Investing in a Brave New World

The novelty of rising interest rates, the prospect of proliferating macro shocks and a profound demographic shift all have serious consequences for real assets, says CBRE IM’s chief economist and head of insights & intelligence Sabina Reeves

Q: What changes have you seen in terms of investor appetite for real assets over the years?

The biggest change that we have seen took place after the global financial crisis, when central banks brought in quantitative easing to deliberately push fixed income investors toward riskier assets in search of the required yield. That hunt for fixed income substitutes providing both steady cashflows and additional yield is what has really driven interest in real estate and infrastructure, taking allocations from 5 to 10 percent to 15 to 20 percent, depending on individual objectives and where in the world you are.

Q: So, interest in real assets exploded on the back of one crisis. But how have these asset classes fared during the pandemic?

I think it has been a tale of polarization. On the one hand, logistics and residential held up incredibly well, and it has been gratifying to see the sectors we have favored continue to perform. On the other hand, retail is facing the double whammy of covid and e-commerce headwinds.

Perhaps the most interesting sector, however, has been office. There has been a great deal of concern about the future of office, and that has been reflected in the listed markets. But on the private side, valuations have actually held up pretty well; we didn’t see the sharp markdowns that listed office names experienced in the initial days of the pandemic. It’s likely that big corporate occupiers, including ourselves, are still trying to work out what the future of the office really is and, in the meantime, are willing to keep the space they have and even roll over. They haven’t wanted to make big decisions while so much uncertainty persists. And so, despite all the doom and gloom, income has held up remarkably well.

There has also been a big divide in infrastructure. Obviously, airports and to a lesser extent toll roads got hit hard in lockdown. But the beauty of infra- structure is that a lot of the income payments are contracted or underpinned by government spending and so, again, those have held up well. Over the past 18 months, we have also seen infrastructure emerge as a beneficiary of an enhanced focus on ESG, as well as a surge in demand for connectivity.

Q: Are you seeing the boundaries blur between those two asset classes?

Clients are increasingly viewing their real estate and infrastructure exposures holistically, both because of similarities in their performance characteristics and commonality in the objectives they are designed to fulfill – enhanced yield at a time when fixed income yields are low. We therefore made a strategic call to acquire Caledon Capital Management in 2017, which has now been rebranded as our private infrastructure group. Shortly before that, our listed team developed a pure infrastructure product as well, which has proved to be extremely successful.

You are right; there are also increasingly subsectors that may be considered either real estate or infrastructure. Data centers is one obvious example. Are data centers real estate or infrastructure? The answer is probably a little bit of both, because you have the building in which the data center is housed and then the actual operations within it. There is a definite crossover between the two asset classes. What they both share are good-quality, long-term income streams which are highly attractive to institutional investors.

Q: What about some of the newer, or alternative, sectors that now fall within the parameters of real assets?

We estimate that alternative assets make up around 8 percent of the investable universe, but we recommend a holding of around 30 percent, so, for us, I am not sure ‘alternative’ is the right word. These sectors form the bedrock of our portfolio alongside residential and logistics. Certainly, we find life sciences and medical office very attractive, alongside student housing and senior living. We also have a few farmland holdings, which are slightly more niche.

As with any form of real estate, however, while it is important to identify the big, secular trends that are often driven by demographics or technological change, there will also be cycles within that, when particular markets are either underbuilt or overbuilt.

For example, we went into UK and Irish student accommodation in a big way five or six years ago. We were ahead of the curve. But around three years ago, we realized the market was becoming crowded, so we sold the assets and harvested the profits for investors. That doesn’t mean we don’t believe in the rise of higher education; we’re active in other markets and have recently acted on UK opportunities that presented valuation increases. But while we want to play structural trends, we also don’t want to take our eye off the cyclical trends within that. Ultimately, real estate will always be a pro-cyclical sector.

Q: What role do you see non-bank capital playing in driving the global sustainability agenda?

The challenge involved in transitioning to net-zero carbon economies is vast. We have seen governments really step up recently, but government capital alone will not be enough. Banks have a role to play too, but the role of non-bank capital will be especially significant and, within that, the role of real assets owners will be huge.

The bulk of the world’s economic activity takes place in buildings, whether that is retail, office or logistics. As owners and operators of those buildings, we can and must be a part of the solution, both in making those properties operate in a more sustainable way and in providing the capital required to help make that happen. As much as we all want to build out- of-the-ground shiny, category A buildings, it is arguably more valuable to society if we invest our capital improving the properties we already have, without creating embedded carbon in new developments.

It is going to be complicated to underwrite that capex and to balance what we are doing for the environment and for communities with the returns we provide to investors. But underwriting those thornier, more complicated structures, is precisely where real asset managers such as ourselves shine. As such, I think non-bank capital has an incredibly important role to play.

Q: As head of research globally, to what extent do you see data as a differentiator today, and how can it be best applied? 

Back in 2016, I remember CBRE making the bold statement that digital change and the data revolution were not a threat, but rather an opportunity. And, of course, being embedded in one of the largest real estate platforms in the world means we have a huge advantage. We are a massive repository of data, and so the challenge has been to harness that data and interrogate it to gain a competitive edge.

For example, during the pandemic, we were receiving real-time insights that were bucking market expectations, owing to our broad spread of investments across geographies, sectors and the listed and unlisted markets. Even when everyone was saying that office was dead, we could see that it was performing well from our own, real-time data, rather than relying on slightly stale, quarterly rent and yield indexes from other brokers. Understanding your own data is crucial and, to that end, we have ramped up our investment in tech infrastructure dramatically.
 
It is no coincidence that while I am head of research, I am also the executive committee sponsor of our tech transformation counsel, which is all about ensuring every decision maker has insight from our data, and other data, at their fingertips. After all, I am very much research 1.0. I have an economics degree. These days, we are more likely to be hiring data scientists. The skillsets and the tools we need to succeed have been revolutionized, and that makes this an incredibly exciting time to be a part of this industry.

What are the biggest challenges facing the real assets industry today?

Real assets have fared extremely well in an environment of quantitative easing. Now we need to figure out how to operate in an environment where interest rates are rising. Some of my younger colleagues have never done cap rate forecasting in a rising interest rate environment, so it will be an interesting transition. I don’t believe it is a threat, because so many real assets have inflation hedging built into lease contracts. But we will need to look for different types of assets and different contractual arrangements against a different monetary policy backdrop.

The second big challenge for our industry is acknowledging that we live in a time of increasing uncertainty. We have to accept that we are going to face these supposedly once-in-a-century shocks every two to three years, whether that is an epidemiological shock like we have been experiencing, or a financial or even a social shock. The fact that a protest movement sparked by a specific event in the US reverberated all around the globe, with young people on the streets campaigning for social justice, shows that we live in an incredibly interconnected world. Real assets managers will have to prioritize portfolio resilience.

Finally, while the move to net-zero carbon is the challenge that everyone is talking about right now, an equally disruptive challenge is our aging population. China and Germany saw their working-age populations start to shrink in 2020. Meanwhile, the average number of children born to a woman in India has dropped below the replacement level for the first time.

We are at a demographic turning point, and that raises big questions for us as real assets owners. Should we be moving from conventional senior living to nursing care, for example? At the same time, our industry is providing income to pensioners, and so we must continually ask ourselves what kind of real assets investments we should be making to deliver for this wonderfully greying economy.