Balanced core portfolios have been at the heart of real estate strategies for decades, following what appeared to be a relatively low-risk approach to provide steady income to match insurers’ and pension funds’ current and future liabilities. 

Daniel McHugh

Daniel McHugh

This view may have prevailed during the long period of low interest rates and inflation, but the world has changed so much in the last five years that such strategies are now far riskier than many investors appreciate.

The bulk of the real estate investment world has for too long been focused on prospects for individual assets and sectors, rather than major longer-term trends and the structural changes affecting the market more materially. There is a real risk much of our industry is sleepwalking into negative returns over the medium to long term – this is especially true of assets where obsolescence will become a problem. When you factor in inflation, you quickly move towards negative real returns. We estimate more than half of the market could be at risk of this.

Risk, return, regulation and reward: these are at the heart of what fund managers should be incorporating into any credible investment approach if they want to remain relevant in this fast-changing world.

Total UK property returns are expected to deliver mid-single-digit returns in 2022. A combination of rental income and some capital appreciation contributes to that, although forecasts vary widely by sector.

In fact, real estate assets that yield 3% to 4% a year are in danger of generating negative real returns due to a combination of factors that have the potential to blow conventional wisdom apart. The Consumer Prices Index including owner-occupiers’ housing costs rose by 4.8% in December 2021, a 13-year high. With inflation running hot, and interest rates increasing in a bid to contain it, we are beginning to see falls in the real value of assets.

The days of buying a balanced portfolio look out of step with the market

A low-yielding ‘prime’ asset might tick all the traditional boxes for a balanced core portfolio – location and catchment, strength of tenants and length of leases – but sustainability considerations can also mean this property’s prospects are far less healthy than they appear at first glance. Demand for more precise, vigorous valuation of sustainability features will only intensify, as will ’green premiums’ on better-performing buildings. So even properties in prime locations could be exposed to far greater levels of obsolescence and vulnerability to achieving low EPC ratings than anticipated.

We need to be on the right side of sustainability-related obsolescence. With the built environment responsible for a significant portion of UK emissions, it is important to refurbish older buildings, not just demolish them to be replaced with something new.

Property returns concept graphic

Source: Shutterstock / WHYFRAME

To generate the returns and rewards investors have become accustomed to and get ahead of the macro and structural themes beginning to dominate our world, real estate managers will need to become expert in ‘active equity’ or debt strategies, depending on their clients’ risk appetite.

For clients with a lower-risk bias, rather than being vulnerable to steep declines in asset values, it may be more appropriate to allocate to real estate debt, offering secured cashflows with strong covenants. This should generate returns similar to core balanced portfolios, albeit with less risk.

For those seeking higher returns, by setting a sensible hurdle rate for our active equity investment strategy, we believe this will better reward our clients against the riskier macro and structural environment.

The days of buying a balanced portfolio look numbered and out of step with the market. It is time we moved to more sophisticated strategies that reflect the changing dynamics and risks in the market.

Daniel McHugh is CIO, Real Assets, at Aviva Investors