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Kempen Real Estate Update: How will it “work” in the future?

09 June 2020

Over the last three months we have seen the Covid-19 pandemic affect just about every part of our daily routines. It has changed the way we work, shop and most certainly play. Global listed real estate markets experienced quick and often violent corrections as investors attempted to price-in quickly changing fundamentals in the space. This has proved to be by no means an easy task as tangible transactional evidence is lackluster due to the inevitable material slowdown in leasing and investment activity. This is further complicated by the disparity in views on how long and deep the recession might be. 

Real Estate

Real estate is heterogeneous and despite the all common “bricks-and-mortar” base, the uses and dynamics of each property type can differ dramatically. We are all aware that physical retail is in an increasingly difficult situation with most of the pre-Covid trends only accelerating. For many real estate owners in that space the next few months and years will be a true battle for survival. We can also all agree that logistics real estate is largely “eating the physical retail’s lunch” with strong and accelerating fundamentals. This sub-sector came up strong in keeping the essentials of the economy going and asset owners in that space are profiting. Residential and living (barring some difficulties in student housing) is also arguably an essential social good, and thus few governments want to risk causing a crisis in that space which makes the sub-sector resilient. 

One real estate sub-sector which leaves the biggest question mark is offices. It is an area which has generated meaningful debate amongst industry experts and investors. We outline our thoughts on what the future might look like for this space. We explore several themes which have seen an interesting shift in trends which will affect offices in the future. These are mainly: urbanization, globalization, digitization and densification, mass transit and government policy.

Office detox
It is a fact that this pandemic has seriously changed the way we work (for those that still have a job). Several years ago we probably would have thought that working from home (WFH) was an excuse to catch-up on household chores as technical difficulties connecting to the workplace network were all too common. Fast forward to today, and managers are desperately appealing to their employees to take breaks during working hours to prevent burnouts as employees seem to be working longer and harder at home with the help of stable technological infrastructure and fluid communication lines. 

We do not believe that offices are dead and that we are all going to work from home every day. However, we are convinced that flexible working will spread over to many industries that traditionally wouldn’t have given it a chance. This means that there will undoubtedly be some obsolete office stock, often in suburban clusters or outdated in age/design in central clusters. These buildings will experience an increase in structural vacancy, especially if they are in secondary locations to begin with.

“We do not believe that offices are dead and that we are all going to work from home every day. However, we are convinced that flexible working will spread over to many industries that traditionally wouldn’t have given it a chance.”

Not all offices are created equal

Historically, offices has been  a highly cyclical sector which investors must time well through the cycle to achieve strong risk-adjusted returns. This is partly due to the high relative sustained capex that is required to keep an office building in good shape for usage, as well as the capex spent when re-leasing space. As office leases are getting shorter, the landlord is increasingly having to ensure that the real estate is up to the latest standards. 

Since the Global Financial Crisis, demand for office space as a whole has grown as economies recovered, but the sources of that demand have changed materially. There was a shift from the industries that were downsizing (financial, insurance, legal, business admin) towards well capitalized technology, advertising, media and information tenants (known as TAMI) as well as life sciences firms with resilient revenue streams, which were responsible for the marginal growth in global office space. As landlords need to align themselves with tenants, for some it is an easy task, for others it is nearly impossible given their location. It ultimately all comes down to this once again: location, location, location. We believe that the TAMI tenants use their office space and working environment as one of the key levers to compete for attracting young and tech-savvy talent that they are after. This trend may accelerate even further after the pandemic eases off. Co-working however (not to be confused with flex working) may well see the final nail in the coffin after sporadic and unsustainable growth over the last three years, as hot-desking will surely be looked at differently post-pandemic

Traditional, more commodity-like office space, typically used for work that can be automated more easily, whilst not going away anytime soon, will see some challenges, with the pandemic ultimately being a negative factor. We believe that this space, usually occupied by larger and older workforce, will likely see an increase in capex requirements as well as operating costs (e.g. cleaning costs). For example, as a result of SARS, Asia already has emergency systems in place with infrared temperature scanners, contact tracing via apps and mandatory masks and disinfectants. We will likely see the same in Europe and North America too, at the landlord’s expense. Another theme, supported by government policies, in this space is intensified urban planning away from extremely dense sites where infection can spread easily and that employees with homes outside of central locations have difficulty commuting to (often using overcrowded public transport). As governments want more cars off the road, commuting towards less urban (but still gateway located) flexible hubs via e-bikes or short range electric cars may mean less commodity-type office space demand within the main working clusters in the future. Office space per employee was on a downward trend over the last decade but we will likely see this trend stall or reverse mildly providing some cushion for the structural decline in these types of buildings. Prime locations should still attract strong headquarter demand from global corporates due to the branding effect offsetting some of the weakening trends mentioned above.

Winners and Losers
So where does this leave us? Who are the winners and who are the losers? We believe that the TAMI sector will continue its strong trend as the theme of digitization and globalization accelerates with better and more consistent technological solutions. As real estate investors, we track over 300 investible real estate vehicles, both listed and non-listed, and over 200,000 buildings via our extensive database and proprietary quality scores. We have streamlined our database variables to pick out the winning tech-friendly locations of the future. What do those look like? To understand this, we need to get in the mind of a hypothetical twenty-something year-old software engineer. They would want to be in a population centre which offers strong cultural and entertainment amenities, a chance to exchange ideas and build relationships with other like-minded global citizens, be able to commute by bicycle and contribute towards saving the environment. Mental and physical wellbeing of employees has both tenant and government support and hence more green spaces, better air/light quality, less cars/CO2 emissions and better, bike-friendly end-of-trip facilities (storage, showers, dry cleaning) are paramount for success of future office clusters and buildings. At the same time, the employees of the future would need time and space to be focused and creative. This is where we believe  the flexibility to WFH as well as, well located fringe flex office solutions for some smaller sized tenants in gateway cities will be important.

From Analysis to Alpha
The Kempen real assets team picks out these locations, analyses real estate landlords with global office exposure to these locations and focuses on attractively valued opportunities.  We use our tenant scores to rank tenants, awarding higher scores to the companies with exposure to the aforementioned attractive industries and lower scores to the landlords with more commodity-type office exposure (at the building level), with less resilient tenants that will most likely face downsizing in the longer term. We believe that the devil is in the details and combine deep data analysis with the gradual but inevitable unfolding of these global trends to come up with the right exposure at the right price.  Throughout this fundamental property analysis, we are able to change the weights of all the variables that allow us to rank markets and sub-markets in search of the best locations to be exposed to. As we reemphasize the acceleration of trends that are already occurring, we have not made material changes to those weights at this point.

What will offices look like in the very long term? We suspect that technological advances in the field of virtual reality, driverless cars (but most likely carless drivers!) could slow down and even reverse globalization and densification. These are the trends we follow closely and as and when we see signs of real acceleration we will be, as ever, quick to price them in efficiently through our systematic proprietary data approach and ensure that the office exposure we own is resilient to whatever the future may be.

Important Information

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. 
The information in this document is solely for your information. This article does not contain investment advice, no investment recommendation, no research, or an invitation to buy or sell any financial instruments, and should not be interpreted as such. This document is based on information that we consider reliable, but we do not represent that it is accurate or complete, and it should not be relied on as such. 
The views expressed herein are our current views as of the date appearing on this document. This document has been produced independently of the company and the views contained herein are entirely those of KCM. 
KCM is licensed as a manager of various UCITS and AIFs and to provide investment services and is subject to supervision by the Netherlands Authority for the Financial Markets.

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