Has COVID-19 amplified offshore property growth trends
There are a number of compelling reasons to include this asset class in a (South African) balanced portfolio, including:
- Enhancing performance expectations
- Managing risk through diversification (asset class, geography and sub-sector)
- Managing exposure to the rand
Global property* has proven to be a dependable performer, delivering 10% annualised returns in US$ (more than 15% in rands) over each of the last two decades. It was also one of the best-performing asset classes in 2019, achieving a 24% US$ total return.
In our view, the correction of share prices across all markets in the first quarter of 2020 provides a compelling re-investment opportunity for the savvy investor. Indeed, we believe the lower entry point provided by the COVID-19-induced correction sets the stage for another decade of double-digit returns. The economic recession will accelerate existing property megatrends and will create even more growth opportunities for high-quality companies. Here, we set out our view of the megatrends shaping the global property landscape, as well as the distinct opportunities they present.
* As measured by the FTSE EPRA/NAREIT Developed Rental Index
How will this global recession shape the future of key property types?
1. Residential: always a necessity
Home ownership in the US has been in decline since the end of the Global Financial Crisis (GFC). We believe that it will remain structurally low as generational forces and increased rent regulation will make renting, rather than owning, a more sensible decision for many. These generational forces include urbanisation; increasing supply challenges because of tighter planning requirements, ownership preferences (especially in Europe), affordability, and the growing cost of ownership (energy-efficiency requirements and rising municipal and maintenance costs). Institutions with large portfolios and low financing costs will often be better equipped to manage these challenges and thus offer value for money in serviced rental accommodation. As a result, demand for institutionally managed residential property is likely to benefit from structural growth for decades to come.
In the US, we expect an acceleration in the trend of net migration of younger generations away from large coastal cities to more affordable but fast-growing cities in the Sun Belt states (the Carolinas south to Florida and west to Texas and Arizona). This will be because affordability, flexibility and quality of life are becoming increasingly important criteria for talented employees.
In Europe, most institutionally-owned housing that is listed is in Germany (although there is some in Austria and Sweden). Here, social safety nets are more accommodating and recession is amplifying the need for affordability in context of declining interest rates, increasing immigration and insufficient supply.
2. Industrial: sustainable tailwinds
Industrial warehouses, especially those that are logistics-focused, are enjoying a structurally growing wave of demand that far outpaces supply. This is due to the ever-increasing costs related to developing and owning property in densely-populated urban environments, rising construction costs and shortages of dedicated and appropriately skilled labour to work in these ultra-modern logistics warehouses. In particular, demand is driven by:
- Online commerce: The convenience of online retail is driving change in global supply chains and reducing the need for physical store space. To achieve a particular turnover target, online businesses require three times more warehousing space than physical retail space. In most developed countries, online commerce comprises only 10-20% of overall retail sales but is growing at double-digit rates every year. Space close to homes and workplaces (‘last-mile space’) is especially limited and highly sought after.
- Cost rationalisation in supply chains: Increased focus on cost optimisation in global supply chains is driving occupants to move out of older, less efficient warehouses into newer, fit for purpose facilities, where rent represents only around 5% of total supply chain costs.
- More inventory required: Global lockdowns have accentuated the need for warehouses to hold more inventory to ensure stock consistency and speed of delivery. This also partly mitigates the risk and associated costs of an abrupt halt to manufacturing and supply chains, which far outweigh the cost of holding additional stock in warehouses.
3. Towers and data centres: plugged into the digital economy
The need for digital connectivity through streaming and storing data continues to grow, driving the ever-increasing demand for more bandwidth and faster transmission speeds. This is making the property that houses digital infrastructure as well as the location of this property ever more critical. Mobile phone towers and network-dense data centres are an essential part of the solution for cloud services providers, content delivery networks, over-the-top content providers, businesses with outsourced IT requirements and so many others. Three factors are driving secular growth in demand for this type of property:
- Cloud storage: Lower maintenance costs, fewer physical space storage requirements in existing premises and global, remote and instant access to company data are leading businesses to transfer all or part of their data infrastructure to the cloud. The cloud is housed in data centres.
- Migration to up to 4G and 5G: The advent of the Internet of Things (IoT) requires an exponential increase in sensors and therefore data transmission, as users continue to expect more volume at fibre speed and this drives demand for more bandwidth and faster download speeds. The equipment required for this is accommodated on mobile phone towers.
- Edge computing: The recession is increasing the focus businesses place on operational efficiency, automating business processes and improving performance and safety. This requirement powers the need for more computing to be done at the edge of networks rather than in centralised locations.
4. Offices: likely to experience significant change, presenting niche opportunities
Offices represent a major portion of global property investment stock. While we believe that across the world offices are more of a cyclical property subsector than one supported by secular growth, there are some niche markets experiencing consistent demand from strong relative employment growth within more future-proofed industries. These are in cities such as Toronto, Austin, Miami, Seattle, San Francisco, Stockholm, Paris, Barcelona, Singapore and Hong Kong.
The COVID-19 pandemic is a catalyst for a more health-conscious work environment. Therefore, we expect that in time, landlords and corporate tenants will likely make significant investments into their spaces, accommodating a more health-conscious view towards workspaces, canteens, elevators as well as sanitary areas.
In the right locations, however, offices should perform more defensively than retail and leisure property over the medium term thanks to longer leases. They will also be supported by the following factors:
- Some activities can only be carried out in offices, such as research and development, especially in the life sciences sector that requires specialised laboratories
- Workspace density could now decrease, meaning more and larger meeting spaces with potentially more individual offices, which would mark a comeback from open-plan layouts
- Shared workstations are now less appealing and may be against new regulations, making ‘hot desking’ and co-working less attractive
- Centrally located and modern offices with amenities are factors in talent attraction and retention and will remain so as a home cannot offer the same level of amenities.
- Working from Home (WFH) may not be compatible with diversity and inclusion standards, as not everyone has access to a comfortable home working environment from which to be productive and could represent an additional cost for employers
- Some office buildings can have higher alternative use values (residential conversions).
5. Self-storage: with you wherever you go
Self-storage is a niche property sub-sector with one of the highest returns on investment around (net rental income margins of over 70%). It is benefitting from long-term growth in utilisation. In the short term, self-storage REITs are being impacted by the pandemic and the resulting economic weakness in the following ways: lower or no renewal rate growth, delinquent customers, declining move-in rates, greater discounting, and some occupancy headwinds.
In the medium term, the following trends are likely to emerge:
- Portfolios that are located in cities with slow population growth and that are most exposed to oversupply and employment losses will suffer disproportionately relative to others.
- Landlords are focusing on cutting costs and removing the friction associated with move-ins and move-outs by introducing contactless leasing and access.
- In the US, net migration to fast-growing cities in the Sun Belt states will provide better prospects for portfolios concentrated in these locations.
- Listed REITs will likely continue to grow organically but also by consolidating the market, enjoying significant operational, scale and cost of capital advantages, ensuring growth for many years to come.
In the long term, we believe that the low obsolescence nature of self-storage, combined with low capital expenditure requirements and low nominal rental payments, will act as a relative buffer to economic headwinds as landlords’ break-even occupancy rates tend to be lower than other property sub-sectors. In the UK and Europe, greater densification and lower utilisation rates offer a more defensive outlook with higher return prospects than in many US cities, where temporary supply headwinds are likely to temper growth rates.
6. Retail property: time for a makeover
Retail property is going through what we believe is at least a decade-long transformation that is likely to be characterised by a secular reduction in space needs, where retail space is increasingly becoming redundant and being converted to alternative uses. The plight of regional malls (particularly B-quality and below) will be that tenant demand continues to contract, leading to eventual mothballing and likely destroying shareholder value. The reasons for this demise are:
- Rapid and sustained growth of online sales at the expense of physical store sales
- Accentuation of oversupply of retail space per capita from the recession (as a result of mall space growing at a faster rate than both consumption and disposable income per capita for the last 20 years)
- Reduced rental affordability as the narrowing of retailers’ margins accelerates, with many retailers burdened with debt from private equity leveraged buyouts that occurred post the GFC
- Changes in spending habits (less time to spend in department stores and more experienced-based spending).
However, A-grade shopping centres located in densely populated areas will continue to attract the lion’s share of demand and house tenants’ flagship, experienced-based stores. These portfolios will benefit from the conversion of low-density retail space as well as the eventual utilisation of air rights (where foundations allow) to become mixed-use assets.
We expect the impact of the pandemic to accelerate megatrends within the property sector. Listed property companies most exposed to these trends will continue to outperform in both the short and long term. We consider sectors, such as data centres, towers, industrial, self-storage and niche residential property as growth sectors, whereas, retail, lodging and hospitality REITs represent value. Global office property lies somewhere between growth and value, depending on its location.
Our investments are, therefore, concentrated in companies owning assets in markets with higher barriers to entry, portfolios that dominate in their niche(s), and companies that have appropriately-geared balance sheets, enjoy cost of capital advantages and have on average higher retention of free cash flow than their peers.
The stock market correction of Q1 2020, the ensuing compression in monetary base rates, as well as the record stimulus provided by central banks have combined to support expansion in the sector. A return to relatively secure long-term income growth from 2021 onwards will provide the runway for another decade of double-digit rates of return.