Property: as the humans move out, the robots move in…, August 2023

Hot property is changing. Canary Wharf, once the darling location of financial sector dealmakers, is being forced to forge “a new purpose”, according to its developers, by diversifying into other sectors, as banks like HSBC move out.

With more people moving to flexible working, the east London district has its highest office vacancy rate since 2005. Other locations face similar post-pandemic occupancy issues.

But, as the humans move out, the robots are moving in. At least that’s the bet one of the world’s biggest real estate funds is making, and others are following suit.

Growth in data centres

The $122bn Blackstone Real Estate Income Trust has turned into a seller in recent months to support its artificial intelligence data centre play (as well as to meet redemption requests), recognising the growing need for that type of property as AI proliferates.

Given increasing requirements for high computing power and AI data storage, Nigel Ashfield and Roger Skeldon, who manage TIME: Commercial Long Income, a direct property fund, believe there should be a long runway of demand for data centres. 

Ji Zhang, portfolio manager on the Cohen & Steers Global Real Estate Securities strategy, who also works alongside the firm’s European Real Estate fund team, agrees. 

She says: “We still expect supply and demand dynamics to benefit landlords of these data centre properties, particularly as more regulation around AI will lead to a greater barrier to entry and benefit incumbents in the space that can expand.”

A material change in the workforce due to AI could be a negative for overall office space. But elsewhere AI and other data analytical tools are already being used to aid a reduction of the environmental impact of the property sector, says Nigel Ashfield.

The impact of inflation

If AI is the property story of the fast incoming future, high inflation is the property story of the immediate present.

While real estate is often thought of as performing strongly during periods of inflation, as Cohen & Steers’ Ji Zhang points out, 2022 into early 2023 was a story of stagflation, which historically is a challenging environment for real estate, and many other asset classes.

As such, currently falling inflation and the slowdown of interest rate hikes in the US is a positive indicator that a more accommodative environment for real estate investment trusts (REITs) may be on the horizon.

An end to central bank tightening historically tends to be followed by notable strength in listed real estate performance.

The recent public REIT market correction in Europe further strengthens the argument that we are moving towards an environment that has historically produced attractive entry points for global REITs, says Ji Zhang.

James Yardley, senior research analyst at Chelsea Financial Services and an investment adviser to the VT Chelsea Managed fund range, agrees that there are selective opportunities in REITs today and spoke about this to The Times in a recent interview.

Inflationary shocks

Bouts of unexpected inflationary shocks may be part of the next several years. If so, Ji Zhang believes real estate companies with high operating margins, low sensitivity to commodity and labour prices, and inflation-linked rents, are well-positioned.

TIME’s Commercial Long Income fund provides a degree of protection for inflation, with around 60% of rent reviews linked to RPI, a further 8% linked to CPI and around 25% fixed.

The average cap for RPI linked rental uplifts is nearly 4% “which obviously means not all inflationary increases are passed through, however this cap is important for medium-term tenant affordability”, say the fund’s managers.

“The reduction in inflation should be supportive of current property values and if this trend were to continue it should support capital value growth in the future,” they add.

The end of cheap financing

One trend that seems over is the more than a decade of cheap financing in the UK, US, and Europe, that often fuels the property sector.

Yet Cohen & Steers sees REIT balance sheets in strong shape compared to the global financial crisis, given much lower loan-to-values of about 30-40%.

In Ji Zhang’s view, real estate supply is likely to remain lower for longer, due to tightening lending standards and capital availability, which raises economic barriers to new supply and reduces potential competition for existing properties.

The UK, as an example, is in a good position compared to the previous cycle of large valuation declines in 2008-09. According to the Bayes Business School surveys, UK commercial real estate leverage was around 50% in June 2022, and closer to 70% in 2007.

Despite this, there will likely be an increasing number of properties or portfolios that might have to be sold due to the inability to refinance, especially if interest rates remain close to where they are now.

TIME’s managers believe “this could also provide an opportunity for investors in a position to buy”.

Motivations for property investing are certainly changing, from AI to inflation-hopping. But the opportunities are still there.

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The views expressed are those of the author and fund managers and do not constitute financial advice.

Published on 15/08/2023