Feature: The state of real estate
By Geoff Cook, Chair of Mourant Consulting
High inflation, supply chain disruption, pandemic tail effects and tightening monetary policy; a potent mix of factors have disturbed the equilibrium of investment markets in the first half of 2022, with equities and bonds seeing substantial declines. Attention has turned to the potential impact on property prices around the world, with concerns being voiced over the historically high residential prices in some countries. Recent research by Capital Economics indicates that price falls are already occurring in markets such as New Zealand and Canada, where valuations appear to be stretched. And there has been increased speculation about the combined effects of post-pandemic hybrid working and escalating borrowing costs on occupancy and demand in the commercial property market.
A strong start to 2022
The first quarter of 2022 saw a further strengthening in global real estate, a key sub-sector in which the leading private fund sponsors are active. According to property giant JLLS, the first quarter of the year saw one of the most successful periods on record. Global volumes of new investment reached $292bn in Q1 2022, with the US, EMEA and Asia achieving record highs in transaction volume.
Strong investor demand saw fund allocation to real estate continue its upward march with new funds oversubscribed on average by 10% and dry powder at the all-time high of $338bn.
With borrowing costs rising, investors are increasingly focused on hard assets with good revenue growth opportunities and the ability to pass on inflationary costs. The pandemic-induced acceleration of the move to e-commerce and the associated increases in demand for logistics and warehousing are on-point examples.
The rise of inflation
While rising property prices may see some level of correction; it seems unlikely they will be upended by a reset of base lending rates nearer to long-term norms. Substantial rate hikes are expected but, at this point, leading commentators anticipate that US rates will not rise much beyond 4%, the UK 3% and the Euro area 2%. This scenario is contingent on central banks acting to head off a hard landing by bringing inflation under control and obviating the need for more drastic measures.
Policy action could lead to a technical recession in some markets, and there is no doubt that risks have increased. Still, a cautious approach to asset target selection will be paramount.
In this respect, other categories of real estate with inflation-proofing characteristics will see support from yield-hungry investors such as pension funds, who are under considerable pressure to maintain the purchasing power of their member’s pension pots as the cost-of-living crisis bites.
The view from the top
Blackstone’s real estate arm is the most significant private sector player in the commercial real estate market. Stephen Schwarzman, Founder Chair and CEO, and Jon Gray, President and Chief Operating Officer, shared some telling insights at their first quarter 2022 investor call. The firm holds an astonishing $550bn of value in global real estate and, in common with its leading peers, has invested heavily in logistics, life sciences, digitisation, rented housing, content creation and hospitality. Importantly each is the subject of high demand, tapping successfully into the pandemic recovery cycle and broader societal changes that are deeply embedded, providing the opportunity for increased revenue growth. Inflation tracking, including interest rate trends, is built into the private equity real estate model, and inflation combatting hallmarks are very much part of the target asset selection process. JLLS paint a similar picture in their May 22 real estate perspectives publication: “investors remain focused on portfolio diversification and are aligning investment strategies to longer-term economic and demographic shifts, a dynamic that benefits logistics, living and healthcare assets.”
Properties that protect from inflation
Another sector that has historically held up well in slower growth environments has been student accommodation. It has proven to be an attractive long-term investment hedge for real estate investors against both inflationary and recessionary environments, with student numbers tending to rise in periods of economic downturn. The recent sale of the Brookfield UK Student Roost portfolio to GIC and Greystar for more than £3bn would indicate there is still life in this strategy.
Of course, the risk of recession is tangible, and the astute real estate firm will already be weighing the increased risk very carefully. However, properties with shorter duration leases and good locations should continue to protect from the sticky inflation driven by wage demands and supply-side shortages. Unlike bonds, rental returns can increase, and upward pressure on construction costs may constrain new development, further supporting price levels, higher occupancies, and demand for existing assets.
We expect a quieter period over the summer as the interest rate cycle works through the system, but the quantum of investment interest is likely to be reignited once the policy-tightening phase matures.
The importance of tax neutrality
As with all investment fund structures, tax neutrality is essential for a real estate investment structure. Jurisdictions like Jersey, Guernsey and the Cayman Islands provide this in addition to giving investors and sponsors a huge amount of legal certainty while providing access to flexible corporate, trust and partnership models (making repatriation of capital and income straight-forward) and robust but pragmatic fund regulatory regimes. Ultimately, investors in this market want to take investment risk not structural risk.
These advantages are all backed by the substance of a deep and experienced pool of real estate experts, whether directors, trustees, administrators, lawyers, or auditors.