How is COVID-19 impacting the UK and European real estate investment sector? A transformation is underway
While COVID-19 has been tough on real estate funds, the economic recovery will create new opportunities for the asset class. We explore why institutional investors are optimistic about the potential upsides available with real estate funds.
As an asset class, real estate currently sits in an attractive position with income yields well above those of corporate bonds. "If this is the new normal, and low inflation and low-interest rates persist, then investor appetite for real estate is likely to stay strong," said Anne Breen, Head of Investment Strategy (Real Estate) at Aberdeen Standard Investments during a recent RBC Investor & Treasury Services (RBC I&TS) webinar. 1 Private capital, principally real estate, however, is not immune to today's challenges. Managers with exposures to certain real estate sectors, such as retail, or markets whose recoveries are likely to be protracted may find the start of 2021 difficult.
- While COVID-19 has been tough on real estate funds, the economic recovery will create new opportunities for the asset class
- Institutional investors are optimistic about the potential upsides available with real estate funds, with some believing the asset class should be opened up to retail investors
- Open-ended real estate funds have generated a lot of interest although concerns about liquidity risk remain
Opportunities for real estate managers
As the new normal emerges out of the COVID-19 crisis, it is expected to provide ample opportunities for real estate managers. Breen said real estate firms needed to pay close attention to environmental, social, governance (ESG) factors, especially as a growing number of corporates and investors are signing up to binding net-zero carbon pledges. Similarly, the added importance of technology during the pandemic is also expected to fuel further demand for data centres. Elsewhere, the spectacular surge in e-commerce is leading to major changes with distribution centres likely to see significant growth, often at the expense of the traditional bricks and mortar retail infrastructure. The widespread introduction of remote working will usher in an overhaul of the office environment, she continued. “There is an increasing case for converting obsolete offices into residential. With rents having fallen so dramatically in some locations, it could be economically attractive to convert office blocks into alternative uses," she said.
Investors move into real estate
Allocations into private assets – inclusive of real estate – have been rising over the last few years, a trend that is likely to continue beyond the pandemic. Preqin found assets under management (AuM) in real estate reached USD 1.09 trillion in June 2020, a 40 percent increase from five years ago and a 4.7 percent jump since the end of 2019. 2 Overall, investors are generally favourable towards real estate with 36 percent of allocators telling Preqin that they planned to increase their exposures to the asset class over the next 12 months.3 “We have noticed an increase in institutional money going into real estate. However, a lot of this investment is being concentrated in some of the larger ‘flagship funds’," said Dirk Holz, Director, Head of Private Capital Services at RBC I&TS. This is supported by Preqin data, which found that the 10 largest real estate funds secured 34 percent of all capital raised in 2020.4
Nonetheless, some argue that asset classes such as real estate should be made more accessible to affluent retail or high net worth investors (HNWI), especially as the latter are struggling to generate returns amid the desultory interest rate environment together with the equity market volatility. Holz said most real estate funds have traditionally been marketed to professional allocators such as pension schemes and insurance companies, meaning the minimum investment thresholds were typically in the region of USD 5 million, reaching as high as USD 50 million to USD 100 million at some of the larger managers. These minimum investment criteria are a deterrent for HNWIs. Instead, he urged managers not to underestimate the size of the HNWI market. “If you look at the affluent retail and HNWI market, it is roughly the same size as the institutional market," he said.
Flight of capital into open-ended real estate funds
Between 2013 and 2018, closed-ended funds saw a compound annual growth rate (CAGR) of four percent whereas open-ended co-mingled funds increased by 18 percent. "Open-ended real estate funds have seen significant investor inflows, often to the detriment of closed-ended funds," said Holz. However, open-ended real estate products are not without their risks. Three times in the last 13 years (2008 financial crisis, Brexit referendum result, COVID-19), open-ended real estate funds in the UK have been forced to suspend redemptions.
"Although these products offer daily liquidity, there is an inherent risk, particularly if a significant number of investors suddenly redeem en masse during periods of uncertainty, something which can force managers to fire-sell their assets, leading to further volatility," said Holz. In response, some experts have urged open-ended real estate funds to hold plenty of cash, a suggestion critics say could exacerbate performance drag. It is also possible that open-ended property funds could be subject to further regulatory scrutiny, with the UK Financial Conduct Authority (FCA) currently conducting a review into the sector's liquidity risk management practices.
After navigating a challenging 2020, real estate managers – who are able to evolve their businesses to take into account some of the COVID-19 induced changes – will be in a strong position to raise funds. With investors openly bullish about real estate, the asset class could be poised for rapid growth later in the year.
RBC Investor & Treasury Services
1. RBC Investor & Treasury Services (February 2021) Webinar: UK & European Real Estate Investment, How has COVID-19 affected these markets?