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investing in core plus real estate

June 2021
Marketing Material

European real estate: the core plus opportunity

In a world where inflationary pressures are rising but interest rates remain near zero, core plus real estate can offer investors a strong, sustainable income stream, inflation protection and a degree of equity upside through active asset management.

Written by
Zsol Kohalmi
Zsolt Kohalmi
Deputy CEO & Global Head of Real Estate

It’s a time of change for real estate. The Covid-19 pandemic has accelerated changes in how we live, work, shop and spend our leisure time while demand for more efficient, environmentally-friendly buildings is growing. These shifts demand a more thoughtful approach to how we refurbish and construct buildings; they also represent a large, long term and growing investment opportunity.

Such an opportunity is all the more precious when you consider the macroeconomic backdrop. In a world of sub-zero interest rates, most investors cannot get their desired level of income from traditional bond investments. And even if inflation clouds are starting to gather on the horizon, it doesn’t necessarily mean the end of low rates. Indeed, there is a growing expectation that central banks may be more tolerant of higher prices than they have been in the past for fear of sabotaging the burgeoning economic recovery and of making debt servicing costs unmanageable. 

It all adds up to a tough environment for income seeking investors, but one where the attractions of real estate investment in general – and the 'core plus' approach (see chart) in particular – should improve. 

For one thing, core plus offers one of the few opportunities for inflation-beating current income. In Western Europe, for example, long-term rents with good covenant tenants can generate an annual income of around 3-5 per cent on a relatively secure basis. This compares to yields of -0.25 per cent on German Bunds. 

Then there’s inflation protection. Rents are usually linked to inflation, so if that picks up so too will rental income. Admittedly, if the rise in inflation prompts a significant increase in interest rates, cap rates – the return investors are willing to accept from property investments – will also rise after a while, effectively acting as a counterbalance to the rent rises. Real estate is thus not a perfect hedge against inflation, but it is a better one than many other asset classes.

Real estate investment: risk versus return
risk return
Source: Pictet Asset Management

Core plus has other advantages, too. It gets the benefit of secure, long-term rents, while having the potential to boost returns through refurbishment, repositioning or development of some properties. In contrast, value-add and opportunistic strategies maximise overall returns, but tend to have a lower proportion of current income (see chart).

Green opportunity

Another ‘plus’ in ‘core plus’ comes in the shape of sustainability. In the wake of the pandemic, people are more aware than ever of the need – and the urgency – to protect the environment. Real estate has a big role to play here. In the European Union, buildings account for 40 per cent of total energy consumption, 36 per cent of CO2 emissions and more than half of electricity use.1 That’s in part because many of the buildings are old and don’t have the latest efficiency features – more than 40 per cent were built before 1960, and 90 per cent before 1990.2

Of course, starting from scratch might be tempting, but that comes with its own sizeable environmental footprint. The greener option can often be to refurbish. A study found that new homes gave off 50 tonnes of CO2 during the building process, while refurbished ones gave off just 15 tonnes, and that it took around half a century to close that emissions gap.3

Following the pandemic, it will become less acceptable to house a company head office in a non-green building. Already, sustainable properties are starting to command a premium – occupancy is, on average, 4.3 per cent higher in green-certified buildings, while rents are about 4.6 per cent higher, according to a review of data across the developed world. They also have lower operating costs and higher sales prices.4 The latter could in part be because a growing number of institutional investors are now only investing in green buildings – creating a potential market for any refurbishments done by 'core plus' funds.

Socialising and shopping

For nimble investors, there are also opportunities to respond to changing trends in society. Post-pandemic, offices will need to be more flexible, geared more towards people meeting by chance during the days that they are in the office, which means a larger communal area footprint. Major capital cities in Western Europe should continue to do well, but some other key gateway cities (such as Birmingham, Manchester, Gothenburg or Lyon) may benefit from more flexible working practices due to their more affordable living, work and travel costs.

With people doing more online than ever before, we expect to see continued growth in demand for logistics properties. Research from CBRE suggests that for each incremental USD1 billion increase in e-commerce sales, an additional 1.25 million square feet of distribution space is needed.5

More online shopping means less traditional retail, with change of use to residential or other services. This is more likely to be fertile ground for higher-risk real estate strategies (value-add and opportunistic). However, core plus investors could still potentially tap into the trend by looking at mixed-use buildings with a retail component which can be transformed over time.

By combining tactical refurbishment and active ownership practices with investment in strong, core assets, core plus real estate can thus offer attractive returns, a sustainable income stream, a contribution over time to improving emissions, and a degree of inflation protection.

[1] https://ec.europa.eu/energy/topics/energy-efficiency/energy-efficient-buildings_en
[2] Boosting Building Renovation: What potential and value for Europe?”, European Parliament, 2016
[3] "New tricks with old bricks”, The Empty Homes Agency, 2008   
[4] Median values, Sustainability Review/MDPI: A Review of the Impact of Green Building Certification on the Cash Flows and Values of Commercial Properties, N. Leskinen et al, 2020
[5] CBRE Research, CBRE Econometric Advisors, 2017
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The property industry is the largest emitter of CO2. By making buildings more sustainable, we can help the environment and boost returns.
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About

Zsolt Kohalmi

Zsol Kohalmi

Zsolt Kohalmi joined PAA in 2018 as Deputy CEO & Global Head of Real Estate.
Previously he was Managing Director and Head of European Acquisitions at Starwood Capital Group. He was instrumental in sourcing and executing a number of successful investments for Starwood Capital’s commercial, hospitality and debt platforms. Starwood was twice (2013, 2015) voted The European Private Equity Real Estate Firm of the year by its peers (PERE magazine) during his tenure. Prior to joining Starwood Capital in 2013, Zsolt was Chief Investment Officer at Meyer Bergman for 8 years, a European real estate investment firm that he co-founded. Before that he was a Director at GE Capital, where he acquired financial platforms as well as loan portfolios across Europe. Zsolt previously worked in investment banking with ABN AMRO Hoare Govett.
Zsolt, who is fluent in nine languages, holds an M.S. degree in economics from the University of Budapest and an MBA from INSEAD.

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