Investors, managers go where the technology is

Real estate investors and managers are increasing investments in newer property types that will benefit from the growth of the tech economy.

Investors in real estate investment trusts, for example, have more exposure to categories of properties such as cell towers and data centers that didn't exist 20 years ago. Asset owners top-heavy with core properties have a smaller percentage invested in niche sectors, but even in core funds managers are filling out their small allocations to new construction of these niche property types that they expect will evolve into core real estate.

At the end of 2018, real estate equity investors had larger portion of their portfolios in "other" buckets than in industrial, the highly popular traditional asset class, according to the 2019 Investment Intentions Survey by the Pension Real Estate Association, European Association for Investors in Non-Listed Real Estate and Asian Association for Investors in Non-Listed Real Estate Vehicles.

This year's survey showed that global investors had 11.1% in the "other" category, compared to 10.3% in industrial. North American real estate investors had 17.5% in other but only 13.1% in industrial. Five years ago, a survey of just PREA members showed that North American investors had 12.6% in other and 12% in industrial.

Investors are turning to property types outside of the traditional four — industrial, retail, multifamily and office — to boost returns, said Greg MacKinnon, Hartford, Conn.-based director of research for the Pension Real Estate Association.

In an overall low-return world, investors are looking for places not popular in the past for returns such as student housing, mobile homes and data centers, a newer niche section, Mr. MacKinnon said.

According to PREA's quarterly consensus forecast of U.S. commercial real estate returns, investors continue to expect real estate returns to decline, he said. A 6.5% total return is expected in 2019, which will fall to 5.3% in 2020 and 4.5% in 2021, the third quarter report shows. Industrial, too, is expected to decline but will remain the best-returning sector, Mr. MacKinnon said. The 2019 return forecast for industrial in 2019 is 11.7%, dropping to 8.2% in 2020 and 6.1% in 2021.

Indeed, property-sector selection will get more important in the future because changes in the economy will not affect all property types in the same way, he said.

For example, the office sector will slow along with the economy, while apartments are more protected in an economic downturn, Mr. MacKinnon said. "People will not suddenly move out to buy a house," he said.

Investors are moving into alternative property types, which many believe could still perform well in an economic downturn. These alternative real estate categories have grown to be a significant part of investors' real estate portfolio but they are not as large as office and retail.

The PREA/INREV/ANREV survey showed that the largest category is office, which is in 34.4% of global investors' portfolios and 28.3% of North American portfolios.

Carlyle Group's open-end core-plus Carlyle Property Investors Fund is structured differently than a typical core-plus fund; it is weighted toward niche property sectors expected to be less sensitive to changes in economic growth, according to a Townsend Group report to New Mexico State Investment Council, Santa Fe, which runs $26.1 billion in endowment funds. The council at its Sept 24 meeting committed up to $100 million to the fund.

"Overall, Carlyle was selected given their exposure to niche property types that are less sensitive to GDP movement, historical performance, strength of the platform and team," the Townsend report states. Townsend is the council's real estate consultant.

There is keen investor interest in data centers, cold storage or any property category that could benefit from the technology economy and might withstand moderation of economic growth, said Zachary Streit, Los Angeles-based senior vice president of George Smith Partners Inc., a real estate advisory firm that assists investors with financing and arranging real estate deals.

The economy has been in recovery for more than 10 years and investors are searching for alternative asset classes that might outperform traditional real estate sectors in a downturn, said Mr. Streit, who said he personally has arranged and closed more than $1 billion and underwritten in excess of $6 billion of debt and equity financings for real estate transactions.

One brand new area is co-living in which tenants share spaces, providing them with affordable rent while creating community with close proximity to amenities, he said.

It plays off millennial trends while giving young workers affordable housing in often pricey locations.

Institutional money managers are not yet investing in the area, but it's "one to watch," he said.

In June, for example, startup firm Starcity won approval from the cities of San Francisco and San Jose, Calif., to build co-living projects. The projects offer furnished private bedrooms and private bathrooms with communal cooking, dining, lounge and laundry spaces on each floor.

Asset owners have greater exposure to niche property sectors through real estate investment trusts than private real estate, REIT managers say.

"The private real estate market is playing a little bit of catch-up,"said Jon Cheigh, a New York-based executive vice president and head of global real estate for publicly-traded real assets manager Cohen & Steers Inc.

REIT investors have low exposure to retail, which makes up about 15% of the U.S. equity REIT market, and more exposure to data centers, health care-related and industrial properties, Mr. Cheigh said.

Some investors are starting to look at REITs as a way to gain access to niche real estate sectors. Recent REIT outperformance over real estate equity hasn't hurt. The FTSE Nareit All REITs Index returned 12.65% and the FTSE Nareit All Equity REITs Index returned 13.01% in the year ended June 30. By comparison, the NCREIF Property index returned 6.51% and the NCREIF Open-end Diversified Core Equity index rose 4.14% in the year ended June 30.

Over the last three to four years, retail REITs have been selling properties and therefore are getting smaller. Other REITs concentrating on newer sectors such as data centers are taking up some of that market share, Mr. Cheigh said, adding that REIT market is reflecting future U.S. economic needs.

The number of data centers is growing as the amount of data generated by the 21st century economy continues to grow, he said. Today, data centers make up 7.5% of the U.S. REIT market, which is larger than the 5% mall REIT sector and the 5% shopping center REIT sector, Mr. Cheigh said.

Another growing segment is cell tower REITs, which now account for 15% of the U.S. REIT market, Mr. Cheigh said.

"You can own a big shiny mall but it better be close to cell towers" so shoppers can find their way to and around the mall, he said.

A big component of investors' private real estate portfolios is in core, which are properties established in sectors that are well understood, Mr. Cheigh said.

"Investors are in a little bit in danger of being left behind" on where the economy is going, he said.

However, some core managers say they are embracing the newer property types. Nuveen Inc., which is top-ranked in Pensions & Investments' list of core real estate managers for U.S., tax-exempt clients with $71 billion in core AUM, is making a big push into alternatives such as cell towers, billboards and health care-related properties, said Melissa Reagen, New York-based head of research, Americas, Nuveen Real Estate.

The tailwinds in these sectors will remain whether or not there is a downturn, she said.

Nuveen offers a variety of investments; in addition to open-end funds, it also offers closed-end funds with more niche strategies.

Investing in alternative strategies is an expectation that they should produce higher returns than traditional asset classes, Ms. Reagen said.

The new markets are fragmented and one way to boost returns is to buy smaller operators and consoldiate them into larger portfolios, she said. Acquiring a REIT specializing in alternative sectors is another way to gain a large portfolio as well as an operator to oversee it.

PGIM, which ranks third on P&I's new list of core managers for U.S., tax-exempt clients is also investing in alternative real estate sectors for the expected premium on returns, said Eric Adler, London-based chairman of PGIM Real Estate and PGIM Real Estate Finance and CEO of PGIM Real Estate. PGIM has an expertise in senior housing and is investing more in data centers, he said.

"The technology story is compelling," he added.

PGIM executives are spending a lot of time on refrigerated industrial to take advantage of a move to sell food online, he said. There are not a lot of properties to buy and so there aren't many deals.

But if online shopping continues to move into grocery, there will be a more demand for refrigerated industrial properties.

With the exception of senior housing properties, some of these niche property types are being held in PGIM's open-end funds, he said. PGIM has core, core-plus and value-add open end funds. What's more the open-end funds are unconstrained in terms of asset class, Mr. Adler said.