René Veerman, head of Real Assets at MSCI and Ian Goldin, professor of Globalization and Development at the University of Oxford, headed up the first part of the MSCI Global Real Assets Conference with a conversation around transformations and opportunities in our current economic climate.
Goldin explained that there are many things happening simultaneously in our current turbulent global system. While this turbulence creates anxiety, it also creates opportunities for growth and development.
In terms of global issues and concerns, Goldin explained that one of his largest source of anxiety is tension across borders. “My greatest concern is the rising tension between the U.S. and China,” said Goldin. He explained that although it is unclear where the conflicts may go, we are unlikely to beat global threats without interconnectedness between the countries.
Goldin also spoke to the recent interest rate hikes, noting that it is his belief that we are likely to see higher interest rates for a long period of time. If inflation is above The Federal Reserve’s target zones, which will likely occur for at least a few years, inflation rates will remain high. This in turn means that those on lower and middle incomes will see a real downward pressure on their earnings.
“Rising interest rates and the turmoil in markets…has led to a rebalancing in portfolios and the need for more liquid assets,” Goldin said in the conference. Repricing, opportunities and consolidation will become common in the real estate market, he believes. High-end office, residential, urban, entertainment and warehousing are some of the markets that will see sustained pricing. He believes these asset classes are relatively immune to the effects of higher interest rates and other external economic factors.
Another fundamental transformation that is happening, according to Goldin, is that outsourcing is largely coming to an end. “You cannot outsource to another country the manufacturing of great food. That needs to be local, in the restaurant. You cannot outsource a massage to a far-off place. What economists call non-tradables become more important as countries become wealthier,” said Goldin. As a product of the trend of diminishing outsourcing, trade will become less significant while cities will become more important.
“Urbanization and cities are the future,” said Goldin. He believes that cities are the heart of economies and the engines of the future. Cities will continue to grow our economy, and therefore the scale of investment in cities needs to increase. Public transportation, the grid and clean energy are some of the things in cities that need further investments to grow productivity.
Due to climate change, coastal cities will be under a lot of stress, Goldin notes. This leads to one of the key questions of the future. For real estate investors, the question is: What types of real estate do you invest in, in these cities that are resilient to the shocks of ocean-related events?
Making decisions in an uncertain world
For the conference’s segment on real estate decisions in a time of uncertainty, Fidelity International’s Neil Cable, head of European real estate investments, Will Robson, global head of real estate solutions at MSCI, along with Savills Investment Management’s Kiran Patel, global CIO & deputy global CEO, and Ben Sanderson, Aviva Investor’s managing director of real estate, engaged in the discussion.
Global real estate is teetering on the edge of immense change. Risks to consider include cyclical risks, rental growth expectations, tenant default risk and leverage and active management risk, according to Robson.
“Certainly, it is a different sort of cycle we are experiencing,” said Sanderson. “For me it is about the economy and tenants.” He explained that the main risks he is considering concern tenants and rental growth. This includes how to keep buildings occupied in a high interest rate and high rental rate period.
Sanderson believes that the regulatory environment has improved and that investors are more disciplined with debt being looked at in a well-informed way (compared to previous cycles).
“The primary [risk] today is around pricing and leverage, and they will have consequences,” said Patel. Going forward and living with inflation, leverage is impacting property prices and affordability in terms of the tenant’s ability to pay rent. Similarly to Sanderson, Patel said he is looking at tenant margins and the headwinds that will impact the real estate industry there.
In any downturn, Patel noted, there is opportunity to be discovered. The industry has a tough time ahead, but that will lead to opportunities down the line.
“There is a consensus broadly in the market that we are headed for hard land,” said Cable. The two things that are at the top of his mind now are clients and sustainability. In times of crisis, he notes, you stick closely to your clients. Efficient markets are about the efficient allocation of capital, and clients wait to invest until they believe it is the appropriate time. Clients, according to Sanderson, are being more discerning in terms of how they determine their optimal investments. One thing clients are considering in their investments is the climate risk in assets.
Sustainability and climate risk create an existential crisis for CRE, and something that must be built into portfolio strategy. “Through our underwriting, we do a lot of climate risk assessment,” said Patel. He explained that climate risk does not necessarily deter him from investment, but it is a factor. Tenant demand and business growth are drivers that come above climate risk in terms of investment opportunities. However, one must consider the carbon footprint and sustainability in property investments. Pricing in sustainability will evolve, and the transition to net zero capacity for properties will factor into this pricing, explained Sanderson.
The future of hybrid and remote work, a trend accelerated by COVID-19, is another key topic in the industry. With high inflation and high energy costs, engaging with tenants creates long term relationships. Understanding tenants, their constraints and flexibility, is something the market must do to find equilibrium.
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Cable noted that break clauses, and other leasing events, need to be underwritten properly. Agreeing with Cable, Sanderson explained that tenants are only part of the equation, while location, operational risks and team structures are factors that are changing in leasing as well.
Top trends altering the investment landscape
Jim Costello, chief economist at MSCI Real Assets, was joined by Peter Hayes, the global head of investment research at PGIM, Olafur Margeirsson, head of global real estate research at Credit Suisse, Elizabeth Szep, real estate department at the Abu Dhabi Investment Authority and Craig Thomas, senior vice president of market research at AvalonBay Communities, to discuss trends in the CRE investment landscape.
Szep explained during the conference that one key trend the pandemic fueled is the debate around the future of cities. Places in the U.S., such as the Bay Area and New York, saw massive migration out of urban cities and city centers. Now, however, that tide is changing.
“Residents are returning to cities. They just aren’t returning to the office,” said Szep. The onset of the pandemic saw residency rates as well as office occupancy rates drop. Now, office vacancy is rising while residents are returning to cities and decreasing vacancy rates in residential buildings. “Don’t bet against cities,” she said. On the other hand, global office vacancies, she believes, will get worse before they get better while individual work is performed offsite.
Hayes spoke about how 2022 is seeing a pattern of job growth coming out stronger than expected, as has historically been true as well. “The forecasts for job growth have been revised upwards from where they were a year ago,” explained Hayes on the 2022 projections. From a real estate perspective, the good news is that job growth is strong. This translates into the idea that the occupier market could remain stronger than is currently expected. The bad news, from the real estate perspective, is that the Central Bank may interpret positive job growth to mean interest rates should remain higher for longer.
Thomas spoke to the nominal effective rent of dollars per unit, versus the real effective rent (inflation adjusted effective rent). Nominal effective rent is currently significantly higher than the real effective rent. Apartment demand has skyrocketed and rents are rising. This discrepancy in the nominal rent being much higher than the “real” effective rent had led people to believe there was something happening in demand to cause this trend. “The truth of the matter is, nothing was going on,” said Hayes. Part of what was occurring, he believes, was inflation.
Margeirsson spoke to how real estate investors can interpret what is “normal” in CRE markets through pricing indicators and models and rental growth forecasts. “At some point you simply just need to make the judgement call,” said Margeirsson.
Climate—from talk to action
Meggin Thwing-Eastman, global ESG editorial director and research director EMEA at MSCI, led a section on climate joined by Sven Bienert, Head of the CRREM initiative and managing director at IIO Ltd, Jessica Pilz, Global Head of ESG at Fiera Real Estate and Paul Sutcliffe, executive director & founder of EVORA.
“If we are discussing net zero, we have to differentiate between what is a net zero commitment on a property level versus a net zero commitment on a company level” said Bienert. On the property level, a net zero commitment could be a renewable offsite energy source or high renewable energy within the property. From a company level, it is making efficiency target statements. The real estate sector is responsible for a high amount of pollution and green house gas emissions, so working on efficiency is crucial when working on properties.
“Climate is the priority,” said Pilz. For investors to effectively manage climate risk, industry best practices focus on removing reliance on fossil fuels, reducing the carbon footprint and offsetting residual emissions. Investments and capital funded toward sustainability is not a one size fits all, according to Pilz. While it can be difficult to cut through all the regulations and metrics, the objective is to align priorities with that of the investor to build a clear framework about what net zero means and how to achieve it.
“Make sure you have the right governance in place,” said Pilz in terms of what helps investors and owners to understand the fundamentals needed to achieve sustainability goals.
Sutcliffe said that on executing goals related to sustainability, the approach considers factors such as geography, transition risks, investor appetites and regulations. “We need to find ways of progressing,” he said. Access to data in real estate is a challenge in terms of sustainability and energy expenditure. But, data, or a lack of data for that matter, should not slow progress.
“I think the clear call is to increase data coverage and increase the reliability of data,” said Bienert.
