Kempen Real Estate Update: 2021 – Something to look forward to
The year behind us has been exceptional on many fronts. What started out as just another solid post-GFC liquidity fuelled year of even higher highs, unexpectedly turned into a year where business models were tested, companies had to evolve or face collapse and the ever-more important global political economy took a central role all due to a truly global pandemic. Hypothetical scenarios turned into reality and theoretical debt covenant terms were often tested with serious consequences. Moral hazard as we knew it since the Global Financial Crisis (GFC) has returned as an important topic when dealing with government support. At the backdrop of it all, we learned to use our homes as living space, working space, gym space, leisure space, day-care, education space, vacation home etc… Whilst some thought that offices may never be needed again, this couldn’t be said for the other newly created uses for our personally reconverted “multi-purpose” home. Whilst certainly practical and more effective for some, surely this was largely wishful thinking for others. At the end of the day, there is a reason why we need real estate for different purposes, and our working life is still a big part of that.
And then came November, a timely release of the vaccine (just after the US election win of Joe Biden) made everyone dream and imagine of a world that once was… just nine months ago. So are we going back to normal as if this was just a bad dream? Most likely not.
“This pandemic has taught us many things. As crises of this proportion often do, some of the lessons we had seen coming a mile away. ”
What would it all mean for real estate markets in 2021?
Physical retail to continue to suffer
Physical retail was already suffering before coronavirus, but the pandemic had 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. And yet we believe that the mall remains an important form of leisure 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 in the long term the share of online grocery will increase. Due to the pandemic, many people moved to online shopping for their groceries primarily for health and safety reasons. As such they have likely learned the convenience of it and may thus adjust their behaviour on a more structural basis. We have seen the industry growth significantly, albeit coming from a lower base.
Experiential retail is a hotly contested point of debate. With the news of the vaccine, one can begin to imagine a scenario where people return to places such as waterparks, ski resorts, theme parks and of course movie theatres. However, cinemas likely need a major rationalization as many customers may surely have gotten used to watching new releases at the comforts of their homes and may not want to revert back. That said, we believe that there will always be demand for well located cinemas (particularly in locations where that may be one of only a few forms of entertainment) as well as for independent or boutique cinemas in urban locations.
Residential still a safe play overall
Even though some residents have difficulty paying their rent, for example in a free market like the US, 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 is less impacted 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 biggest risk we see is political risk. Politicians have learned that voter friendly initiatives, like proposing a freeze of rents, is a very effective way to win votes. Even though this will eventually not solve the supply/demand imbalance present in many markets. This is where the “S” in ESG will take centre stage. Residential landlords will increasingly have to consider all stakeholders involved in their business including the tenant/human side of it. How various management teams handle that will separate the winners from the losers, in our view. The risk of rents collapsing is higher in freer markets such as the US. and to a certain extent the UK. However, with the introduction of the vaccine, and upon a successful (at least partially) administration, we can expect the free-market urban based multi-family segment to lead a recovery.
Be selective in Offices
Since the beginning of the pandemic we have been vocal on the upcoming polarization of offices. The higher rise urban towers will see a rise in capital expenditures as we see the workplace evolving to a more sustainable and healthy place. Naturally this means that low to mid-rise buildings in more commute friendly locations will be more attractive. This is nothing new as the TAMI (technology, advertising, media and information) tenants have been accustomed to this since the GFC. This does not mean that central offices are going to go away, quite the opposite, a well located urban office with good specifications (natural light, controlled healthy air quality, spacious access points, commuting amenities, healthy break-out spaces that foster creativity and idea exchanges and other desired amenities) will continue to be well sought after, in our view. However it may take a few years to shift through some office space supply and for office landlords to make the necessary capex investments. And some traditional centre space should still be resilient often acting as “branding” for executive headquarters. As the vaccine news positively surprised the market, we saw a lot of the structurally challenged office spaces jump in valuation. Once again, with our data model we are able to nimbly price in the changes (which are not extremely positive in our view) and are quick to capitalize on the relative valuation within offices.
Logistics powers on, regardless of how the vaccine evolves
Logistics had already been doing well, and this was again accelerated by people feeling less safe to do physical shopping and in some cases during the lockdown being forced to buying 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 and broad based market rental growth may appear in places that may have rarely been considered as such before.
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 digitizing 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 digitization, e-commerce and working from home, which are all leading to higher demand for data centres. A counter-argument for this sector has always been the possibility of obscurity in the business model, or the lack of scarcity in land value. However, we just don’t see that yet but remain cognisant of the potential tail-risk for the space.
ESG – 2021, 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 help reduce the CO2 footprint of the planet, predominantly by reducing their own carbon footprints. Real assets are carbon-intensive, and most of the firms we cover are working towards: greenhouse gas (GHG) emmision reduction targets, introducing decarbonization strategies, are using green sources of financing. Our portfolios are less carbon-intensive than the benchmarks we follow. More importantly, we actively engage with the companies we cover on improving their carbon footprint in line with the 1.5C pathway laid out in the Paris Agreement, and reward them appropriately for a strong flight path ahead (or penalize them for complacency or staleness in improvement) via our valuation methodology. All else equal, the better the efforts for sustainability, stakeholder management and governance, the higher the price we are willing to pay for the company.
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 depths of 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 some less professional landlords who do not emphasize ESG do just that in some markets. However, the social component can be extended to look into a broader theme which we believe will rightly return to centre stage – that of diversity and inclusion. The protests in the US labelled as “Black-Lives-Matter” (BLM) acted as a much needed electrical shock to the world to wake up and prioritize making changes to a system which had steadily evolved to favour some and systematically disadvantage others.
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. Companies in the Nordics are still massively lagging in terms of governance, transparency and alignment and hence we spent disproportionate time in engaging with Nordic companies, and with success.
We want to see the whole sector adopt good ESG practices. With the election of Joe Biden as the next US president, we should see the country rejoin the Paris Agreement and thus officially the environmental issues should no longer be side-stepped. Some firms still do so though, 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 valuation if they don’t improve their practices.
Looking forward to 2021
We believe that 2021 can truly be a year to look forward to. As real estate markets continue pricing in a vaccine-led recovery we can theorize a scenario where certain sub-sectors begin to close their valuation gap to the underlining value of the assets. Volatility may continue to be high as evidently we are in for a period of uncertainty on the administration and effectiveness of the new Covid vaccines. However, equity markets look ahead into how recoveries might look like but they often fail at pricing in that impact effectively at the get go. This is why we believe that particularly in this fast changing environment, our systematic and data driven investment approach will continue to provide an edge for our fundamental valuation models to be able to be more accurate at estimating the true value of the assets of each real estate company and be able to utilize our active approach to continue capturing the plentiful mis-pricing opportunities.
As at 31 December 2020, the Kempen European Property Strategy held shares in Shurgard Self Storage and Big Yellow.
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