Private real estate – in search of diversification?

There is an undersupply of multifamily housing across Europe and rents continue to rise faster than the rate of inflation. (Image: Warszawski)

Private real estate has been the focus of investors for some time now. According to Simon Martin of Tristan Capital Partners, over the past five years, institutional investors have sought to build allocations to private markets to improve performance. Real estate played an important role.

"The attractive combination of current income, potential capital gains and value creation through active management has not lost its appeal for yield-hungry investors worried about record high stock valuations", points out Simon Martin, Chief Investment Strategist and Head of Research& Investment Strategy at Tristan Capital Partners, a partner of Candriam. In his view, the appeal of real estate should actually continue to grow, as the steep rise in consumer prices in recent months has renewed the sector's appeal as a potential way to diversify in times of rising inflation expectations.

As Martin goes on to explain, in Europe, the correlation between inflation and real estate returns has historically been driven by the nature of real estate cash flows. European rents are usually linked to the consumer price index, he said. This ensures that inflation is passed directly onto rents. The ability to increase rent by taking advantage of imbalances between supply and demand is also a key factor in attracting the sector when prices rise, he said.

"We believe the benefit of this effect can be amplified by focusing on sectors that benefit from strong cyclical and long-term demand drivers and where supply is likely to remain limited due to low vacancy rates and limited development activity", Says the investment strategist. In a handful of sectors, these demand-supply imbalances are likely to persist. Martin believes the most scalable opportunities are in the following areas:

Inner-city logistics companies for the last mile

Demand from e-commerce users for last-mile locations remains significantly higher than the supply of high-quality logistics properties close to consumers. Rents are rising dramatically and shortages are so acute that demand is expanding to other properties. This is driving significant reuse activity, for example in retail centers.

High-quality ESG-focused offices in innovation hubs

The return to offices in Europe was more positive than many had expected. While the impact of the pandemic-related demand shock is still evident in increased vacancy rates. However, these are mainly concentrated in lower quality properties. "Prime office space remains in short supply. In fact, given the capacity constraints and rising costs in the construction sector, we believe that European office markets will be shaped by Covid's impact on supply, not demand", says Martin.

"Such diversification could prove increasingly valuable over the next five years."

In key innovation centers, where demand is growing rapidly and supply is limited, this could drive rental growth of well-appointed properties with high energy ratings in advantageous locations. "In our portfolio, we are already seeing signs of this trend in London, Birmingham, Dublin and Barcelona. Given the lack of new supply and lower construction activity, it is likely that the increasing demand will move from prime properties to a broader range of high-quality, certified ESG properties", expects the investment strategist of Tristan Capital Partners.

Residential real estate strategies focused on key demographic niches

In a number of different sub-sectors, Tristan Capital Partners observes continued mismatches between supply and demand in the residential real estate sector: in multi-family housing, there is an undersupply across Europe and rents are still rising
higher than the rate of inflation. Housing offers for the elderly are scarce, while demographic and wealth dynamics are exceptionally advantageous. The student housing sector remains highly fragmented and is expected to grow significantly, he adds.

"With a balanced combination of these strategies, we believe investors seeking to maximize their risk-adjusted returns at a time of rising inflation risks are well positioned", Martin notes. Building an allocation to these themes, which are benefiting from significant tailwinds thanks to acute supply shortages while the cost of fixed-income credit remains low, appears to be an easy and attractive way to maximize diversification and reduce correlation to other asset classes. "Such diversification could prove increasingly valuable over the next five years,", Martin concludes.

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