Attractive returns without excessive risk? If it sounds too good to be true, it usually is. But for over a decade, investing in core European real estate – buying established buildings in predominantly urban locations – delivered something very close to that.
Now, the risk-return trade off is less favourable. Rising interest rates (with cap ratesCap rates reflect the return investors are willing to accept from property investments. They are usually calculated as a property's annual net operating income divided by its market value. moving north as a result), changing occupier preferences, and tougher environmental regulation make for a less forgiving climate. Yet that doesn't mean real estate investors should resign themselves to more modest returns. Rather, it means looking beyond the more traditional property investments.
More specifically, we believe institutional investors looking for a certain level of return from real estate should consider allocations to value add or core plus investment strategies.
Although core real estate traditionally relied on rental income for the bulk of its returns, in recent years the strategy has received an unusually strong boost from rising property values. That’s because in an era of low interest rates and low inflation, investors were willing to pay more to secure an income stream, leading to ever lower cap rates and higher property values.
Now, however, that trend is reversing. Higher interest rates and higher inflation are already pushing up cap rates, leading to lower valuations for the same income stream. In prime European real estate, cap rates have widened by 30-100 basis points in 2022, with more widening expected.
And some of the previously most sought-after properties – real estate in central locations – might suffer the most. That’s because another key shift is also under way in real estate: a tightening of environmental regulations. Today, sustainability considerations are no longer an option; they are virtually a necessity.
Responsible for sustainability
Over the next decade, the real estate industry will finally have to face up to its environmental responsibilities. It promises to be a major undertaking: in the European Union, buildings account for 40 per cent of the region's total energy consumption, 36 per cent of its CO2 emissions and more than half of its electricity usage.https://ec.europa.eu/energy/topics/energy-efficiency/energy-efficient-buildings_en The industry is already coming under intense scrutiny from governments and regulators, and the signs are environmental rules will become even tougher.
The Netherlands has recently banned office buildings which do not meet a minimum energy efficiency standards of having an Energy Performance Certificate (EPC) rating of C – meaning moderately efficient – or higher. That will cause major upheaval because, as the real estate agent Savills says, some 40 per cent of existing office stock in the country does not meet the requirement. In other words, much of the Netherland's offices risk becoming a stranded asset overnight.https://www.savills.co.uk/research_articles/229130/336539-0 Making matters even more complicated, the Dutch government plans to increase the minimum threshold in increments to EPC A by 2030 and to broaden it to other sectors, rendering even more of the nation's real estate stranded. Refurbishment is urgently required but that's not what many owners of core real estate owners are equipped to carry out.
Proportion of office stock by Energy Performance Certificate (EPC) category, %
Source: Savills Research, December 2022. For office stock where EPC ratings are provided on national building registers; known no label only applies to the Netherlands, 30% unlabelled.
Similar trends are at play elsewhere. Most European countries will have minimum energy efficiency requirements within a few years. The European Parliament has just adopted an updated Energy Performance of Buildings Directive which sets out how the property sector will become carbon neutral by 2050. The blueprint includes a proposal to ban fossil fuel heating systems from 2035.https://www.europarl.europa.eu/news/en/press-room/20230206IPR72112/energy-performance-of-buildings-climate-neutrality-by-2050
This is a particularly big problem for core real estate investors, who typically buy and hold buildings for long periods and tend to limit refurbishment to cosmetic changes. One pension fund we recently spoke to estimates that as much as 70 per cent of its portfolio is at risk of obsolescence in coming years.
But tightening environmental regulations also present fresh investment opportunities - not least for investors who have the expertise and capacity to refurbish and modernise the properties they buy. Some 85 per cent of European buildings standing today will still be around in 2050, and the refurbishment rate across the region is currently just 1 per cent per year. To meet net zero targets by 2050, Europe must “retrofit at scale” according to GRESB.https://www.gresb.com/nl-en/green-or-bust-the-future-of-real-estate/
At Pictet, refurbishment is a key pillar of our value add and core-plus real estate strategies, and we focus primarily on improving the sustainability credentials of the properties we invest in. That could mean, among others, installing heat pumps (which can both heat and cool), sourcing only renewable energy, using sensors to help optimise energy and water consumption, and additional isolation of walls and windows. It might also involve using sustainable building materials (such as laminated timber), installing photovoltaic panels to generate renewable energy or committing to send zero waste to landfills. The recent refurbishment and repositioning of our data centre in Sweden, for example, succeeded in cutting carbon emissions by 62 per cent compared to what they were when we acquired the property.
Premium opportunity
Green buildings are already commanding a valuation premium. Research from MSCI shows that office buildings with sustainability ratings sell for prices that are a third to a quarter higher than those for non-rated buildings.https://www.msci.com/research-and-insights/2023-trends-to-watch-in-real-assets
They also command higher rents as occupiers – be that businesses or individuals – increasingly rent out sustainable premises not only on principle, or because doing so also allows firms meet their own net zero targets, but also because energy efficient properties have lower running costs.
Over the past five years, rents for European offices with green certification, for example, have on average been 21 per cent higher than for non-certified ones, according to research from CBRE.CBRE, “Is sustainability certification in Real Estate worth it?”, 2021
Investors are starting to see the opportunity in proactive real estate strategies that are able to adapt to these changing conditions. Preqin data shows that value-add funds emerged as the dominant strategy in 2022, accounting for some 35 per cent of aggregate capital raised – up from 27 per cent in the previous two decades."Preqin Global Report 2023: Real Estate"
During the last 15 years core real estate offered very interesting risk adjusted returns to investors. We believe that in the coming decade, given the new realities of where interest rates are, as well as the greenifying imperative for buildings, the value add and core plus funds that can help the green transition will offer the more compelling (and somewhat counterintuitively less risky) investment opportunities.
