Investing through market corrections has historically driven outperformance for real estate investors. We believe this will continue into 2024.
To succeed in this volatile environment, we believe investors will need to shift their investment strategy.
As well as focusing on the value created by recent market volatility, we are focusing on demographic changes, sustainability requirements, and technological change.
There is a quote commonly attributed to Mark Twain which says, “Whenever you find yourself on the side of the majority, it is time to pause and reflect”. It is good advice in general – but perhaps particularly relevant to active investors on the lookout for non-consensus opportunities.
2023 has proven to be a volatile year, and many of the real estate headlines have focused on the price volatility that rising interest rates have created. However, this disruption has already offered opportunities for those who are prepared, and we believe this will continue into 2024.
Investing through corrections has historically driven outperformance and, in our view, this opportunity is set to repeat in 2024 and 2025. We believe that ongoing refinancing pressures and sustainability concerns will continue to drive mispricing in our markets, allowing active investors to benefit from value-creation opportunities for the rest of the decade.
As introduced previously, real estate investors have historically benefitted from outsized returns after market corrections. To illustrate this further, let’s take a look at Figure 1.
Using industry data from INREV, the chart shows the five-year returns of “value add” funds in Europe at different start points. As you can see, there is a clear pattern of outperformance for funds that invested in the aftermath of the global financial crisis, and particularly after the euro crisis in 2013. While the below chart focuses on “value add” portfolios, a similar pattern is evident when you look at the five-year returns from core real estate funds too. The analysis below still shows clear patterns of outperformance even when we adjust for yield shift.
This outperformance is driven by a range of factors – not least the ability to benefit from mispricing when transaction volumes are reduced. Furthermore, investors like Invesco Real Estate have the resources needed to reposition assets, if we feel they could benefit from capital expenditure projects. Meanwhile, less experienced owners may lack the confidence to undertake expensive projects during periods of economic turmoil, and instead look to sell.
We think that 2024 is likely to offer similarly strong performance, and believe that investors can benefit from this by “carefully playing offense”, as outlined by Invesco’s Kevin Grundy in a recent podcast. Kevin is one of our managing directors and looks after European fund management.
Source: INREV as of January 2023. No value-add funds were launched in 2009 or 2013. Indexed to 100 at first close. Past performance does not predict future returns.
Having established the valuation opportunities that are available in markets right now, let’s take a moment to reflect on the potential direction of economies going forward.
Central banks spent 2023 fighting inflation, and the challenge now will be keeping it under control. While the annualised rate of price increases has slowed globally, it remains clear that some underlying pressures persist.
With this in mind, financial markets are adjusting to two key realisations. The first is that interest rates are likely to remain elevated for longer than previously hoped. The second is that economic growth is unlikely to recover significantly in the near term.
The decline in GDP growth going forward may weaken demand for some real estate sectors. However, even in a slower growth environment, occupational demand from some tenant groups will remain strong. At Invesco, our investment strategies focus on identifying these opportunities, which we describe in further detail below.
To succeed in a volatile economic environment and benefit from the valuation opportunities available, we believe investors will need to shift their investment strategy. Recent history has seen persistent trends in the relative performance between real estate sectors. However, our conviction is that sector allocation will break down as the dominant driver of returns going forward.
At Invesco, we have stopped thinking in terms of the four large sectors: residential, industrial, retail and offices. Instead, we think about sub-sectors and how assets are positioned within smaller niches. For example, the industrial sector sees huge variation in the return outlook between research and development space, cold storage, and urban distribution. In other words, the details matter.
Going forward, asset-specific returns will be driven in part by clear business plans and a disciplined approach to delivering these. But net operating income (NOI) growth is also strongly shaped by secular trends, which drive changes in the relative demand patterns over time. This includes shifts in the tenant landscape, which are further exacerbated by changes in financial markets.
We have identified four key trends that we believe will shape real estate investment over the short and medium-term.
Today’s higher interest rate environment has caused property prices to fall, as many asset owners have become motivated sellers.
We will be keeping an eye on:
We will also use our real estate debt expertise to provide financing in situations that are overlooked by mainstream lenders.
Today, we are experiencing:
We will continue to target the demand that these demographic changes are creating.
To build resilience for the future, and to tap into investor demand, we are:
Investing in existing assets to improve their efficiency.
Technology and hyperconnectivity are reshaping everything – and the implications are important for real estate investors to consider.
Life science facilities, which will accommodate increased healthcare investment, are just one sector we are keeping an eye on.
One important area that we haven’t touched on so far is real estate debt – an asset class that has been thrown into the spotlight by today’s higher interest rate environment.
These loans are typically floating rate in nature. This means the coupon payments increase in line with rising interest rates, making them an attractive option for many investors.
Furthermore, the current market correction is leading to banks taking a more cautious approach to new lending. This is creating an opportunity for alternative lenders to step into the funding gaps left where banks retreat.
We recently financed a hotel in Barcelona, one of our favoured hotel markets. When underwriting the loan, we used a combination of Invesco Real Estate’s hotel and debt expertise.
Located in the city centre in a destination that is a favourite with tourists, the hotel was already performing well. Occupancy was above 90%, and its average rates were above pre-Covid levels.
Given valuation concerns, local banks were restricted to very low loan-to-value ratios. This allowed us to lend at a modest loan-to-value ratio, relative to historic levels, while delivering an attractive return to our capital.
At Invesco, our real estate debt team underwrite opportunities based on real estate fundamentals. They back strong sponsors and partners by financing assets in less traditional property sectors, or where assets have an element of redevelopment or repositioning.
As such, we believe the current retrenchment of the banks away from more alternative real estate sectors will continue to provide attractive opportunities. This is something we will look to capitalise on.
As we head into 2024, the market consensus is generally that interest rates have peaked – which is exciting news for bond investors. We explore the implications across a broad range of fixed income asset classes.
It’ll be a challenging backdrop for equities in 2024. From an investment perspective, company fundamentals are likely to become more important. Read our investment outlook for more.
In our assessment of the alternatives investment universe, we offer insight to areas of opportunity in private markets in 2023 and share asset class specific views.
The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.
Property and land can be difficult to sell, so investors may not be able to sell such investments when they want to. The value of property is generally a matter of an independent valuer’s opinion and may not be realised.
All information is provided as 17 November 2023, sourced from Invesco unless otherwise stated.
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