We are seeing significant structural changes in the way occupiers use their buildings and these changes are happening at pace.
Real estate can play a number of roles in a portfolio and generating income is one of fundamental importance. Typically over the long term, 70% of the performance of real estate assets is delivered through income return. This ability to deliver an attractive and stable income return has been one of the main drivers of the growth in demand for exposure to direct real estate, particularly amongst institutional investors over the past 10 years.
However, we are seeing significant structural changes in the way occupiers use their buildings and these changes are happening at pace. This has called into question the ability of real estate investment to deliver stable incomes. A traditional approach to real estate investment - that primarily focuses on diversification by sector and geography, and equates length of lease with quality of income - is not fit for purpose in delivering stable income in this environment.
In the context of these challenges, we believe that a valuable approach to real estate investing puts a core focus on ‘Know Your Occupier’ and incorporates cross asset class perspectives, leveraging a fixed income like approach to occupier due diligence and thematic insights from equities. In this way, real estate can continue to offer an attractive stable income solution.
Keeping an eye on yields
In a low yielding environment, the relative pricing of real estate has also been attractive to investors (Figure 1). Prime real estate continues to offer a significant yield spread over global Investment Grade bonds and over European High Yield bonds. This spread does provide compensation for the relative illiquidity of direct investment in real estate, but it continues to be wide by historic standards.
Challenges to real estate income performance
Real estate’s income return is derived from the regular rental payments made by occupiers. Typically, key risks for real estate delivering income returns are lease events that result in loss or reduction of income (e.g. breaks, lease ends, reviews) and occupier covenant quality. Institutional investors such as pension funds have typically addressed this issue by acquiring long leases (15+ years) with guaranteed inflation linked uplifts.
But pursuing such a strategy comes at a cost, with yields for ‘long’ income at a significant premium. In the UK, where such long leases are more prevalent, the yield for a long index linked lease is c.2.5% compared with yields of 3.5%-5% for shorter leases with open market rent reviews. Creating a diversified European portfolio of long leases is more challenging as typical lease structures in Europe tend to be much shorter.
Furthermore, the disruption caused by technological change and other macro trends means that such a strategy is not bullet proof. For example, one source of long leases has been department stores, where the disruption will be significant from the increase in online shopping and reduced demand for physical shops.
The impact of Covid-19
Covid-19 has thrown into doubt the stability of income return from real estate. Lockdowns and government interventions have resulted in a significant reduction in rent collection rates, with rent collection for UK real estate falling from 99%+ to as low as 78% during the country’s first lockdown. Collection rates have differed significantly by sector, with rent collection on retail assets at low levels as occupiers have been unable to trade, whilst it has been much closer to normal for industrial and office assets, even though offices have remained largely unoccupied for the past year. Lease length has been little protection against a tenant’s ability to pay.
Further, the pandemic has triggered a rapid change in occupiers’ space requirements - from retailers changing their focus from physical stores to warehouses as e-commerce continues to grow, to office occupiers adjusting to greater levels of home working post pandemic. These changes are likely to have significant impacts on real estate performance in the short-to-medium term. Shifting supply and demand dynamics are likely to result in a reshaping of real estate portfolios, and potential disruption to income returns.
Know Your Occupier (KYO)
We believe that one of the consequences of the pandemic will be a shift in investors’ focus from traditional concepts of ‘prime’ real estate (e.g. location, building quality and lease length) to a greater focus on ‘Know Your Occupier’ (KYO), which refers to the proper understanding of risks at the specific occupier level. This combined with risk management at the asset level, careful portfolio construction and good asset management, makes it possible to deliver stable income return at the portfolio level even through periods of significant disruption. To achieve this, real estate investors need to draw not only on real estate expertise, but also on the skills and knowledge of the fixed income and equities sectors.
The traditional approach to underwriting real estate cashflows often conflates the quality of the asset and the length of the lease with the quality and certainty of the income. Taking a fixed income approach to underwriting the credit quality of the occupier provides a better understanding of the risks to the income available from the asset. A quants-based risk adjusted cashflow modelling approach provides additional stress testing of assumptions about tenant failure and provides further insight as to how an individual asset contributes to the stability of portfolio level income returns.
Cross-asset class perspectives
Within the real estate industry, occupier due diligence has typically focused on looking at the Dun & Bradstreet rating of a tenant. A 5A1 rating, the highest available, is taken as being a safe indicator that an occupier will pay the rent. While such assessments are valuable, the data they focus on are backward looking and can be 18 months out of date.
We believe that there is plenty of additional data that can be utilised to provide deeper insights into an occupier’s credit quality.
- For listed companies, it is relatively straightforward to review any corporate bond issuance, and to review how the market views the company’s ability to service its debt.
- Plenty more can be gleaned from reading the company’s latest balance sheet, which can, for example, help to understand the relative affordability of the rent to be paid.
- A company’s business model is also informative in helping to understand the robustness of their balance sheet.
Further forward-looking indicators are also important to consider:
- A company may be able to afford the rent today, but will they still be trading at the end of the lease?
- Is their business model sustainable, and what are the macro trends that are driving growth and success in their business sector?
This is where leveraging insights from cross-asset class perspectives becomes valuable. For example, monitoring how sentiment is changing within business sectors, or having discussions with equity and fixed income analysts to provide further insights into the key drivers of growth (or decline) within different business sectors.
These insights then need to be applied to the asset and the occupier. Having a good understanding of how the occupier uses the building, how they have invested in it, and how it may be suited to the future development of the business are all important factors in considering whether the occupier has an increased propensity to stay in the property at lease end, in addition to the traditional factors of building quality and location.
Of increasing importance in understanding some of the risks is also the ESG assessment. The growth of Article 8 and Article 9 funds under SFDR means there will be a greater focus on whether occupiers meet increasingly stringent ESG requirements. The increasing prevalence of green leases, and the desire to achieve good ‘in use’ credentials for buildings will result in occupier due diligence incorporating an assessment of a potential occupier’s ability to meet increasingly stringent sustainability standards. This will be a rapidly growing element of ‘Know Your Occupier’.
Thematic portfolio construction for future sustainable income
Leveraging cross-asset research from equities and fixed income analysts can help to identify the themes that will drive occupier demand and long-term income growth. In a period of rapid change, understanding the themes that are changing demand for real estate is important in understanding the medium- and long-term risks to income in a portfolio, as well as the emerging opportunities.
Insights from the equities markets may be helpful in identifying important macro trends before they impact real estate values. Often structural change within a sector becomes clear in equity markets long before the ramifications are felt in real estate. A good example is the retail sector: the impact of e-commerce on traditional listed retailers’ margins was clear in the equity markets several years before it started to impact real estate values. Portfolios that were able to reduce their exposure to retail assets, by selling existing assets, or by focussing acquisitions in other sectors have tended to out-perform those with a high exposure to the sector.
Taking a more thematic approach will result in a different look to diversified portfolios. Instead of focusing on real estate sectors and geographies, we can start to explain how investing into different thematic ideas will drive long and stable income (Figure 2).
While much of the discussion about thematic investing in real estate has focused on alternative sectors such as healthcare, life sciences, data centres, and specialist parts of the residential sector such as student housing, a thematic approach can also underpin investment decisions in the core commercial sectors of office, industrial and retail.
As an example, the above portfolio has an overweight allocation to Luxembourg offices if it is analysed from a sector-geography perspective. However, it makes more sense from a thematic perspective. Luxembourg is the world’s second largest fund domicile after the US and is a world leader in cross-border fund distribution. The Luxembourg authorities require domiciled funds to have a physical presence in Luxembourg. An exposure to the Luxembourg office market can therefore be seen as a proxy for exposure to long-term demographic trends and the growth of the European pensions market. There are therefore structural and regulatory reasons as well as real estate supply and demand reasons why it is possible to have a high conviction that investing in this theme will provide long-term income stability.
Real Estate for income-focused investors
Despite the disruption and challenges that real estate has faced during the pandemic, we believe that a ‘Know Your Occupier’ approach to investing in the sector, drawing on a fixed income approach to assessing the quality of the cashflow, and leveraging themes and signals from the equities market, can deliver an attractive and stable income return for investors. Direct real estate investments offer an attractive yield premium over other asset classes and this will continue to draw capital into the sector, underpinning capital values and supporting the overall performance of the sector.
 Fidelity International, based on data from MSCI Multinational Real Estate Indices, 2004-2019.  Remit Consulting, UK Q3 2020 rent collection, all property excluding leisure  5A1 meaning the company’s net worth is $50 million or higher and its credit risk is low
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