Real Estate Outlook
Opportunities as megatrends accelerate
A series of megatrends—the growth of e-commerce, advances in technology and connectivity, population and migration shifts—are gradually transforming how and where we live and work. In the process, they are shaping the very nature and form of real estate investing.
The COVID-19 pandemic has accelerated these megatrends, with repercussions across all real estate sectors—from positive for industrial/logistics to perhaps most disruptive for traditional retail. The opportunity set is shifting. In the current environment, informed asset selection is more important than ever in building diversified real estate allocations.
The implications vary regionally as well, depending on the progression of these megatrends, the current economic cycle and the pandemic experience in each region. These are important considerations for real estate investing.
What’s more, near-term visibility has been clouded by the pandemic—at least, until more transactions and lease renewals take place. Some properties may become obsolete while the more flexible and adaptive will survive and thrive. As a result, bottom-up analysis of individual properties and an informed view of sector and regional drivers of income and return are critical.
With that backdrop in mind, we look at opportunities within the major real estate sectors (industrial/logistics, retail, office and residential), including extended sectors, and identify the differentiated trends and resulting investment implications and opportunities our regional specialists are seeing in their respective markets.
Overall, we believe that with careful, diligent asset selection across regions and sectors, both traditional and extended, real estate investing can provide the alpha, income and diversification investors are seeking in this environment of persistently low rates (Exhibit 1).
Real estate can be a stable source of income and yield in a continuing low interest rate environment EXHIBIT 1: REAL ESTATE VS. BOND YIELDS
Industrial and logistics: Opportunity—with a pandemic boost
The industrial/logistics sector appears to be the greatest beneficiary of accelerating megatrends. The continuing shift to e-commerce, along with technological leaps in connectivity, cloud computing and the internet of things (IoT), is creating demand not only for traditional industrial assets (Exhibit 2) but also for specialized core assets, including data centers, cold storage and truck terminals. The pandemic, with its social restrictions, distancing and adaptive work from home (WFH) practices, has amplified that demand. In a low rate environment, this expanding opportunity set can offer long-duration, stable cash flows and the potential for yield enhancement over core bonds.
The growth of industrial/logistics assets at the expense of retail is not new, but has been fast-tracked by the pandemic
EXHIBIT 2: NFI-ODCE INDEX ALLOCATION BASED ON GROSS ASSET VALUE
As e-commerce accelerates, our U.S. team prefers infill warehouses (within a close drive to consumers) to those located farther from high density points of final consumption (and more susceptible to increasing supply). Our specialists are strategically focused on sectors where value is driven largely by the land component of a site vs. building improvements and special tenant amenities. Truck terminals and outdoor storage yards look particularly attractive. These long-leased properties require relatively low capital expenditures, are readily adapted to specific tenant needs and can generate stable cash flows.
E-commerce penetration has progressed more slowly in Europe vs. the U.S. and the UK, but the pace is picking up. That is driving demand for modern warehouses, which are in short supply. Online businesses need efficiently designed, well-located warehouses to be competitive—and they are investing capital to fit out these spaces to meet their specific needs. Given supply-demand dynamics, rental agreements are becoming more attractive from an investment perspective, with longer terms, inflation links, stronger covenants and high renewal rates. We see the potential for upward pressure on rental values over time.
The growth of the industrial/logistics sector in APAC’s key gateway cities is evident in warehousing, as well as in cold storage and data centers. This growth story is not just about e-commerce expanding at the expense of traditional retail, but about economic growth and a rising middle class. Warehouse stock is old, and an acute land shortage is driving a distinctly vertical build-out in many markets. Among the region’s supply chain modernization opportunities our APAC experts highlight:
- Japan, with its low e-commerce penetration and the highest ratio of warehouse demand growth to economic growth among major markets in APAC.1
- China, with over 90% of warehousing stock in need of modernization2 and spending power in its top-tier cities expanding strongly.
While our REITs team remains positive on the traditional industrial sector, we focus here on the compelling opportunities team members see in data centers. As with traditional warehouses, this fast-growing extended core sector can rapidly scale by leveraging the specialized skills, efficient service platforms and access to public markets that best-in-class REITs can offer. In Europe, our specialists highlight opportunities in, for example, Frankfurt and Paris as the shift to a hybrid cloud model accelerates. APAC (e.g., Singapore, Tokyo and Osaka) is likely to provide the greatest development returns, though land acquisition remains difficult, driving up returns but limiting opportunities. That said, the key listed players with established teams on the ground are well positioned to capitalize in this space.
Retail: Down but not out
Retail properties have suffered significantly as COVID-19 has hastened the trend toward online purchases. In our view, it is not time to abandon the sector but rather to take a more discerning look at its variety of property types and to be laser-focused on diligent asset selection.
Retail property types have varying levels of susceptibility to online shopping. Generally, “necessity” retailers have fared better than those considered discretionary. Additionally, e-commerce penetration varies by regional market (Exhibit 3), as do retail property supply-demand dynamics.
We see significant opportunity for operators that can reimagine and develop spaces in line with emerging retail models—models driven not by consumers’ pandemic-constrained behavior but by how people prefer to procure items, from groceries to big-ticket luxury purchases, in a more normal environment. The showroom aspect of retailing is expected to thrive as digitally native brands compete to establish their images and reach customers.
Online retail penetration varies across regional markets
EXHIBIT 3: GLOBAL ONLINE SALES’ SHARE OF TOTAL RETAIL SALES
Given the oversupply of retail outlets in the U.S., consolidation is inevitable, providing opportunities for survivors to become stronger and more dominant. As our U.S. team sees it, the winning retail model will not aim to physically reach as many customers as possible (suggesting that generic “big box” stores are more likely to succumb to online retailing). Instead, the victors will have created highly differentiated spaces targeting specific market segments, with a carefully curated, synergistic collection of businesses—stores, services, restaurants and entertainment—that together drive demand and support the image retailers want to establish. In a post-pandemic world, entertainment and leisure will again thrive as a key driver of retail demand.
Much of the European retail sector cannot currently be viewed as core, given the impact of excess supply and changing demand dynamics on both rental and capital values. Our European team views this period of uncertainty and transition as a potential opportunity to selectively acquire non-core properties that can be developed and delivered to the core market as the new core retail model emerges.
While situations vary intraregionally, the APAC region as a whole appears to be leading the COVID-19 recovery globally. Oversupply of mall space is not as significant a headwind relative to other regions, and distressed properties are fewer. Here, much of the pain has been due to tighter social distancing measures and a loss of tourist demand, which should rebound when travel restrictions are lifted. Retail sales have bounced back to the pre-pandemic levels of 2019.3
Some REITs with retail portfolios have issued equity at a discount—for redevelopment purposes and/or to shore up balance sheets in the current storm. While potentially detrimental to current investors, these offerings could be an attractive entry point for new investors seeking a certain risk profile. Selection is critical: Our team looks for portfolios of sound assets likely to survive the pandemic and participate in a recovery rally, guided by a top-notch management team that can effectively employ new capital to reconfigure existing properties.
Office: A brighter than consensus view
Some are calling for the pandemic-induced demise of the office sector. We are more optimistic. Working from home has accelerated under COVID-19 and proven its technological feasibility. But an optimal, sustainable home/office balance depends on economics and human nature—and may vary across businesses and regions. Here are some of the dynamics supporting our more constructive outlook:4
- Collaboration is essential to productivity, especially in industries for which innovation is a competitive necessity.
- The share of office-using jobs is growing, and those jobs’ share of wages is growing even faster (Exhibit 4).
- Spending fewer days in the office doesn’t necessarily imply a commensurate reduction in space needs. Companies have to plan for peak usage.
We believe that employers’ needs to attract the most productive workers to performance-enhancing, collaborative spaces in dynamic locations continue to drive a large and viable investment opportunity.
As seen in the U.S., wages are increasingly being earned in office-based jobs
EXHIBIT 4: SHARE OF ALL U.S. PRIVATE SECTOR WAGES EARNED IN OFFICE-USING JOBS
Our U.S. team continues to favor central business district (CBD) vs. suburban offices, despite recent CBD underperformance and market concerns about a potential departure of jobs from urban centers. The de-urbanization trends following 9/11 reversed sharply and quickly, the team points out. Another positive sign for the CBD sector: manageable new supply and occupancy costs prior to the pandemic-induced recession, compared with those in the periods preceding the tech and global financial crises.5
Submarkets where innovation companies (tech, biotech and other heavily collaborative enterprises) reside should fare well. Even during the pandemic, some of these companies have made sizable commitments to new space (e.g., Facebook within midtown Manhattan). We remain bearish on suburban offices due to the lack of a cluster effect, and on those CBDs where the demand is not driven by innovation companies but, rather, dominated by traditional users (e.g., law, insurance and banking).
In Europe as in other regions, WFH practices were underway prior to the pandemic and have accelerated with COVID-19, weakening demand for office space. In the core space, higher quality properties—those in accessible and vibrant locations, able to provide flexibility, technology and connectivity in an environment conducive to productive, in-person collaboration—should be more resilient to WFH trends. Selection will be critical.
At the country/city level, our team is relatively optimistic on Germany, given its more positive supply-demand balance and fewer economic and pandemic-related headwinds. The team is taking a more cautious approach to the UK in the face of rising vacancy rates and Brexit uncertainties. Regardless of the Brexit outcome, relatively high real estate and bond yields suggest that London could benefit from yield compression and, therefore, greater short-term capital value protection from occupier market weakness—with opportunities for both core and non-core investors.
The COVID-19-induced recession has impacted the APAC office market as well, tempering demand, increasing competition for tenants and pressuring rents. Cyclical supply-demand dynamics, coupled with greater uncertainty around the timing of the recovery, requires increased scrutiny of markets, asset characteristics and tenant profiles. What’s more, given tighter living quarters in many markets and less historical adaptation to, and perhaps less cultural acceptance of, WFH, the trend has progressed more slowly and the return to the office has been generally swifter.
Our team sees particular opportunity in Osaka, Japan’s second largest city by GDP,6 with vacancy rates below 2% at the end of 3Q 2020, new supply expected to be limited and white-collar and office-based employment growing at a stable pace. Identification of modern, energy-efficient buildings with flexible floor plates, the amenities tenants demand and few expiring leases will be critical.
Our REITs team sees potential near-term pricing opportunities in office space but cautions that visibility will be limited and selectivity critical until more new leases are signed and/or renewed. Team members are generally more constructive on offices in selected European markets (e.g., Paris and Madrid) and Japan (e.g., Tokyo), where pandemic-induced declines in office demand are less likely to be exacerbated by too much supply. In the U.S., they see potential opportunities in Sunbelt markets (Charlotte, Atlanta, Austin), where leases are still being written. These nongateway cities, offering many of the attractions of major urban areas but with lower costs and taxes, are drawing corporate headquarters and an aging millennial workforce.
Residential: Longer-term population dynamics continue to drive the outlook
Opportunities within residential real estate around the globe are being driven primarily by population trends in place prior to the pandemic. COVID-19 may be impacting the speed of these trends, largely through work-from-home dynamics and limited access to the dining, shopping and cultural experiences that make urban centers vibrant, desirable places to live. The pandemic’s effect on demand is being felt unevenly across geographies, but we believe it is likely to be relatively short-lived.
Millennials starting families and retirees moving to the Sunbelt continue to drive opportunities in multifamily and purpose-built single-family rentals,7 helped at the margin by COVID-19.
Despite the exodus from urban centers in the U.S. during COVID-19, 3Q 2020 rent collections for our Real Estate Americas platform were back near pre-pandemic levels. What’s more, nearly 60% of renters leaving New York City during COVID-19 put their belongings in storage, suggesting potential for a fairly rapid snapback in urban multifamily rentals and selective investment opportunities.8
The European/UK market is attractive but complicated by the potential for government regulation and controls. Our regional team sees opportunity in the UK purpose-built rental (PBR) sector, which is leading to the creation of institutional-quality assets in what has traditionally been a market dominated by specialists in Europe and small players and individual homeowners in the UK. These rental housing communities are supported by demand-side growth, given the high price of homeownership. Developers can realize economies of scale in developing and managing these properties, which have the potential to generate attractive cash flows.
Asia’s residential markets have shown resiliency in the face of COVID-19. Long-term regional migration trends persist, and most urban centers have not seen the outflows experienced in other regions.
Japan’s multifamily sector continues to stand out, led primarily by Tokyo and Osaka. Net migration growth rates may slow slightly in 2021 but should continue to provide a substantial tailwind. Rental units, particularly for single-person to small households, located near mass transportation should continue to see strong demand. Newer multifamily properties, from our experience, achieve high rental collection (currently near 100%),9 retention and renewal rates, and are expected to contribute to stable income streams. Yield spreads over bonds remain attractive.
Our Global REITs team sees particular opportunity in the institutionally managed multifamily rental sector in Europe, though government regulations to control rent could pose a challenge. In Germany, some of Europe’s largest listed multifamily companies are taking advantage of a still-fragmented market to assemble portfolios and build scale. Focused on the affordable end of the rent spectrum, these companies have had a stable collection experience during COVID-19 and have the potential for steady growth and solid income generation.
Once considered the most traditional of nontraditional asset classes, real estate is undergoing a transformation, driven by megatrends and fast-tracked by the pandemic. Some assets are set to benefit; others may not keep pace. Quality assets will adapt and thrive. With diligent asset selection, global real estate’s evolving opportunity set can continue to provide the alpha, income and diversification investors need.
1Oxford Economics, Jones Lang LaSalle; growth rate from 2015 to 3Q 2020.
2 “Order delivered: China Logistics Property in the Decade Ahead,” Jones Lang LaSalle, May 2020.
3Oxford Economics, Datastream; as of October 31, 2020.
4See David Esrig and Aric Chang, “Remote work and the future of office space,” J.P. Morgan Asset Management, November 2020.
6Estimates according to Oxford Economics, as of December 2020.
7Single-family homes built specifically for rental, generally in a community setting and providing apartment-like services and amenities.
8Hodges Ward Elliott, Data Insights Series (presentation), October 14, 2020.
9Based on J.P. Morgan Asset Management – Real Estate Asia-Pacific experience across approximately 5,500 units; as of December 31, 2020.