Selectivity is key to capitalizing on post-pandemic property improvements – Simon Martindale

By Simon Martindale, Fund Manager, Property Income Trust for Charities, Mayfair Capital.

With UK markets expected to face heightened geopolitical risk and rising inflation through 2022, the economic environment should provide plenty of opportunities for property investors.

The decline of the pandemic is expected to translate into greater tenant demand, as occupants seek new spaces to work and live. At the same time, positive property returns are historically correlated with periods of robust economic growth.

However, the structural changes induced by the pandemic have accentuated the sectoral polarization within the real estate market. For many years, real estate investment has been divided into three main sectors: industry (including logistics), offices and retail, with the rest falling under the “alternatives” label. The pandemic has accelerated sweeping structural changes in the way we live, work and play, fundamentally changing the profile of real estate portfolios.

Now the winners and losers of Covid-19 can be narrowed down to specific sub-sectors. This means that investors must be selective to capitalize on the powerful momentum at play. Understanding the themes that guide business behavior will allow investors to identify specific areas of the real estate market that have clear long-term growth potential.

Going forward, it will also be important to build diversified portfolios aligned with structural changes and to prioritize high-quality assets to mitigate lingering uncertainty.

Sector specific

The rise of e-commerce has dramatically changed the retail landscape, which has seen logistics properties gain strength, at the expense of traditional high street locations. After a banner year for underwriting, we expect warehousing and logistics to dominate again in 2022 and beyond.

The warehouse market has seen rental growth of 9% over the past 12 months, while our space assets have generated capital growth of 27% over the same period.

Office space is an area that is coming under increasing scrutiny. Despite a challenging Covid-19, we believe the sector still has long-term growth potential as companies realize the fundamental role offices play in fostering productivity, collaboration and culture.

Already, 80% of our previously vacant offices are now leased or currently offered, which coincided with the easing of pandemic restrictions. However, it will be important to select assets aligned with the themes of the future, such as those that enable co-working, have strong sustainability and well-being credentials, and are well-connected.

We are also attracted to the hotel sector, which should rebound as tourism and business travel gradually recover to pre-pandemic levels. This alternative sector provides exposure to a different type of tenant – emphyteutic leases to operating entities with short-term stays by the underlying occupants – and represents an important diversification factor within balanced portfolios.

Away from commercial properties, we were increasingly drawn to the UK residential space. This sector has seen nearly 100% rent collection during the pandemic and offers a different return profile from the commercial real estate sectors. Residential rents have significantly exceeded RPI and CPI inflation over a 30-year period. Several compelling thematic factors are also supporting the growth of residential space.

There is a structural shortage of high quality, energy efficient and affordable rental accommodation in the UK, a problem exacerbated by the current cost of living crisis. This is why we are launching a new residential strategy targeting low-income families, with rents set at a maximum of 35% of the household’s salary.

Quality is king

In a context of ongoing structural change, investors must prioritize high-quality assets that match professional demand. Better building quality not only results in satisfied occupants and lower vacancy rates, but it can also lead to lease extensions and help justify further rent increases.

Undeniably, tenants are increasingly demanding about the quality of the buildings they occupy. If construction increases to meet growing demand for real estate, occupiers will have even more choice and it will be important to own the highest quality assets.

For example, although the warehouse sector has record vacancy rates, we are seeing an increasing demand for well-specified assets, especially those that feature generous eave heights, spacious yards with good storage facilities, mooring and are well located for multiple transport nodes and labor supply. . The anticipated increase in future supply is likely to cause a valuation correction for the specified weaker or poorly located assets.

The environmental impact of real estate is also increasingly in the spotlight, as the UK progresses in its aspirations to carbon neutrality. As such, buildings with poor energy efficiency credentials face potential declines in revenue and capital value, due to lower tenant demand and increased risk of capital expenditure, as increasingly strict legislation is introduced. Selecting high-quality properties with good climatic and environmental characteristics will help create resilient long-term portfolios.

We recently acquired a modern, purpose-built hotel in Leeds that meets these requirements. Built in 2017, the property is an operationally zero-carbon building and has an EPC rating of A, as well as solar panels and electric vehicle (EV) charging stations. This asset is isolated from the risk of future investments and should prove attractive to users, thus offering a sustainable and growing source of income.

Active improvements

Along with selecting high quality new buildings, improving the quality of existing assets within a portfolio is crucial, especially as 80% of UK properties that will exist in 2050 have already been built1 .

We prioritize a lean portfolio to build strong relationships with our tenants and make targeted improvements to the assets they occupy. By capturing energy consumption data with permission from our tenants, a key initiative to achieve realistic net carbon emissions, we were able to improve the Fund’s environmental credentials and improve our GRESB score by 15%2.

Collaboration between occupiers also allows us to more accurately identify tenant preferences and take advantage of opportunities to add value to the underlying assets. We recently completed the refurbishment of T2 Trinity Park, an office building adjacent to Birmingham Airport and the new HS2 interchange station.

When we purchased the site in 2016, the property had an EPC rating of E. Following significant modifications and capital expenditure, including the installation of electric vehicle charging stations and improved bicycle facilities and showers, its rating was raised to B. demand and resulted in a 10-year lease with leading facilities management company, Mitie Plc.

These positive results reinforce the importance of taking a proactive approach to portfolio and asset management. Ongoing structural change and increasing pressure to achieve net zero means that tenant demand will only become more demanding. This requires constant reassessment of portfolios to ensure they can remain relevant to the modern occupant.

Recent years have seen a widening gap between asset gains and losses. Rather than a transitory trend, this now looks set to become a permanent feature of the market and a key determinant of the performance of real estate fund management.

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