certificates and are using green sources of financing. Our portfolios are less carbon-intensive than the benchmarks we follow. 

But we believe social issues – the S in ESG – are really going to move to the fore next year as the pandemic has been a social crisis as much as anything else. We’ve been suggesting to management teams in the residential sector that they shouldn’t raise rents during the pandemic, even though they’re contractually within their rights to do so. Residential real estate is now being seen as a social good, so for a landlord to send eviction notices because someone lost their job due to coronavirus would be highly unethical. But we’ve seen management teams do just that in many markets. 

Improving companies’ governance is also an ongoing process. We’re highly engaged, and have had successes in aligning management compensation with shareholders, making vesting periods for bonuses longer and getting firms to be more transparent, especially in the Nordics. 

We want to see the whole sector adopt good ESG practices. Some firms still don’t, especially in North America, where, despite some of the world’s best governance practices, we sometimes get asked by management teams if ‘E’ and ‘S’ criteria are just for cosmetic purposes. No they aren’t! We tell them that they’re priced into our models and that they’ll get a lower premium if they don’t improve their practices.

 

 

DATA TO BECOME EVEN MORE IMPORTANT IN OUR INVESTMENT PROCESS

Data quality will continue to gain in importance next year, and we’ll be looking for the right big data sources to use as inputs in our investment process. 

Data is integral to our investment process. For example, we’re working with a large German reinsurance company on pricing climate risk. Based on our work together, we’ll be populating our models with climate risk data at the postcode level and start attaching it to the buildings we track, enabling us to add a climate risk score to our prices.
 

 

So is Real estate a good investment for 2021?\

According to our calculations, real estate stocks are trading at a high-single-digit discount to our own estimate of gross asset value – the underlying bricks and mortar. We think it looks highly attractive as an asset class at a time when rates are very low and equities are extremely volatile. Real estate provides predictable, repeatable cashflows. The main problem is some firms could go bankrupt due to coronavirus, especially on the retail side. But, as we’ve discussed, some sectors are doing extremely well.

It’s important to remember that some sectors that are doing well might be overpriced, and some that are risky might be underpriced. We do our work on a bottom-up basis and we’re not afraid to buy the discounted riskier company or avoid the overpriced safe company. Lots of generalists drive real estate prices, buying and selling the market indiscriminately. We love that, because it creates lots of opportunities for us as we analyse the assets in depth. 

One thing we would say is that we don’t believe investors should go passive next year as indices still contain a lot of firms that could be in trouble. Take Unibail-Rodemco-Westfield, Europe’s biggest mall owner, as an example. It accounted for a large share of property indices, and anyone owning a property ETF would have suffered this year as its share price has plunged. 

Owning such firms isn’t the end of the world – you just need to make sure you’re buying them at the right price. As active managers, we price these companies accurately. At a time when there’s so much indiscriminate selling and so much divergence of opinions, there’s huge scope for active managers to add value – which we’ve shown our ability to do over the long term.

What could scupper our forecasts?
Any second large-scale lockdown would be disastrous. For us, it’s not about how deep the recession is, it’s about how long it lasts, because the longer that everything is shut down the worse companies’ solvency problems become. It’s great that central banks have been providing abundant liquidity, but governments will find it increasingly difficult to sustain everyone for a second major lockdown. There would be dire consequences on people’s health and mental health, and there could also be huge economic and social consequences, with the potential for civil unrest. 

Thankfully, while we think there will be more lockdowns, we expect them to be highly localised, with governments using technology to keep virus outbreaks contained in small areas rather than spreading throughout countries. That said, this will come at the expense of some loss of people’s privacy.

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The Author

Mihail Tonchev

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The views expressed in this document may be subject to change at any given time, without prior notice. Kempen Capital Management N.V. (KCM ) has no obligation to update the contents of this document. As asset manager KCM may have investments, generally for the benefit of third parties, in financial instruments mentioned in this document and it may at any time decide to execute buy or sell transactions in these financial instruments.

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