Featured in IPE Real Estate’s September/October 2019 issue:
Why Build a Pan-European, Pan-Living Sectors Portfolio?
Four years ago in these pages, we identified the Living sectors in Europe as a target for real estate investors seeking attractive risk-adjusted returns (“Introducing the Living Sectors” by Brian Klinksiek, IPE Real Estate Magazine, September/October 2015). We defined Living as the properties where people—young, old, or otherwise—make their homes. Living spans the full range of residential properties, from student housing at one end of the age spectrum, through to senior housing (at all levels of care) at the other. The largest component of Living is the mainstream multifamily sector, the rented portion of which is, in some countries, known as the private rented sector (PRS). Living also includes newer, innovative concepts such as co-living and micro-apartments, which seek to address housing shortages and affordability challenges in larger cities. These concepts can also provide a bridge between student housing and more traditional multifamily accommodation for younger professionals.
In 2015, we coined the term “Living” in order to unite sectors that we believe have common attributes in terms of supply, demand, supporting secular themes, service provision, operations, and design. In the US, where institutional multifamily investment is well-established, student and senior housing historically have been categorised as specialty or alternative, typically being more operationally intensive. In Europe, however, we believe that they should be grouped together, especially given that the European Living sectors are in a state of relative adolescence and the lines between studying, living, and working are becoming increasingly blurred.
The idea has caught on. Since our first use of the Living sectors label in 2015, the term has come into widespread use in the European property industry. Brokers and investors now regularly use it to describe or define their products and services. At least one property agency has reorganised its business lines to create a Living-focused business unit. Meanwhile, investment in the Living sectors has continued to grow. By the middle of 2019, according to Real Capital Analytics data, annual transactions in Europe in the combined category had reached €61 billion, double the volume recorded just five years ago. As recently as 2016, the share of the Living sectors in the overall European investment universe was barely in double digits. Today, that share has grown to a quarter of all real estate transactions. In several countries like Germany and the Netherlands – which have deep rented residential markets – residential is now the second largest property type by investment volume.
Given the industry’s embrace of Living as an investable asset class, we thought it would be useful to clarify why we believe rented residential, senior care homes, student housing, micro-flats, and the other sub-sectors belong together in a single portfolio. The constituent sub-sectors have important complementary similarities, while possessing differences that contribute to diversification. Likewise, we argue that it makes sense to build a pan-European portfolio of Living assets rather than allocate to separate national strategies managed in isolation. Doing so achieves diversified exposure to the Living sectors, combining lower-risk regulated markets with higher-growth liberalised ones, and less mature sectors with more institutionalised ones. A pan-European approach also retains the flexibility to react quickly to changing market conditions, evolving regulatory considerations, and flows of capital. The discussion that follows makes the case for investing in European Living as a single discrete category, instead of targeting smaller separate strategies split along either asset-type or country lines.
Why invest across the Living sectors?
The rationale for creating a Living strategy that spans multifamily, student, senior, and micro-apartment sub-types in a single portfolio is multi-faceted. At a broad level, doing so enables investors to address the needs of tenants throughout their lifecycles, and to redirect capital into promising sub-sectors as the opportunity arises. More specifically, all of the various Living sectors in Europe benefit from common trends and are characterised by a structural mismatch between housing supply and demand. They are also increasingly similar, with blurring lines between their operational requirements and definitions. Finally, there is a balancing aspect to including them in a single portfolio, both in terms of regulatory diversification and complementary performance attributes.
Common trends: Broadly speaking, the student and senior housing sectors benefit from the same trends that are driving the performance of the rented residential sector, namely urbanisation, demographic change, growing mobility, and structural undersupply of product. Increasing migration and mobility evident in the European population has its parallel in more students choosing to study further from their hometowns. With the rapid growth of English-language degree courses, European and non-European students are venturing beyond the traditional Anglophone destinations (US, UK, Canada, Australia) to enrol at universities in Germany, France, and the Netherlands. Meanwhile, skilled young workers increasingly move across borders to economic and cultural hotspots such as Berlin, Barcelona, and Amsterdam. Micro- and co-living is especially well-suited to meeting the needs of such transient talent.
Structural mismatch: The changing structure of urban families necessitates a diversified blend of Living assets that meet the needs of the fastest-growing segments of housing demand. The existing stock of conventional residential was built mainly in the 19th and 20th centuries, and was designed with large families in mind. But, in many European cities, the proportion of single-person households has been steadily rising; in the German A-cities, their share has increased to 52% of all new households. A decade ago, only 26,000 homes in Berlin were one-bed units, out of a total housing stock of 1.9 million units (1.3%). By contrast, half of all apartments had four rooms or more. Even today, one-bed units make up less than 5% of all homes in Berlin. The solution to this profound mismatch lies in the creation of more one-bed units, as well as the provision of co-living and micro-living solutions for those residents who face affordability constraints but value convenience and community over dwelling size. Likewise, rapidly ageing populations across Europe are poorly served by a senior housing stock characterised by both insufficient quantity and quality – in addition to a provision of care that differs materially from country to country.
Blurring lines: The steady blurring of lines that is occurring across the various Living sub-types provides a strong rationale for a broader Living sectors strategy. Categories such as student, co-living, and micro-living are starting to overlap and merge with each other; the latter two often function as an extension of student housing and their primary catchment typically consists of early-career professionals, fresh graduates, and mobile workers, all groups that have similarly pronounced needs for central location, social space, and age-specific amenities. A key trend is the growing emphasis on service provision and community. Student and senior living have long led the way on these dimensions, but we also see increasing operational intensity in the multifamily sector, with smart managers focusing much more on services and amenities, and working harder to generate a sense of community among residents.
Regulatory diversification: Rent regulation differs widely among the various sub-sectors, with student and senior housing typically subject to fewer rent restrictions. Market-based rents are more prevalent in these asset types, even in otherwise rules-heavy jurisdictions such as Germany. Combining senior and student housing with rented residential can thus perform an important returns-enhancing and regulatory risk-reducing function, especially in a regulatory climate that appears to be turning more inclement for multifamily in a number of different markets.
Complementary performance attributes: The performance attributes of the various Living sub-sectors tend to be complementary. Student and senior returns are primarily income focused, while returns from regulated rented residential are typically driven by growth. This helps to stabilize the returns profile of the strategy over time, minimizing performance volatility.
Why invest on a Pan-European basis?
At the geographic level, increasing Living sectors investment has taken a variety of forms, ranging from local and country-specific vehicles, to pan-European strategies. It is our view that the latter is a more promising approach for investors wishing to achieve diversification while being able to adapt to changing market conditions. Many of the motivations for building a portfolio spanning the various Living sub-types have analogues at the geographic level. Key cities across Europe face similar trends, including a widespread housing shortage. As at the sector level, the case for regulatory diversification among countries is strong. Another key reason to be pan-European in scope is to benefit from differing sector maturity by country through mixing established and early-mover market segments to generate an attractive blend of risk and return.
Widespread housing shortage: In the decade since the financial crisis, demand growth has far outstripped that of supply across most Western European countries. In Germany, the UK and the Netherlands, this shortage has typically ranged between 20% and 30% of annual household formation. The only major country that has managed to maintain supply rates even close to demographic requirements is France. The housing shortage is especially acute in Europe’s major cities, which have been the prime beneficiaries of demographic trends such as urbanization, immigration and internal migration. Since cities and their suburbs constitute the principal locus of residential investments, combining these geographies that share broadly similar occupier trends into a single strategy makes sense.
Regulatory diversification: Adding a range of different countries into the mix delivers significant diversification gains. Diversification in the first instance is inherent in the different regulatory frameworks across jurisdictions. Some markets (most notably the UK) operate on largely free-market principles. Other markets have a mix of regulated and free-market housing (e.g., the Netherlands), while still others have wide-ranging regulations that cover all aspects of the housing market. The risk-return profile for each market differs accordingly, with low-volatility, bond-like income at the regulated end of the spectrum, and a greater ability to generate rental growth and boost returns in more market-friendly jurisdictions. Should the regulatory framework change in a particular country or city, the investor has the flexibility to change allocation decisions accordingly and to redeploy towards other jurisdictions. This is playing out in real time in the German market, where a sharp tilt towards tighter rent regulation in the city of Berlin has made some investors take a pause and led them to look at opportunities elsewhere. In a pan-European vehicle, reallocation and redeployment can be achieved relatively smoothly and swiftly.
Differing sector maturity: The need for flexibility also extends to the ability to bring new countries into the strategy as deemed appropriate. Investment markets evolve at different paces; some countries already enjoy deep and mature Living sectors, with a large quantum of tradable stock, transparent pricing, and secondary-market liquidity provided by domestic and international capital. These markets form the bedrock of stable returns in pan-European strategies. Other, less mature markets can deliver distinct early-mover advantages to those willing to engage in development, especially in regions marked by scarcity of supply. Development has been the principal route to accessing the major cities of the UK over the past few years, with secondary transactions still at minimal levels. Another market that has quickly climbed up the investability ladder is Ireland, where the sheer strength of economic and demographic fundamentals has caught the eye of numerous institutional investors. The management experience Heitman gained from its earliest engagements with the German and Dutch multifamily sectors has proved invaluable in later investments in the UK, France, and Ireland. Going forward, countries as diverse as Denmark, Poland, and Portugal may also prove to offer compelling opportunities for Living sectors investments.
Building exposure to a de-linked sector
Our analysis shows that, taken as a whole, the Living sectors deliver an attractive combination of stability and growth to investors. The sectors are broadly de-linked from the fluctuations of the economic cycle, providing a measure of insulation from macro volatility. This is an especially important consideration today, with trade disputes threatening global growth and policymakers struggling to make sense of negative interest rates. While commercial property types are inherently cyclical and exposed to a correction, the same does not apply to the Living sectors. In the key markets of Western Europe, they have continued to mature as a result of secular and structural growth drivers that have proved their durability over time. In addition, Living provides the opportunity to benefit from active asset management plays, leveraging off the regulatory frameworks in different jurisdictions, and a further ability to improve returns through creation and conversion of product.
The key question for investors, then, is how to gain access to the space. Existing investment strategies do not, in our view, provide appropriate exposure to the Living sectors. For example, pan-European core funds are only lightly exposed to the sector, with MSCI’s Pan-European Property Fund Index (PEPFI) carrying only a 2% weight to residential as of Q1 2019, compared to 20% for retail and 27% for office (both sectors that face significant challenges). Some pan-European core funds are only now making their first allocations to residential. As such, investors must identify alternative avenues to gain exposure to Living. One potential route is to identify separate strategies at the sub-sector and country-level. It is our view that such a fragmented approach misses the significant diversification and flexibility benefits from building a unified, balanced portfolio that targets assets across the Living sectors and across European countries.