Rome wasn’t built in a day: Long-term trends driving real estate in volatile times

next issue no. 7: Investment corner

The current state of real estate

In the very first edition of next we discussed the potential benefits of direct real estate allocation in target date vehicles. Nearly three years later it is time to see how our hypothesis held up, especially after the ups and downs of 2020. Did the asset class perform as we expected it to? What has changed in the real estate investing universe? Is there an archetypal direct real estate allocation that should be part of a target date suite? We explore these questions and more in the following section.

Private real estate in defined contribution

We believe that real estate plays an important role within target date strategies. The long-term focused asset class can be a differentiating factor in portfolios by creating a diversification benefit and producing additional income. In our opinion, the ideal allocation to direct real estate is about 5% of a target date portfolio. While other portfolios may have allocations to direct real estate of 5 – 15%, our analysis has shown the need to balance the additional yield and diversification benefits with liquidity challenges inherent to the asset class.

Referring back to next issue no. 1, analysis favors direct real estate over real estate investment trusts (REITs) because of the lower volatility and relatively high risk-adjusted returns.

The benefit of REITs is that they are much more liquid than direct real estate investments. That liquidity is derived from the fact that they represent a public market investment, and thus tend to move in a manner more similar to public markets. Specifically U.S. equities and REITs have a 0.71 correlation over the past 20-year period ending 31 December 2020. On the other hand, direct real estate only had a 0.15 correlation with U.S. equities over the same period. This information stands to prove the diversification offered by direct real estate in a target date portfolio.

Fundamentally, there are principal reasons to invest in real estate at this time such as the additional income generated by real estate. Additionally, real estate may provide a particularly attractive investment for investors seeking to hedge against inflation, at a time when inflation may be running above average. Further, rental prices and property values are highly correlated with rising consumer prices. Most long term leases have built in rent escalators that are tied to inflation, which protects the income generation of in-place leases. Residential leases tend to average twelve months and allow for adjustment, while office leases with longer contracts allow for less inflation buffering. The industrial sector also often offers medium-to long-term leases which can benefit from inflation driven by growth, as many properties currently have below market rent prices. Typical annual rent bumps are 2.0-3.0% as real estate owners need to keep up with the inflation of expenses as well. In the multi-family space, Nuveen Real Estate aims to institute at least 2.0% year-over-year increases in rent. We are sensitive to timing as we prefer annual increases. However, some retailers and industrial tenants will agree to mid-term increases and negotiate percentage rent which is based on exceeding a sales threshold.

Our target date portfolios remain committed to commercial real estate as a long-term investment. We believe our policy focusing on consistent income and stable tenants while monitoring current trends in alternative real estate investments will help position individuals for retirement. Our target date strategies enable participants to benefit from reduced volatility, improved risk-adjusted returns, enhanced diversification and inflation hedging.

Our direct real estate predictions

The principal driving force behind our outlook hinges upon continuing demographic trends that were accelerated by the COVID-19 pandemic. The aging millennial generation will continue to have outsized effects on the economy. Factors such as this generation having children at a later age when compared to prior generations and having lower rates of home ownership lead us to predict growth in single family rentals and other alternative real estate classes, such as self-storage. Further, this demographic is increasingly focused on the importance of ESG factors in real estate, both at home and at the office, so we see demand for services such as green energy projects growing.

Not all financial crises are equal

The impact of the COVID-19 pandemic was harder on some commercial real estate sectors than others last year. While this may seem like an obvious statement, it is different from the great financial crisis of 2008 when pretty much every sector was equally hit, and saw roughly parallel rebounds (Figure 3). This time, the impact exacerbated trends that were extant in the marketplace. An example of this are struggling malls and lodging which were hit hard and have taken longer to recover. Whereas industrial buildings, medical offices and multi-family homes continued to do well. There were interesting conclusions to be drawn within sub-sectors as well. For instance, we saw resilience among grocery-anchored centers and necessity based retail (such as beauty, food & beverage and fitness) in contrast to the struggling brick and mortar retail sector. This was because consumers were increasingly buying durable goods on the internet, but were reliant on physical stores for groceries and services.

Office space

The traditional office sector is one that has constantly been in headlines since the start of the pandemic, with the effects of work-from-home rippling through urban centers. While forecasts predict the majority of the workforce to be back in the office by the beginning of 2022, our near-term outlook remains fairly bleak. National office usage is around 25%, but improving over time. Net effective rents appear to be down around 10% nationally versus pre-COVID levels, though this varies by market and asset quality. Green Street, an independent research and advisory firm concentrating on the commercial real estate industry, forecasts the combined cumulative drop in effective rents and occupancy will bottom at 17% by the end of the year and slowly recover from there.¹

We are seeing numerous properties under 80% leased, and while we expect fall to be a turning point, the sector will likely struggle for some time.

One difficulty is that leases are expiring, but no one is renewing or backfilling the vacancies. Furthermore, tenants who did commit to leases typically chose short term leases (around 12 months) as opposed to long term (five years or more). Office real estate has always been capital intensive as tenants moving into new office space demand more build out than other property types to accommodate business needs. This can slow down the process and make it more expensive for building owners. Additional ancillary revenue generators have also seen a collapse. Parking income has fallen precipitously, and ground floor retail units are often now vacant, or leased and not open for business. When tenants do return to the office it will take time to see the ecosystem recover fully.

Out of office

Conversely, we are seeing strength in alternative sectors, specifically medical offices, self-storage, data centers and life science. These sub-sectors have additional yield (around 100-200 bps) which is beneficial at this time. While we are seeing the industry pivot to these property types, we particularly like the medical office sector. The pandemic accelerated a trend toward telehealth, and we believe non-hospital medical care is the sub-sector most insulated from potential negative effects of that transition. Further, the growth in outpatient procedures being performed in medical offices should drive growth in rents. We forecast medical office net operating income to grow from a 1.5% increase in 2020 to a 2.5% increase in 2021.

Revenge of the retail

One much maligned sector where we see positive signs is retail. Consumers are revenge spending, and while certain sub-sectors, such as mid-level apparel, suffered, generally everything else did well during 2020. Home goods, tech, electronics, and groceries all saw strong sales. Brick and mortar retailers with internet sales, known as multichannel distribution systems, are a particularly interesting growth area. The delivery mechanism is efficient, and it minimizes problems with shipping costs and returns. Grocery-anchored centers and strip malls that are protected from e-commerce will also remain strong and exhibit attractive pricing relative to other asset classes.

Home is where the growth is

Within alternative housing, single-family rentals are favorably positioned given the pandemic’s impact on urban areas and millennials. During COVID-19, city dwellers fled major urban areas for the suburbs and Sunbelt cities. While it is unclear if this is a secular or cyclical trend, single-family rentals offer a permanent lifestyle change at an affordable price as many millennial households cannot yet afford homes. Self-storage is projected to outperform due to single-family rental growth, the sector’s attractive initial yields and extremely low capital expenditures relative to traditional sectors.

Healthcare vitals

The pandemic exposed the country’s medical capabilities and thus the importance of medical innovation and discovery. The need for drug testing, therapies, and vaccines for future virus outbreaks will be paramount in the coming years which will ultimately fuel demand. Given the high levels of spending on medical offices in the U.S. relative to other developed nations, we believe more care will be delivered outside of hospitals in more cost effective settings such as medical offices.

Technical support

Alternative technology includes several sub-sectors, such as data centers, which have significant tailwinds behind them. Data centers increased in importance throughout the COVID-19 pandemic as large companies modified their IT infrastructures to ensure employees could effectively work from home. We believe this trend will continue as more companies provide hybrid, and in some cases, permanent work-from-home policies. Cell towers outperformed the broader real estate market during the pandemic as mobile data usage increased as consumers relied heavily on mobile products and online services. We expect the sector to benefit from structural changes that have been accelerated by the pandemic.

As mentioned prior, we see a macro-economic trend in the growth of medical offices and life sciences that will continue over the coming decade as they barely slowed during 2020 and continue to grow rapidly. Alternative technology plays an integral role in this evolution.

The future of real estate

We expect our portfolio allocation within real estate to evolve over the next decade. We suggest moving toward alternative real estate classes, while maintaining core allocations to other favored sectors. We predict continued institutionalization of alternative real estate, specifically alternative housing, alternative healthcare, and technology (Figure 4).

As we think about investing in direct real estate in our target date portfolios, we are examining burgeoning trends in the real estate market and looking to evolve our portfolios to capitalize on these trends, particularly within alternative real estate sectors. Maintaining an allocation to direct real estate allows individuals in our target date strategies to benefit from reduced volatility, improved risk-adjusted returns, enhanced diversification and inflation hedging, while being offered the ability to invest alongside institutional investors in rapidly emerging sub-sectors.