In a research report published this month by UBS Real Estate & Private Markets, entitled: ‘Real estate questions for 2020’, UBS REPM’s lead real estate strategist, Paul Guest, outlines what we can expect to see next year and why, against all odds, a retail comeback could just be on the cards.
Q: Now that industrial returns are starting to slacken, which sector will take over as the out-performer?
Guest: This answer may seem controversial but 2020 could be the year that some retail starts a comeback. This needs some very heavy caveating. Any out-performance from retail will be exclusively on an asset-level basis, and not a market level. And given the stages of retail value decline to date, it is only the US and possibly the UK where values have dropped to a point that opportunistic buys may make sense. But in these markets, for very selective assets which demonstrate all the right attributes of tenant mix, dominance and sensible rental levels, the substantial discount which can now be achieved on the purchase price means that much of any future decline in values and rents has already been absorbed. And with retail parks/neighborhood retail in particular delivering very high income yields off the discounted price, in a period of relatively low growth in other sectors this could be enough to deliver outperformance despite all the obvious challenges. But we must emphasize: we are talking about very selective assets and not the sector as a whole!
Q: How should property investors position themselves for an economic recession?
Guest: In the past, recessions often combined the peak of development activity with a drop in tenant demand. Real estate used to be more highly levered and declining capital values led to defaults. As a result, investors were advised to de-risk by moving towards core and long income streams.
Despite the economic recovery since the global financial crisis, office development remains relatively muted, and the current supply shortage limits the downside risk of a widespread rental fall. As businesses are likely to focus on their core activities while incorporating tighter ESG standards at the same time, investors should de-risk their office strategies to core locations and ESG-compliant assets.
As the retail sector is in structural flux, leading to shorter leases at a time of slower growth, it has become more difficult for investors to de-risk, leading to historically low allocations. Logistics benefits from the challenges in retail, but is challenged itself by the decline in manufacturing. The evolution of supply chains supports investment in more recession-resistant urban sites. As real estate as a whole is less levered than pre-GFC, interest rates remain low, and the banking sector is more tightly regulated, lower risk debt can also provide recession protection.
It is no secret that it has been a tough year for retail. Most company failures come as no surprise as those with outdated business models and large legacy store portfolios fall by the wayside. There are, however, examples of successful adaption. E-commerce has freed consumers from the necessity of shopping, so retailers have to make them want to shop. "Experiential retail" has become something of a buzzword, but there are clear signs of robust sales in stores and schemes that invest time and money in the retail environment.
Q: Is core overpriced relative to value-add, or is levered core a safer investment strategy?
Guest: This question typically arises after a period of high returns, as performance starts to "normalize". This time, there are also very low absolute yields across assets. Investors are drawn to any undertaking with expected returns closer to recent history. Often, risks are dismissed because they are hard to measure and economic weakness is a distant memory. Value-add investments typically trade away current yield for higher capital growth. It should be noted that the volume of value-add available at any given time is a small portion of the core volume available.
Furthermore, value-add is project specific. There can be a wide range of outcomes depending on individual conditions. UBS's current outlook is that interest rates, and thus required yields, will remain low and economic growth will be positive but also low. As such, we might expect that core investment will be low yielding. Although future returns in our sector will likely be lower than recently, this expectation is consistent across asset classes. Value-add tends to be more successful in a high growth environment. Investors can successfully execute value-add in today's environment but conditions will likely lead to a wide range of outcomes. Selection will be harder than during a growth phase. Thus we argue that core is not over-priced relative to value-add. Rather, both strategies are responding to the current environment. Investors should anticipate low yields paired with modest growth and a wide range of value-add outcomes.
Q: Demand for flexibility is changing real estate usage; such as e-commerce or flex office. How will this spread to other sectors?
Guest: Corporates and end users are increasingly rejecting the notion that real estate is a fixed cost, and are embracing the concept of space-as-a-service, enabled by shifts in technology. This has manifested itself in self-storage, co-working and short-term accommodation, amongst others. From the landlord and investor point of view, the commercial viability of flexible solutions is debatable, at least for now. However, the real estate industry has always been quick to respond to the changing needs of end-users and this cycle is no different.
Looking ahead, we expect the retail and logistics sectors to accelerate the adoption of plug-and-play formats. The retail segment was the first to be affected by technology and changing consumer habits, but landlords are now offering excess space on short leases. There are already aggregators that serve to link up landlords and transitory tenants, and we can expect this trend to pick up as retailers adapt to smaller footprints. In the logistics sector, pop-up supply chains are evolving. Especially for smaller -ecommerce players, temporary and on-demand logistics provide a solution for expanding fulfilment capabilities during peak periods. The logistics sector will see a slight shift from build-to-suit towards a build-to-serve model.
