The world is changing at breakneck speed, upending the way we live, work and shop, and by extension the demands we make of the buildings in which these day-to-day activities take place. A global pandemic has collided with a climate change emergency, overlayed by transformative demographic shifts, unprecedented technological advances and changing consumer preferences. Real estate managers must respond by remodeling assumptions as they strive to build conviction in the investment themes of tomorrow.
Of course, many of these trends were in play pre-covid; the pandemic has merely accelerated what was already in motion. The result, however, is that real estate allocations have been turned on their head, as investors carve out more space in their potfolios for logistics, residential and other ‘new economy’ sectors.
The future of the office
There are pockets of opportunity in every segment, of course, but also areas that risk rising vacancy rates, tumbling rental prospects and even obsolescence. Nowhere is this polarization more apparent than in an office sector shaken by pervasive work-from-home orders.
Real estate investors are scrambling to determine the future of the working environment. “While covid and the rise of more flexible working arrangements will continue to influence commercial tenant requirements, demand for commercial accommodation remains, as tenants seek spaces where collaboration, training, innovation and culture can thrive,” says Michael O’Brien, managing director of QIC Global Real Estate, the property division of the Brisbane-based alternative investment firm. “High-quality assets are anticipated to drive strong risk-adjusted returns.”
Quality, O’Brien adds, means precinct and surrounding amenity; location and proximity to transport infrastructure; and design and quality, including vertical connectivity and flexible floorplates to meet evolving needs. It also means health and well-being, including access to outdoors and strong sustainability credentials; technology and digital connectivity; flexible accommodation spaces, including conferencing; and the ability to appeal to target occupiers of quality covenant.
Alternatives manager Partners Group, meanwhile, had meaningful exposure to the office sector going into the pandemic, and continues to invest selectively.
The firm’s co-head of private real estate in Europe, Rahul Ghai, believes that pandemic fatigue and the associated need for better collaboration are strong medium-term drivers. “There will be a distinction between high-quality and low-quality space, and we have already seen this in our buildings,” he says. “Some of our assets in London, Sydney and elsewhere have experienced excellent leasing demand as a result of being brand-new, high-spec buildings with strong sustainability credentials in great locations.”
Stéphanie Bensimon, head of Ardian Real Estate, adds: “Office will remain a tool for work given the numerous services and opportunities offered: learning, mentorship and social bonding. Remote meetings will never provide the same feeling of mutual achievement as in-person meetings do.”
And indeed, the property investment business of the private equity firm is looking to entice employees with what it calls the ‘hotelification’ of offices. The firm mandated Tristan Auer, known for its work on high-end palaces, for the interior design of its Renaissance project, for example.
“We will return to the office since, after all, we are better together,” says Robert Perry, president of the Americas real estate division at CBRE Investment Management. “But offices will need to offer some form of inducement, some sort of extra dynamism and attraction, to encourage people away from the convenience of their home office surroundings. So, the office is not dead, but there will be a widening divide between winners and losers.”
“We have moved from a just-in-time model of commerce to a just-in-case model. And this shift will persist”
CBRE Investment Management
The reinvention of retail
Another sector that was already buckling under the weight of structural trends is, of course, retail. “Obviously, covid has been an accelerant when it comes to a rise in e-commerce,” says Michael Ness, head of real estate separate accounts for CBRE Investment Management. “But the demise of physical retail has been ongoing for some time.”
But the picture is inconsistent. In some parts of the world, such as Southern Europe, a shopping excursion is still the norm. “We have shopping center schemes in Lisbon that are still extremely well visited,” says Ness. “There is a culture of physically shopping in Southern Europe, which has only been modestly affected by the rise of internet shopping.”
But the longer the pandemic lingers, the greater the likelihood of people adopting new purchasing preferences. “Just look at how much discretionary and non-discretionary consumption has already moved online. This is a major transformative trend,” says Ghai. “Now covid looks to be running into its third year, I think you will see these shopping habits becoming more permanent.”
Indeed, high streets are under incredible strain in many markets. But grocery-anchored schemes and open retail warehouse schemes exhibit strong tenant, customer and investor demand. “The high street may be struggling,” says Ness, “but there are glimmers of investor interest where they can see the bottom of the rental cycle.”
Ghai agrees there will always be a place for some service-based retail, particularly food and beverage, as well as essential amenity and ultra-high-end retail that provides more experience-based consumption. “Retail is an incredibly diverse sector of the commercial real estate economy,” says Sam Chandan, head of the real estate center at NYU’s Stern School of Business and a professor of finance. “The impact of changing consumer behavior will be very different on large, regional malls compared to community shopping centers, and grocery will be very different to high-street retail in high-density urban corridors geared to tourism.”
Brad Hyler, head of European real estate for Brookfield, adds: “Clearly retail has gone through a period of transformation over recent years, but the best assets are actually gaining market share as retailers want to be in the best locations. They are using stores for both traditional in-person sales and to leverage their online offering through fulfillment. So, it is a story of bifurcation where tertiary locations and lower-quality retail is suffering, while higher-quality, better located retail is outperforming.”
The flip side of a struggling retail sector is a booming logistics sector. The rise of e-commerce is undoubtedly a key driver of demand and one that has far from run its course. Parts of Europe are still playing catch up when it comes to e-commerce penetration, and even the US needs an estimated 330 million square feet of additional modern logistics product in the next five years to keep pace with e-commerce demand, according to CBRE Investment Management’s head of Americas direct logistics strategies, Mary Lang.
But e-commerce is not the most significant market force. Indeed, e-commerce represents the third largest user group within logistics, behind third-party logistics providers and home goods and apparel. “While the growth of e-commerce is grabbing the headlines, the more important macro trend is a shift in inventory models that is occurring across the logistics environment as users now carry more safety stock,” says Lang.
“We have all experienced supply chain issues through the pandemic, but this is not just a covid phenomenon. The share of revenue that is driven by customer experience is so significant today that companies will carry additional levels of inventory on their balance sheets if it means retaining customer loyalty. We have moved from a just-in-time model of commerce to a just-in-case model. And this shift will persist.”
Against this backdrop, intermodal and fulfillment facilities are of particular interest to investors. Intermodal products are assets co-located at airports, seaports and railyards; the scarcity of real estate alongside these facilities will drive rental rate over time. Fulfillment, meanwhile, refers to door-to-door delivery, which has been expedited significantly. Again, there is a scarcity associated with the infill required to be close to the end customer. There is also a stickiness associated with tenancy because of the money users are investing in these buildings to automate them, and that means the ability to grow rental rate.
Distribution assets are more challenging given the greater elasticity of demand. “The logistics market is therefore white hot. But not all logistics assets are created equal,” says Ness. “Urban logistics is a very attractive space, and we have bought a huge volume of light industrial assets all over London over the years, which have delivered terrific rental growth, and for some proved ripe for higher-value alternative use.
“Stock selection remains critical when considering the wider logistics sector, with a deep knowledge of markets and tenant requirements essential. Tenant demand remains incredibly strong for assets that achieve the highest standards, with one keen eye on future supply that may disrupt rental growth.”
The long-term growth story of logistics is undoubtedly compelling. Furthermore, warehouse rent makes up less than 5 percent of spend in the sector, while logistics and transportation represent 30 percent. “As the spending associated with transportation declines with more infill delivery models, there is an opportunity for rents to grow in the fulfillment category without cutting into profits for e-commerce users,” Lang says.
We are increasingly seeing real estate sectors blur with the rise of mixed-use spaces.
CBRE Investment Management is regenerating an old outdoor shopping center in Amsterdam, bringing in residential, leisure and community uses. QIC, meanwhile, is focused on introducing complementary mixed-uses to its centers, including education, office, accommodation, health and civic spaces. “The introduction of these mixed-uses helps to evolve traditional shopping centers into town center destinations that serve the whole-life needs of a local community,” says Michael O’Brien of QIC Global Real Estate.
The revival of residential
Another thriving sector is residential, driven largely by a global structural undersupply of good-quality assets. “We are seeing supranormal rates of rent growth due to a shortage of housing,” says Chandan of the Stern School of Business, “and there are record-low vacancy rates across the US.”
“Institutional portfolios are increasingly including residential as part of their strategy, and with good reason,” adds Ness. “The best point of entry into residential is actually to build. You do not see much traded on the secondaries market. The opportunity in US multifamily is particularly large.”
Under the Biden administration, the Federal Finance Housing Agency has mandated that government-sponsored Fannie Mae and Freddie Mac allocate half their origination activity to the affordable housing sector. That has left a void for market-rate multifamily assets, with opportunities for selective investment in the affordable, or workforce-orientated, sector, as well.
Meanwhile, the trend of a dispersing population, exacerbated by covid, is proving particularly important for the single-family space. “People are making different decisions about where they choose to live, based on maximizing space and the ability to work from home,” says Achal Gandhi, chief investment officer, indirect real estate strategies, at CBRE Investment Management. “But single-family residential is not an institutional sector across most markets. That means there is a risk but also huge opportunity. We are already starting to see institutional capital flow into SFR in the US, and I think it is a trend that will continue elsewhere.”
Other trends include the increased use of hospitality within residential, as well as more furnished apartments and flexible lease terms to support demand for convenience, according to Andrew Glanzman, who, as president of CBRE Investment Management, oversees asset and corporate operations.
“We will also increasingly see different demographics looking to occupy the same locations and buildings, as empty nesters move to vibrant university towns alongside students, for example,” he says.
Partners Group’s Ghai, meanwhile, points to a desire for more experiential living and greater integration with the sharing economy. We may also see some repurposing of office to residential. “A significant number of businesses moved out of Lower Manhattan after September 11 and some historic office buildings on Wall Street and in the surrounding area were repositioned as multifamily rental buildings,” says Chandan. “There are technical and engineering challenges involved in repurposing, but it can be done.”
While opportunities exist across all real estate sectors, investors must formulate strategies based on long-term structural trends, without side-lining the inherent cyclicality of the asset class. Against a fast-moving and tumultuous backdrop, it is time for real estate managers to find a new balance.