8 min read 3 Mar 22
The global financial crisis (GFC) sparked a period of hyper risk aversion and market distress, creating what many investors dubbed a 'once in a lifetime' opportunity for value add and opportunistic returns – risk premiums spiked, while the lending market dried up and forced sales by banks meant core assets could be picked up at bargain pricing, including through loan-to-own strategies. Though double-digit value add returns were not guaranteed, this was a period where investors could drive performance through market timing and deep value strategies. In this context, ‘fixing’ assets often meant simply maintaining an asset’s income in a period of uncertainty.
European investment markets have since suffered from a number of crises– economic, political, and most recently, health – but the degree of general risk aversion has ebbed and flowed. The respective fallouts have been more targeted by geography or industry, with structural headwinds in sectors like retail accelerating these pricing swings. At the same time, global interest rates have trended lower since the GFC, thereby adding downward pressure to risk premiums in the majority of markets. Put simply, value add investing has had to evolve.
The current environment is a case in point. We are recovering from an economic crisis, but certain sectors have done very well during the downturn (and others pretty badly). Furthermore we are facing a number of risks, including political. Pricing can be very competitive in some areas, and less so in others. Finally, there are structural changes, inflation and political risks going on in the background. The approach to value add therefore needs to be nuanced and well-targeted, while spanning a wide enough opportunity set.
Investing against, rather than with the herd in today’s market can uncover pockets of value for those willing to explore ‘unloved’ sectors, or sectors hit hardest by the pandemic.
Forced closures in the hospitality and tourism space have pushed pricing spreads above core sectors to between 100bps to 300bps, depending on risk appetite. Hotel occupancy has gradually improved throughout 2021, but European cities are still operating at 50% capacity versus pre-pandemic levels. That said, we believe that tourism will fight back strongly (recent surveys also suggest so), with short-term hotel distress likely to create further pricing opportunities.
Identifying hotel operators that may require investment at a corporate level could also provide access to potentially sound hotel assets at attractive pricing for value-seeking investors. In many cases, hotel assets are already in the hands of lenders or insolvency practitioners, so value investors may require the network and skills to source and acquire from such vendors.
Investor aversion to 'anything retail' has also impaired the true fair value of many retail assets. This sector was under pressure pre-Covid, with the pandemic adding to the hyperbole of widespread structural obsolescence in the sector. While we do not believe that all retail will have a sustainable future in the next five to ten years, there are certainly many assets that will. With the right bottom-up stock-picking and asset management initiatives, this is a sector where assets can now be bought at decade-low values, providing both healthy income potential and the ability to drive cost-effective capital improvements.
The retail park space looks particularly attractive (indeed, performance is already starting to come through), and often benefits from strong food anchors or a tenant mix focused on more defensive sectors such as furniture, DIY or health and beauty. Their ability to compliment multi-channel shopping, via click & collect or in-store returns, may also support footfall and rental values.
Again, as with hotels, many retail assets are already controlled by lenders and insolvency practitioners and can only be accessed by investors with the relevant network and skills.
The pandemic has also brought new sectors to the investor forefront, with structural shifts in working habits and social values likely to drive a reallocation of global capital to areas of new growth potential.
Alternatives such as life sciences or other R&D industries have seen a seismic shift in funding, both from the public and private sectors. Science clusters across Europe, with a concentration of skilled labour and fixed, knowledge-sharing ecosystems, offer multiple real estate avenues for investors, be it providing office space for smaller start-ups or suburban housing for their growing workforce.
Data centres have equally been synonymous with the shift in working patterns, post-Covid – demand forecasts for digital technology show accelerated growth over the next decade, with new and improved facilities needed to store this data potential. These sectors are likely to reflect strong rental growth potential, and could justify strategies that seek to let up vacant space or provide new, fit-for-purpose space, including through conversions.
One of the largest industry shifts over the 2020s will be the focus on climate and achieving net zero carbon and energy efficiency targets. Evolving occupier sentiment towards energy use and worker health has also increased the incentive to improve assets to meet these targets.
While market pricing is yet to truly reflect ESG credentials, the real estate sector is gradually evolving and the differential between buildings that reflect green rental premiums and ‘brown’ discounts appears to be widening. Asset management potential is growing rapidly for space that falls short; upgrading EPC ratings via targeted CAPEX, for example, or improving wellbeing factors and reducing waste. Moreover, five to ten years from now, most core investors will likely own portfolios that are skewed heavily towards greener buildings, thereby providing a deep investor pool in which to sell these upgraded assets.
Fundamentally, the next decade will require less retail and office space, in aggregate, and more logistics and residential, meaning increasing opportunities for real estate conversions. Some space is now functionally obsolete, given more modern ways of working and consumption, while capital values particularly in the retail sector have reduced sufficiently for conversions to logistics, for example, to make greater financial sense. Where there is strongest commercial need, the right asset management plan to reconfigure these buildings can capture the rental upside and maximise the net operating income potential.
But not all assets are fit for upgrading or conversion. Reconfiguring a hypermarket floorplan to allow for a more targeted shopping experience, or adding photovoltaic panels to a flat roof, can be a lot less costly and provide greater net gains than changing structural elements such as stairways, lifts or building facades. Installing energy efficient lighting, electric vehicle charge points, bicycle racks or outdoor communal space in a residential asset can also be more easily implemented than replacing 200 boiler heating systems in an apartment block, for example. For value add investing to work effectively, CAPEX needs to be targeted, and allocated to asset improvements with the highest utility value.
The best risk-adjusted returns can often come from situations with higher complexity. This can include assets that are in the hands of lenders or insolvency practitioners; assets with short-term income issues; or assets that distressed companies or owners are looking to sell quickly, to generate liquidity. Real estate and land tied into larger corporate structures, distressed situations or developer option contracts can provide greater rewards for investors with the right vision and expertise. Once these assets are sourced, specialist restructuring skills can be deployed to resolve the relevant complexity before the acquisition is made. This often results in an opportunity to acquire high quality real estate at a significant discount. Joint venture development partnerships, or accessing stock through liquidators and receivers, can also offer more than just attractive pricing; these relationships, built up over time, can generate a broader pipeline of assets, that are typically unavailable in the open market.
A strong fiscal response to the pandemic by governments has so far helped to shore up corporate balance sheets, with bankruptcy and insolvency in 2020 actually falling to near record lows – declining between 15% and 40% across Germany, France, Italy and Spain1. Sectors such as tourism, transport and construction have been particularly insulated by grants, loans and credit support.
But the key question is what happens next. Government liquidity measures are expected to be gradually withdrawn, while higher inflation and supply chain pressures are causing further disruption for many industries. Over the next few years, liability management and balance sheet strengthening are likely to be a top priority, especially for firms worst affected by Covid-19. Inevitably, this will lead to more opportunities where specialist restructuring expertise can be used to unlock new real estate investment opportunities.
The 2020s, like all previous cycles and phases of structural change, will likely present new and unique opportunities in European value add. The ‘buy, fix, sell’ mantra still applies, but market conditions today have created an environment that requires a different kind of skill set to maximise value. Some of the most compelling opportunities we believe will come from assets which can be unlocked from more complex structures. The ability to resolve these complexities and realise the full potential of a transaction will be key in driving value add performance in the 2020s.
1The business insolvency paradox in Europe, Coface, March 2021
The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.