Economies are another year further along in their mid to late cycles, and many asset classes, including real estate, are generally fully priced. In past cycles, investors concerned about cyclical downturns relied on bonds as a source of income and stability. In a low to negative rate environment, that portfolio insurance comes at a cost. 

In our view, a well-diversified core real estate allocation can help address investors’ needs for income and portfolio ballast. Core real estate has become increasingly global while, at the same time, structural shifts within real estate markets have broadened the range of core investment opportunities beyond traditional property types. Together, these trends are providing investors with an expanded set of building blocks for constructing diversified core portfolios.

To be sure, there are pockets of opportunity across the global core, value-added and opportunistic sectors. However, our outlook this year focuses on regions and sectors within core real estate that our specialists view not as off-the-chart return opportunities but as particularly suitable for building core allocations with the stable income streams and downside protection so many investors are seeking.

U.S.—beyond the traditional core
“Core real estate” refers to assets whose returns are mainly from stable cash flows, generated by high quality, well-leased properties in gateway markets. But the term “core” also reflects the central role of these properties in the functioning of an economy. As economies evolve, through technology, demographics and other structural trends, so too does the definition of core—and core allocations need to adapt.

REITs, given their specialized operational expertise and platforms, have laid the groundwork for the evolution of core investing beyond the four major property types (office, residential, retail and industrial) into what we refer to as “extended core” sectors (such as single family rentals, hotels and health care facilities). These less traditional sectors now account for over 40% of the U.S. REIT market cap—but less than 5.0% of the market cap of the NFI-Open-End-Diversified Core Equity (ODCE) Index (EXHIBIT 1).

We expect extended core sectors to make up an increasing share of private real estate allocations as investors come to better understand these opportunities and their risks and roles in a diversified core portfolio. Among our investment team’s preferred extended core opportunities: 

Single family rentals: Technology has given REITs and, more recently, private real estate managers a platform for buying, managing and renting a large number of single family properties, spread over a broad geography, allowing these properties to be run at attractive margins. The result is a new investment opportunity for institutional investors, with attractive return and diversification potential. We anticipate more private real estate managers entering this space, partnering with REITs or other third-party businesses with the required platforms and specialized expertise.

The definition of core allocations is evolving
EXHIBIT 1: U.S. REIT AND U.S. PRIVATE REAL ESTATE PROPERTY TYPE COMPONENTS

Source: Wilshire Associates for U.S. REITs—Wilshire US Real Estate Securities Index (WILRESI), National Council of Real Estate Investment Fiduciaries (NCREIF) for NFI-Open-End Diversified Core Equity Index (NFI-ODCE); data as of December 31, 1999 (~20 years ago) and September 30, 2019 (now/2019). 

*WILRESI core components as of December 31, 1999—office: 22.8%, apartment: 21.1%, retail: 16.9%, industrial: 7.4%, diversified: 14.2%.
**Industrial category includes classification of industrial mixed. 
†NFI-ODCE market cap represents equity only. 
††Extended category includes classifications of land and other.

We expect extended core sectors to make up an increasing share of private real estate allocations as investors come to better understand these opportunities and their risks and roles in a diversified core portfolio. Among our investment team’s preferred extended core opportunities:

Single family rentals: Technology has given REITs and, more recently, private real estate managers a platform for buying, managing and renting a large number of single family properties, spread over a broad geography, allowing these properties to be run at attractive margins. The result is a new investment opportunity for institutional investors, with attractive return and diversification potential. We anticipate more private real estate managers entering this space, partnering with REITs or other third-party businesses with the required platforms and specialized expertise.

Biotech: Laboratories can be viewed as a specialized type of office space and another area in which REITs have laid the foundation for institutionalizing investment. This industry is growing rapidly around knowledge nodes and requires highly specialized and customized physical environments.

Self-storage: With low capital leasing intensity (i.e., relatively cheap to build and maintain), this surprisingly resilient sector offers investors an income-driven return with low beta to the overall real estate market.

Data centers: Tenant demand for this specialized extension of the industrial sector continues to rise, particularly for locations with access to cheap power, multiple internet connection points and low risk of natural disasters. 

U.S. mezzanine debt 

Real estate mezzanine (mezz) debt—when used to finance experienced borrowers’ investments in high quality, well-leased core assets in primary and fast-growing secondary markets— provides another opportunity for diversifying U.S. core real estate exposure while earning attractive yields.

Mezzanine loans are subordinate to senior loans and secured by the borrower’s equity in the underlying property. Core mezz generally offers a modest yield premium to high yield bonds or leveraged loans while maintaining robust covenants and loan structures. 

Our U.S. mezz team favors two sectors for investors looking for income and diversification: high quality, well-leased multi-family properties, generally outside of the super-luxury apartment sector, and stabilized multi-tenant office buildings in established markets exhibiting strong employment growth.

Europe—a heterogeneous core

Overall, modest economic growth, low vacancy rates and limited new supply—combined with a still-cautious banking system— should support rental growth in major European markets. In the UK, where supply is somewhat less constrained, we are carefully monitoring the market as Brexit developments proceed and trade agreements evolve.

We highlight a few examples of the European core real estate market’s heterogeneous nature and diversification potential, given differences in regulation, demographics, taxation, politics and cyclical dynamics across economies: 

Apartments: Many highly regulated residential markets (in Germany and the Nordic economies, for example), where specialized housing companies manage thousands of relatively low rent apartments, can provide stable, bond-like returns through both private and public real estate investment. In contrast, the fragmented, largely individually owned UK apartment market is slowly giving way to a private rental sector, with apartment complexes currently being developed akin to those in the U.S. This should lay the foundation for a strong residential investment market in the UK over the next three to five years.

Offices: As in the U.S., supply-demand dynamics are supportive of the office sector. Berlin, for example, is coming off a low base, and rents and capital values, in our view, still have room to rise toward those of other large German cities, despite significant rental growth in Berlin during the past several years. We believe the results of the UK’s recent general election have alleviated much of the political uncertainty that had concerned London occupiers and investors, freeing the city’s office market for more robust growth over the coming months and years. 

Logistics: The U.S. is further along in the build-out and reconfiguration of the industrial supply chain. As Europe follows suit, and we think it will, we see opportunity for real estate managers and REITs to build the infill (“last mile”) industrial product that is required to satisfy consumers’ next-day delivery expectations.

Peripheral economies: In the context of a diversified global core portfolio, peripheral economies, such as those of Central and Eastern Europe or the Nordics, may offer attractive yields. However, care must be taken to distinguish between areas that are truly becoming “core”—growing, developing and becoming more liquid, transparent and established—and those that may address the need for yield but may not yet align with the riskreturn parameters of private core real estate.

As in the U.S., we do see investors becoming more active in extended core sectors (self-storage, data centers, student housing, etc.). This is particularly true among REITs with the specific operating expertise and platforms required to invest prudently in them. However, since many of these sectors are, relatively speaking, in their infancies in Europe vs. the U.S., it may take longer for these core opportunities to become accessible in Europe at scale. 

Asia Pacific—still growing its traditional core

The Asia Pacific region (APAC) appears to be at a slightly earlier stage of the economic cycle vs. the U.S. and Europe. While growth is slowing, especially in China, APAC economies are holding up quite well—as is real estate transaction volume—and fundamentals remain sound. APAC core real estate returns and the diversification opportunities the market can provide are attracting investors’ attention globally. Here are a few of its key diversifying opportunities:

Logistics: Our APAC team has strong conviction in this expanding sector. A growing middle class driving consumption and regional trade, together with high and rising e-commerce penetration rates (EXHIBIT 2), a shortage of modern warehouses¹ and, in some markets, the land to build them on should support returns and future growth. 

Offices: Core office markets are tight or expected to tighten, with vacancy rates for Singapore, major Japanese cities and Sydney, Melbourne and Auckland projected to be at or below 6% by 2021. Eight distinct countries or economies account for 90% of APAC’s core office market—the largest investible core real estate market in the region—providing building blocks for a well-diversified core office allocation.

E-commerce penetration in China and South Korea is well above that in the U.S., with room to grow in other key APAC markets
EXHIBIT 2: ONLINE RETAIL SALES AS % OF TOTAL RETAIL SALES (2018)

Source: Australian Bureau of Statistics, Bank of New Zealand, China National Bureau of Statistics, Japan Ministry of Economy, Trade and Industry, Korean Statistical Information Service, Singapore Department of Statistics, U.S. Census Bureau (for 2018 e-commerce penetration rates), Oxford Economics (for projected retail sales CAGRs, 2019–23); data as of December 19, 2019.

*Percentages are retail sales’ projected annual growth rates, 2019-23.

Residential: Multi-family markets in major cities in Japan remain attractive. Occupier demand is supported by small household formation and positive net migration from within and outside of Japan, given favorable job prospects in these cities. With supply constrained by rising construction costs, occupancy is anticipated to remain high and stable.

Of course, there are risks to our APAC outlook, most notably the impact of a potential trade war. We can’t predict that. What we can do is try to understand what’s behind tenant demand across the region and invest in those areas driven more by intraregional activity and less by international trade. 

In summary, in this late-cycle, low to negative rate environment, global core real estate and its extended sectors offer investors a wide range of opportunities to address their need for income and stability.

¹ As used here, “modern warehouses” generally refers to those built within the last five to 10 years. Compared with older facilities, they tend to have greater functionality, greater capacity, floor loading, more automated systems for racking and distribution, redundant power sources, etc.—features needed to support e-commerce.

0903c02a827b6f93