Although recent events suggest that managing Covid-19 remains a headache for us all, the baseline data that is coming through suggests that as restrictions lift and life normalises, people return to the office.

The data suggests that pre-covid office working patterns are normalising, but that expectations have changed and that both employers and employees have learnt from 2 years of enforced experimentation and evolving their working practices. The key themes emerging from agility experiments that consistently rank at the top of the 'learning' list are:

It seems clear that if the combination of flexibility and office work is balanced carefully and proportionately, accommodating a little of each is a net positive, particularly in an environment where talent is scarce.

Culture and collaboration were already core to many business employer brand propositions pre-covid in high knowledge sectors and the concept of 'flex or gig working' was on the rise, so this is not a revolutionary change. That said, the marginal 'option' to work more flexibly is now far more fully ingrained into business practice and so it will not be easily taken back and, given the ongoing ‘war for talent’, we should expect it will endure in the post covid working environment.

The ‘optionality’ outcome is, nevertheless, really important because it impacts the way tenants think about space use. Optionality drives a highly flexible pattern of use. Employers tend to specify core collaboration days and, even if they don’t, the data suggests that staff tend to choose the same days to be in (so that they can maximise the benefits of collective collaboration). In practice, this means that if everyone attends the office on Monday, Wednesday and Thursday, or the firm specifies days/times then, on those days and at those times, the office will likely be at full capacity. If full capacity is reached on any one day (let alone 2 or 3) then it makes it challenging operating with less space, particularly if your space is old and/or poorly configured. Equally, if staff also attempt to cram 5 days of collaboration and meetings into 3 office days, then the office may be stretched to (or beyond) its limits, requiring a shift in the balance between desks and flexible spaces, more meeting and comms space and better amenities (which all require more investment in spaces, not less).

The evidence suggests that once a tenant has given their staff the optional right to choose, office based businesses cannot rigidly control occupancy, limiting the ability to make large scale space and cost savings. Given the marginal importance of rent cost relative to talent retention and acquisition in businesses that have a growth oriented mindset, this 'lost opportunity' may simply pass un-noticed as wed normalise and businesses expand. Such firms are far more likely to focus on the quality of space, design flexibility and amenity of their space.

Ultimately, the data suggests that in a high collaboration, high productivity setting where the office provides significant amenity and talent development benefits, the impact of agility of the level of current tenant demand is likely be a one-off, contained effect. In some businesses where flexibility was already an accepted norm, it may even be negligible.

While we cannot definitively state that some firms will not radically change their needs and shed space, we do now believe that we can now model the effect of agility into our overall demand estimates with more conviction. When combined with our supply forecasts, this allows us to draw clearer conclusions about the forward looking path for vacancy rates and rents. In turn, this brings us to our analysis of supply.

Recent macro-events suggest to us that the long-term supply-side effects are frequently misread when investors are confronted by a demand shock. No one cared about the second order effects of supply chain disruption 18 months ago when the world was locking down, yet today as demand normalises, people are realising that cutting supply chains creates bottlenecks that are difficult to remove quickly and this is having a profound effect on costs and prices. This effect is most pronounced in markets with inelastic supply-chains. Shipping costs rose five fold in the Summer, but the effect on the energy sector has also been notable. Energy is facing an ongoing secular shift to lower long-term demand, but despite the demand concerns, supply-chain disruption means that oil prices hit five year highs and doubled from the levels seen in the Spring of this year. Demand matters, but you cannot ignore the effect of supply on prices in inelastic markets.

Real estate supply is highly inelastic, particularly in office, and, in our view, the supply dynamics that are in play in office markets are significant. There are two specific supply constraint effects visible:

In practice, both the short and long run shifts will contribute to a reduction in the stock of ready to occupy high quality buildings in Europe over the next 3 to 5 years and potentially beyond. The short-run effect has already begun to change the expected path of short-term office vacancy. Our analysis of pipeline developments for 2022 and 2023 shows a 10% reduction in programmed office construction, which given a current vacancy rate of 7% and a modest bounce back in leasing activity associated with pent-up demand in 2022 is expected to mean that office vacancy rates will peak in the next 6 months at no more than 7.5%. To put this into context, this is the lowest peak vacancy level in European office vacancy cycle in the last 40 years. If tenant demand normalises to its pre-Covid levels, our forecast for office vacancy in Europe for 2024 is below 5%.

Tristan's Office Vacancy Forecast (Top 30 European Markets)

These dynamics and the lack of new construction will significantly limit the availability of grade A assets with high energy efficiency ratings and low carbon footprints during 2023 and 2024. Right now, brokers estimate that the stock of available ‘for lease’ Grade A assets is under 2.5% of total stock. As tenants crowd in to try to lease energy efficient highly-amenitised space, the Grade A vacancy number will reduce. It seems highly likely that the stock of Grade A for lease will be negligible until new development activity restarts, which given a 2 to 3 year construction lag means that Grade A supply will be close to zero in most markets until 2024 or 2025. In many markets it is possible to count the stock of ‘net zero’ offices that are ready to occupy in the next 2 years on one hand. In practice, given rising construction costs, we still may be using one hand to count NZC buildings with in 2025.

In addition, data on energy certification (see Savills chart below) suggests that a very significant proportion of the total stock of existing offices falls below minimum performance standards that tenants are starting to demand. In many markets, minimum energy efficiency standards are being written into government policy and regulated. EPC's are far from perfect measures for ESG purposes, but the data implies that a significant proportion of the built stock will need to be upgraded in the next 10 years, and moreover, that large number of tenants will be forced to trade up their office space or work with their landlords to upgrade space upon lease expiry. Tenants may shrink their space needs, the challenge they will face is that ESG factors means that the supply of buildings that they can lease will shrink even faster. 90% of the demand doesn't fit into 50% of the stock.

Energy Performance Certification by Office Market (Savills)

In the key innovation hubs where demand is growing rapidly and supply is constrained, scarcity has the potential to drive rental growth for well located, properly amenitised assets with high energy ratings. We can already see evidence of this in our portfolio in London, Birmingham, Dublin and Barcelona. Increasingly, it also seems likely that, given the lack of new supply and less construction activity, rising demand will spill-over from Grade A into a broader range of good quality, certified ESG assets.

Given the long shadows cast by retail, investors are understandably cautious on the office sector and the tone of the conversation in the investor community remains uncertain. While most LPs accept that good quality core offices are not on the same path as secondary shopping centres, and everyone knows that the market is tilted to the buyer, it is hard to gain conviction, particularly if you aren’t directly leasing buildings and seeing real time data points that allow you to triangulate and untangle the ESG and supply complexity.

Equally, even if you can unbundle the data, there is a limited number of skilled value added managers who have the ability to measure the costs associated with ‘greening’ an asset, can price the detailed capex requirements, juggle tenants and execute a complex ESG-upgrade business plan under such time pressure.

As a result, many may decide to forgo the office opportunity and buy even more sheds and beds at historically lower and lower yields. It’s hard to criticise this choice, but ultimately the crowds and the prices make will make it increasingly hard to outperform. People seeking mid-teens IRRs in the B&S space will need to forecast significantly higher rents or lean on some combination of granular assets, more financing risk and/or development risk. The reality if that there is no easy path to mid-teens IRR’s. Every strategy has its own risks and execution challenges.

Have a great weekend!

Simon

So a few days ago I was rummaging through some research that we have presented at prior advisory board meetings, when I came across this slide from our Spring 2017 meetings :

5 years on it still resonates. We continue to use exactly this data to help clients think about the effects of inflation risk and how it might shift allocations to our asset class.

I also saw this chart today:

I was struck by this chart as it serves to remind us that not all price rises are persistent, particularly in markets where supply is relatively elastic.

This brings me to this piece of research from the BIS - the gist of which is that in the long run everything is transitory... I wish life were that simple!

Ultimately the market doesn't have the luxury of 'forever'. Investors may be able to look past today's spot CPI, but they are acutely sensitive to the risk of inflation over the next few years, particularly given the current levels of real yields. This inflation risk is often viewed through the lens of risks around central bank policy error. If investors think that central bank error is likely and that this may lead to a persistent rise in CPI, then they will look to hedge that risk now.

Real estate attracts capital in these moments in time because supply tends to be relatively inelastic over the short to medium term. But in practice, the efficacy of this 'hedge' is really a function of the scarcity supply at your entry point and the persistence of supply inelasticity (i.e. how much gets built in response to the capital that flows in to take advantage of rising rents).

Sadly, if supply varies over time (which we know it does), no one has the luxury of thinking like the BIS - timing and entry point matter.

Have a great weekend!

Simon

The spectre of inflation has returned. US CPI came in last week at 5%. German CPI hit a 29-year high in September. Right now, we don’t quite know what the future holds but the debate on whether rising prices are transitory or persistent, secular or cyclical is heating up. So is the inflation hedging debate.

Headlines aside, there is no need to panic just yet. As this chart from the ever-excellent John Authers’ Bloomberg blog shows, we are still some way from a return to the 1970s. The consensus expectation is that inflation pressures are higher than they have been for some time but that they are transitory, thus the risks to long term expectations are low and stagflation is not seen as being a threat.

Even so, when it comes to portfolio decisions, ultimately what most investors really care about is the risk that the consensus is wrong. This is largely about surprises and the risk of central bank errors. A surprise that makes it hard to predict prices and causes inflation expectations to become unanchored is ‘bad’, not least because it makes central bankers very likely to err and raises the risk of ‘stagflation’.

That said, it is difficult to precisely delineate ‘unanchored’ or determine a bad inflation ‘event horizon’. The data suggests that the probability of bad surprises increases significantly if CPI exceeds 4% and remains anchored at the level for more than 12 months.

As this Oxford Economics charts shows, although we are passing 4%, stagflation is not an issue today. However, as the four charts below from Oxford Economics, Capital Economics and BAML show, the performance and diversification effects of inflation risk passing 4% and persisting at this level, can be very significant at the portfolio level. The Bloomberg headline on '60/40 portfolios' may have dramatized the situation, but investors are highly sensitive to the risk of high inflation and thus, at current CPI levels, given the risk they are still likely to contemplate an allocation response.

One of the most common moves is to play defence and bond investors typically advocate adding index-linked exposure and adapting the duration and risk profile of a bond portfolio. Equally, as this Goldman Sachs chart amply illustrates, stock investors have playbook and any are already beginning to consider rotating equity portfolio allocations towards sectors and companies that are perceived to have ‘pricing power’.

Even so many allocators will also go the extra mile and begin to look to alternatives that add both inflation correlation and additional diversification to their allocations. Alternatives, real assets and real estate will almost inevitably be at the top of mind under such conditions.

As the chart below suggests, real estate has historically done a fairly good job of hedging inflation surprises.

There are two primary drivers for this performance effect. The first driver is leases that almost always include some form of annual CPI indexation. The second is a glacially slow-moving and highly restrictive planning system, which when combined with a long and complex supply chain creates capacity constraints that lifts market rents. When combined, these factors come together to give landlords pricing power and hence nominal growth (that includes CPI) passes through into net operating income. Some of this earnings effect should theoretically be offset by a rise in cap rates, reflecting an increase in the discount rate that is applied to the cashflow, associated with rising interest rates. However, as this chart shows this cap rate effect has not been that significant in prior inflation 'outbreaks'.

This is largely explained by capital flows. Broadly speaking, the capital that rotates out of other asset classes into the real estate sector in search of the NOI hedge has held down cap rates and worked to offset interest rate shift (creating a so-called ‘reverse-yield gap’ in the 1970's or 1980's). Given the inflation dynamics we are currently presented with, it seems unlikely that we will see the return of a 'reverse yield gap', but even so, the capital flow effects on cap rates should not be under-estimated. As the chart below shows, investors in fixed income assets are currently earning a negative real return, thus the appeal of a relatively high yielding (lower convexity) real asset that offers some level inflation hedge will be strong. Equally it is far from clear that European rates will rise significantly, particularly given the concept of 'curve control' and the scale of the public sector debt burden. The markets ability to reconcile the theory and the practice of pricing risk may well get tested in the next few years.

Where then is the reality of the inflation risk for real estate investors? With capital flowing into the sector and inflation driving nominal growth and tenant demand and as supply is inelastic in the short term, a real estate cycle becomes more probable. The chart below illustrates this nicely. When an inflation cycle builds, investors crowd into the sector in anticipation, pushing up values ahead of rising NOI. This both diminishes any risk premium on offer in the sector and increases the risk of speculation. In the 1970s the flows into the sector in the face of surging inflation risk fed a cycle that culminated in a speculative development boom. History tells us that building booms (particularly when the involve reflexive capital flows that involve bank financing) almost always undermine themselves, values and rents. The risk for investors is that the wider response to inflation may fuel a cycle and that cycles have the potential to undermine the hedge.

The current debate about inflation risk appears to be occurring early in the cycle, in an environment where supply is constrained and with limited evidence of 1970s style spikes in inflation volatility. This affords an inflation sensitive investor some cyclical comfort and also some time to think about what they can do now to prepare for any future risk. In our view there are a range of options to consider across varying 'risk styles. These are illustrated in this stylised inflation model below:

Ultimately, the adjustments required to allocation and strategy really depend on the underlying economics, cyclical dynamics and the levels of inflation that you are seeking to protect against. Right now the cyclical and economic dynamics are supportive, so most of the focus will likely be on your view of inflation risk.

On this basis, if you are in the ‘persistent’ CPI camp then you would up allocation and most likely rotate your equity and debt strategies to accommodate more operating and financial leverage. Some would also tweak the balance between the debt and equity buckets, particularly if the inflation persists and trends beyond our 'magic' 4% threshold. Conversely, if you are in the ‘transitory’ camp but felt you needed some insurance against the remote risk of a bad inflation surprise, you might add to your allocation and keep an open mind about financial and operating leverage across all strategies. If you are in the ‘70’s stagflation’ camp, then you should rotate to equity, lever up and then keep a very watchful eye on the cycle and its effects on the supply of credit and the number of cranes.

IMHO the key to making real estate work for you as an inflation hedge right now is as follows:

1 - Decide type of inflation you think is most likely and think about the risk of being wrong.

2 - If you decide to change allocations/style, then be an early bird.

3 - Never forget that real estate is inherently pro-cyclical.

Simon Martin sits down with Tristan's co-CIO - Cameron Spry and Dan Pottorff our Head of Debt Investments to discuss the post covid lending environment and its impact on real estate markets...

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