Alternative real estate: chronic need, inelastic demand

COMMENT: We’re in a period of hype around alternatives, yet some subsectors are likely to mature over others. I believe that the key to success in the 2020s lies in pinpointing parts of the market that overlay a chronic need with relatively inelastic demand. Commercial real estate investors seem disconcerted. Our investment universe has traditionally comprised offices, retail and industrial property. In some countries, residential is part of the mix. But the 2020s appear to be testing this long period of stability. Covid has created a previously unthinkable question mark around certain offices; retail continues to undergo a major transformation; and industrial property is transacting at eye watering yields. Where lies investment potential? Many in the investment world point to ‘alternatives’ as a one-stop solution. Some may call it a more operational future for real estate. They have a point. Portfolios need to expand, diversifiers need to be found, and many of these are operational in nature. Nevertheless, not all alternative subsectors are equal, or equally attainable. I believe the key to negotiating alternatives successfully is to accept, from the get-go, that some of these sectors will always be niche, while others may well mature and become mainstream.  How to spot winners What defines alternatives? There is no one-size-fits-all, but here is my rule of thumb. They must be illiquid, typically hard to source, and either operational in nature or run by specialist managers.  The way to be successful in this space, in my view, is to identify the ‘winners’; subsectors that have the potential to become mainstream. This rests on a series of fundamental questions. Is there is a chronic market need for this subsector? Is occupier demand relatively inelastic? If so, where? Is the structure of the market such that growth among privately operated occupiers can surge? Is there widespread private equity ownership in the industry, and are operators heavily indebted? And, of course, is the location enduring and could there be an alternative property use? Take student accommodation. There was a massive supply and demand imbalance in the early 2010s. The growing number of international students faced a chronic lack of quality accommodation; I know this well, as I was an international student once. This demand was fairly inelastic, thanks to the rising middle class and parents’ readiness to prioritise safe, comfortable accommodation for their offspring.  At the same time, building constraints were limited and the first few – luxury – purpose-built schemes were a success. This gave room for the mid-market to develop. Liquidity followed, post-global financial crisis. Notably, private equity ownership of operators was rare and, effectively, an operator was just an asset manager, not the tenant.   Million dollar question Are alternative subsectors likely to remain resilient in a downturn? That is the million dollar question. For some clues, let’s look at the last cycle.   Pre-financial crisis, a lot of money needed putting to work and some investors went into alternative subsectors including student accommodation, care homes and leisure properties. But some got their fingers burnt.  Arguably, care homes looked like a no-brainer given the rising ageing population. However, this underplayed the fact that care homes are heavily operational assets and, as such, rely on the quality of the operator, and the health of their balance sheet. The financial crisis put this to the test, toppling a number of private equity-owned care home businesses as occupancy dipped. In some cases, landlords even ended up owning the assets themselves.  Remember, demand can be more elastic than you’d think – and operators might have a different risk appetite to your own. What could determine a successful alternatives strategy? The benefits that alternatives can bring to a portfolio are clear, including potentially higher returns and improved diversification. But that doesn’t necessarily mean that they are a golden ticket. Some subsectors will mature and some won’t. I believe that the distinction lies in a market need and relatively inelastic demand within the bounds of a subsector’s structural make-up. In my mind, there is little doubt that making the right call on this will define investors’ success in the 2020s. José Pellicer is head of investment strategy at M&G Real Estate