M&G Real Estate makes strategic bets amid rising inflation and anticipated asset repricing

/ EdgeProp Singapore |
M&G is entrenched in the UK real estate market with several investments across almost all sectors — office, industrial and logistics, residential and hotels.
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SINGAPORE (EDGEPROP) - Global real estate investment firm M&G Real Estate (M&G) presented its 2022 Mid-Year APAC Outlook on July 14. In an interview after the presentation, the firm’s global head of investment strategy, José Pellicer, shared how the current inflationary environment could affect real estate prices over the next few years, as well as other market trends shaping the industry in the coming quarters.
While there has been “substantial repricing in equities (and) in fixed income instruments over the last few months”, published data shows that real estate prices have barely moved over the same period, notes Pellicer. Some recent real estate transactions, however, are starting to show a softening in prices.
This is most evident in countries whose core inflation is very close to headline inflation and where upward pressure on interest rates is highest. These include Australia, the UK and the US. On the other hand, the possibility of real estate repricing is low in Japan, where property yields are expected to remain steady and inflationary pressures are not as high.

Low interest rates in Japan

Although there are signs that consumer prices are increasing in Japan, M&G expects the level of inflation to remain low compared to other economies, as the Bank of Japan’s relatively dovish stance is likely to persist.
Most of Japan’s current inflationary pressures stem from externally driven market factors such as the price of energy. “Inflation has yet to trickle down to erode wages,” says Pellicer. In contrast, inflationary pressures in the US stem from a much more robust increase in domestic consumption because of government subsidies during the height of the Covid-19 pandemic, and ongoing labour shortage, he adds.
M&G has a sizeable portfolio in Japan that includes residential properties and commercial real estate. In March this year, the firm acquired 30 multi-family properties for JPY49.2 billion ($500 million). In recent years, it has also been acquiring logistics and office assets. Most of M&G’s acquisitions are focused on key gateway cities, specifically Tokyo, Osaka, and Nagoya.
Residential multi-family rental properties continue to draw in new players into the Japanese market, which enjoys relatively low-cost financing. (Picture: Pixabay)
The firm has been investing in multi-family residential properties in Japan since 2014. The multi-family housing sector in Japan continues to be attractive mainly due to its relatively low-cost financing, which has a positive leverage on overall returns, says Jing Dong Lai, CEO and chief investment officer of M&G Real Estate Asia.
“Many institutional investors regard the Japanese real estate market as a bulwark of stable, income-generating assets,” says Lai. “This is why we are investing heavily in Japanese multi-family assets, and we have a relatively large exposure of almost US$1 billion [$1.4 billion] at this time.”
M&G says that multi-family assets in Japan are likely to remain a chief focus for income-seeking investors, and capital growth potential could come from investments in sustainable and efficient urban logistics and fulfilment centres.
Logistics properties in Japan is another sector that is attracting investor interest. In addition to a growing structural demand for high-quality industrial space, Lai says that portions of manufacturing are returning to Japan after going offshore years ago.

Chronic housing shortage in the UK

Tailwinds are also propelling the UK logistics sector into one of its best performances in recent years, says M&G. The impact of the pandemic drove online consumption, and logistics operators had to scramble to bulk up their supply chain networks, which were still reeling from Brexit.
However, M&G cautions that UK consumers could start to tighten their discretionary spending as they feel the pinch of rising living costs due to upward inflationary pressures.
M&G is entrenched in the UK real estate market with several investments across almost all sectors — office, industrial and logistics, residential and hotels.
The prevailing housing shortage in major cities across the UK has led to rising house prices in recent months. While this benefits those who already own property, it is pushing homeownership further out of reach for first-time buyers.
“Typically, a rise in interest rates creates downward pressure on house prices,” says Pellicer. But even if there is downward pressure on prices, owner-occupied houses tend to be less volatile and more resilient compared to buy-to-let properties.
Although the chronic housing shortage in London persists, renters benefit from wage increases as the economy rebounds. (Picture: Pixabay)
“Being a private landlord is a lot more difficult with all the taxation and rising mortgage costs making it less favourable,” says Pellicer. “This, however, gives institutional landlords a chance to fill the gap in supply, while providing better-quality accommodation.”
Many of the recent institution-level investments and transactions in recent years have involved purpose-built rental accommodation. “The market for already-existing rental developments is still relatively small,” says Pellicer. He sees more opportunity for deals in the rental housing segment, but cautions that investors need to keep an eye on prices which have not stabilised yet.
“I envisage that the residential-for-rent sector will be one of the most resilient sectors in the UK,” continues Pellicer. “There is a large and growing pool of renters in the market, a chronic undersupply of quality housing, and wage increases will support renters.”
M&G expects “unprecedented” tenant demand for the private rented sector housing in the UK and rents are set to increase significantly in the coming quarters, supported by a relatively robust wage growth. This makes the sector well-positioned in a high inflation environment.

Strategic calls

In order to navigate a year that is expected to be beset by rising inflation and interest rates, as well as heightened economic and geopolitical uncertainty, M&G has laid out a number of strategic calls that it says will position global portfolios for resilience.
It has identified six real estate sectors that are most likely to be resilient to inflationary pressures. These are: hotels, prime offices in key cities, rental properties on short-term leases, logistics assets, real estate in technology & innovation-linked hubs, and grocery-anchored retail parks.
An example of an asset that is resilient to both inflation and stagflation is food stores, which come with a more defensive lease structure where inflation flows through to rental cash flows.
Green and sustainable assets that achieve net-zero carbon will likely see the greatest demand from tenants and investors, and one of the highest premiums in terms of rents and values, says Pellicer.
Pellicer: While most real estate prices remain firm for now, a handful of recent transactions indicate slightly softer pricing ahead. (Picture: Samuel Isaac Chua/The Edge Singapore)
Properties with contracted rents that are explicitly linked to an inflation index are also well-positioned to benefit from high inflation even during times of economic weakness, notes M&G, provided the tenants can maintain rental payments.
Finally, the private rental sector, student housing, senior living, and affordable housing all offer defensive characteristics for investors, with these rents most closely related to inflation levels.
In fact, student accommodation will be one of the key assets M&G will be looking to increase in its portfolio, says Pellicer. Its focus will be on university towns where there is a lack of quality student accommodation. Examples include M&G’s acquisition of a 513-bed, student accommodation in Bologna, Italy, in 2020; and its investment in the development of a 582-bed, student accommodation in Turin, Italy, in 2021.
In the case of Bologna, the city boasts one of the oldest universities in Europe, namely the 934-year-old University of Bologna, which has an extensive number of international joint education programmes with academic institutions in other countries. “It has many international students,” Pellicer notes.

Value-add with ESG

Investing in sustainable net-zero carbon real estate is one of the priorities for investors, and there are untapped value-add opportunities when it comes to repurposing older commercial developments, says Pellicer.
Typically, new buildings that come fitted with the latest eco-friendly and net-zero systems command a premium over similarly sized, non-green buildings in the same area.
A sort of “green premium” has emerged in commercial markets in the US and Europe as corporate tenants compete to secure space in a relatively small supply of new green buildings, Pellicer observes. Conversely, a so-called “brown discount’’ is emerging among older buildings that fail to meet the latest green standards.
Typically, buildings fitted with the latest eco-friendly and net-zero systems command a premium. (Picture: Shutterstock)
“I think the ‘brown discount’ is going to be far more important than the green premium (for investors),” says Pellicer. He describes “a virtuous circle” where developers have to aim for the highest possible green building classification because the most established tenants will only consider “top-of-class” buildings, he adds.
“The more interesting investment angle is for buildings completed 20 or 30 years ago,” adds Pellicer. “Investors can push up the quality of a building through refurbishment to bring it to an acceptable green standard so that it remains resilient.”
Opportunities to purchase such value-add buildings will materialise over the next decade when the costs of older assets become low enough to make the investment viable after factoring in refurbishment costs, notes Pellicer.

Construction sector crunch

A key market risk is rising construction costs, which have resulted in some corporate failures. Some builders in Australia and South Korea have shut down, according to Lai. “This is usually because they agreed to a fixed-price contract, and they are unable to fulfil their obligations because of rising construction costs,” he explains.
Looking ahead, Pellicer notes the importance of choosing the right partners, scrutinising construction contracts, and understanding the various fixed and variable costs. The track record of construction firms is another important consideration.
On the macro level, the next few quarters will see buyers and sellers trying to strike a new price equilibrium amid the economic uncertainty, says Pellicer. Markets such as the US, UK, Europe, and Australia have seen a plunge in real estate transaction volume in recent months, as sellers stick to pre-inflation prices.
“It will be some time before this temporary illiquidity is broken by a handful of transactions, resulting in some devaluation and asset repricing in these markets,” adds Pellicer.

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