Podcast: Why real estate has become the talk of the town

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[00:00:09.450] - David Brett

Welcome to The Investor Download, in the studio today we've got Tom Walker, co-head of real estate investment here at Schroders. Tom, thank you so much for coming to the studio. Welcome. How's your new year been?

[00:00:18.530] - Tom Walker

So far, so good.

[00:00:19.570] - David Brett

Good. Well, hopefully it will continue because it's been a really topsy turvy time for your sector. You've had the sudden rise in inflation, had interest rates going up. We had the pandemic, of course, which has had a huge effect. Can you just set the scene for us and just give us a brief overview of where it's been over the last couple of years until we've got to where we are now?

[00:00:37.260] - Tom Walker

Yeah, well, you're right. It's been very dramatic. It's been pretty stressful, I'm not going to lie. And not many people have wanted to talk to me about real estate, that's for sure. So really, kind of the issues for the real estate sector go back to around February, March 2022, when interest rates started rising. What we saw then, the start of, was kind of the largest interest rate rise that we have seen almost ever, I think. And what that means for real estate is that the discount rate that we're using to value those cash flows is going to be much higher, which means the value of the assets that are producing those cash flows is going to be lower. So the listed market reacted very quickly to interest rates being higher. We saw most of that kind of rhetoric continue for 2023, apart from in the last quarter, when suddenly the central banks decided that interest rates were now high enough, inflation was under control, and they were even hinting at interest rate cuts. So we saw a very strong rally in that final quarter as investors thought, right, okay, now we can start to look at real estate again,

[00:01:37.150] - Tom Walker

Interest rates have stabilised. What's going on in this sector? Now the interesting thing for me that has happened over the last couple of years has just been the strong fundamentals in real estate markets, that it's all been a macro driven narrative as opposed to the micro. No one's talked to me about demand and supply of data centers. No one cares. It's just about where interest rates going. They're going higher, sell real estate, but actually slowly and quietly in the background. The real estate markets have been quite

[00:02:02.570] - David Brett

strong. During that difficult period, was it difficult to see the woods from the trees? It must have been quite dark.

[00:02:08.780] - Tom Walker

Yeah, it was. It was a very sort of unnerving time. But one of the things that I found strangest was that every meeting we had with companies that we invest in, every research trip we did into real estate markets. They were really strong. Management teams were actually upgrading their earnings. We saw more resilient earnings, we saw more demand, we saw supply cut off. And so I was having kind of this kind of bipolar world where I had very strong management meetings and fundamentals were great. But then in the capital markets world, where interest rates were rising and that discount rate was increasing as I mentioned, values were just falling very fast. And that's probably kind of the most extreme it's been in my career, where the capital markets are doing one thing and then the fundamentals in the direct market are doing something else.

[00:02:52.460] - David Brett

And were company management keeping their cool during that period? Because they must have been panicking a little bit themselves.

[00:02:56.810] - Tom Walker

Well, I don't think they were panicking, actually. I think that management teams, most of them are pretty experienced. They've been doing it for a long time, and they know that listed markets get jittery and they've seen it before. And because they're probably more on the coal face, and they actually see, look, there's no supply. Inflation has been leading to an increase in cost of raw materials. There's no supply coming through, and I've got assets, and I can see more demand for structural reasons maybe. And so actually they knew that it would change, as I think kind of we all did. But they could actually just see that their income stream was growing, and that's really the only thing you can control as a CEO of a property company. And so they weren't panicking, they were happy. They could see that the business was actually in a good position. The key for all of them. And there would have been panic if they had weak balance sheets. And it's debt, which is always the issue when the property market turns or there's something coming. If you've got a strong balance sheet, you're fine. If you've got a weak balance sheet, then you're in a tricky position.

[00:03:53.100] - Tom Walker

And so the only panic would have been, unfortunately, we didn't have any in our portfolio, but companies who had too much debt.

[00:04:10.050] - David Brett

Okay, so you mentioned things have got a little bit brighter. So what has changed? Is it just the fact that interest rates might be peaking?

[00:04:16.070] - Tom Walker

Yeah. Well, so to sort of tell you a little bit, the craziness of kind of our world in listed real estate is from a real estate point of view, nothing's changed. It's still as strong as it was kind of for the last couple of years. It's all to do with the macro. And pleasingly, from an active management point of view. It really feels that that narrative is beginning to shift from the macro to the micro. What has changed is that it feels like interest rates have peaked. That's all we need in the real estate sector for now, strong performance. And people are beginning to talk about interest rate cuts as well. I mean, that's just going to fuel the performance in the sector as much as it hurt it going back to 2022. So what has changed is just that interest rate sentiment and then the discount rate people are using for those cash flows. And that led to a very strong rally in the final quarter when we had pretty passive commentary coming out from the Fed, the ECB, about where rates were going to go. And that gave investors confidence to say, right, rates have peaked and they may well be cuts in 2024.

[00:05:15.970] - David Brett

Yes. I was reading some of our research and it looks like markets are pricing in, certainly in the US and UK, interest rates to fall to potentially 3% next year. Sorry, this year, if that doesn't happen, is that going to cause an issue for the real estate sector?

[00:05:28.980] - Tom Walker

No, and this is the interesting thing for us. Throughout the kind of weak performance in the stock market, we've been very consistent in saying all that we want to happen is stability in interest rates. We don't need rates to get cut for real estate to start performing, because actually what investors have priced into listed real estate is a recession. We kind of feel that there's really quite attractive valuation opportunities in the market at the moment. And so really heading into a recession, or the need for rates to be cut, we feel that's already baked into prices right now. And so if rates were to cut, I think I would see that more as kind of icing on the cake, as opposed to kind of really what's needed to have strong performance at this point in time. Because it feels like

[00:06:17.430] - David Brett

investors have almost disregarded a recession scenario. So you're saying even if it does go into recession, real estate has had such a bad time that it probably wouldn't drive it down any further.

[00:06:26.800] - Tom Walker

Yeah, we think that's priced in. Exactly. And I think, interestingly for me, if we head into a recession, actually real estate can look quite an attractive asset class. I mean, if I think about our portfolio, on average, we've got an income stream contracted to high quality tenants for about four or five years. And so if you're heading into a recession for, let's say, two or three years, whatever time period, you've still got certain income stream coming through from high quality tenants, that's going to be paid. And so your dividends that you're going to receive as investors, that's not going to change. And as I mentioned, as long as interest rates don't start increasing again, that capital value of the assets, that will remain static as well. And so actually, I think real estate could be quite interesting. If we head into a recession. And,

[00:07:07.580] - David Brett

if interest rates don't go down, are there still a few companies at risk bearing in mind how much it cost of capital and how much it's going to cost to repay whatever loans they've taken out?

[00:07:17.690] - Tom Walker

Absolutely. Again, I think what you're going to see for a good six months into this year, if not longer, is pretty negative headlines about the real estate sector. But that's when you start to think about listed real estate and then the direct market. So listed real estate kind of moves quickly. It prices ahead based on new information. So when everyone saw that interest rates were going to increase, that was priced in to listed markets pretty quickly. The direct market is always a little bit slower to react. And so you're going to see investors who've got to refinance and they're going to see their equity wiped out. They're going to have to make distressed sales. There's going to be headlines about unlisted property funds having to sell or perhaps even going to bankruptcy because that refinancing is too much. And so that's what's going on in the direct market. The listed market is priced that new news now. But again, back to my point I made earlier. They've got strong balance sheets, and there's a really different position in terms of that strength of the debt positions that listed companies are in versus the direct market.

[00:08:19.020] - Tom Walker

And so we actually think some of the REITs are going to be in a really strong position to capitalize on that distress if someone is selling a kind of trophy asset at a discounted rate. The REITs have access to debt and they've got access to equity. And I think actually that puts them in a really interesting position for the first time in almost five or ten years, where they've got the lowest cost of capital. And so I think we're expecting some of the REITs in our portfolio to do quite transformational deals over the next six to twelve months, taking advantage of that distress.

[00:08:50.000] - David Brett

Okay. And just for the listener, can we just define what's the difference between a direct client and a listed.

[00:08:55.680] - Tom Walker

Yeah. A listed company is a company whose shares are trading on the stock market. And so if you think about, if we were told today that interest rates were going to be rising for the next two years. Investors would generally be selling those shares because the value of the assets held by that listed company is going to fall. The direct market, it just gets priced when a building is bought or sold. And so that might take six months, it might take three months. So it's much slower to see those valuations move. For some of these unlisted funds, valuers might revalue them every quarter, maybe every six months, and it tends to be very lagged. And so that's sort of just the difference. And in the UK, we've had lots of headlines about bricks and mortar funds. When investors take money out of those funds, the fund itself needs to sell that building, and that's where you get those sort of suspensions. Whereas the listed market, it's always liquid, it's always open, but you have more volatility on the way up and the way down.

[00:09:48.460] - David Brett

I was going to ask, how do investors that are reading those headlines differentiate between the two? When do they panic or when do they just say, okay, I've heard about that, that'll be fine in the future?

[00:09:58.400] - Tom Walker

It's really just to do with valuation. And it's about understanding that the listed market has priced in the fact that interest rates are higher, they've priced in that there's sort of probably a recession on the way, and then direct market transactions that took place over the last six months or so, they probably weren't pricing that in. And so there's just a change in the information lag. It's a difference. The listed markets look forward and they move ahead of price changes. The direct market is always looking in the rear view mirror, so it tends to be slower to react to changes.

[00:10:27.930] - David Brett

And one of the major themes, certainly since the pandemic has been demand. Have you seen any pickup in demand or has the market just settled at a certain level in terms of real estate demand from companies and from workers coming back into the cities?

[00:10:42.970] - Tom Walker

It really depends on sort of which subsector you're looking at. But if we're just to talk about offices, it really depends where you are in the world. I mean, if you just think about Europe. Europe as a region wants to work from home really more than most places around the world. I'd say kind of in Asia, Japan, Singapore, Hong Kong want to work from home the least. Europe is pretty high. And then in America, the west coast of the states is almost kind of non existent, if you like, in the office. And so you need to be very careful about where your office exposure is. And so we've absolutely seen cities themselves become very vibrant post Covid. But what people are doing in cities is very different. There's less working in offices, there's more living in apartments or going out and sort of having fun in bars or restaurants or theaters or whatever it might be. And so it's about understanding the type of real estate you own in a city and how that's performed.

[00:11:43.710] - David Brett

So you guys talk about global cities a lot. That thesis is still there. You still believe in the global city?

[00:11:48.850] - Tom Walker

Yeah, I mean, it's sort of very clear. I mean, if you just sort of look, for instance, at apartment sort of occupancy and demand, wherever you are in the world, demand to live in a city is at record highs, vacancy is at record low, rents are going up very quickly. And back to kind of the inflation that we've seen across the world, and in particular in the US, and the reasons why interest rates went up. One of those core sticky parts of US inflation was shelter, which is kind of owner's equivalent rent. And so, yeah, the thesis for a city is still as strong today as it was pre the pandemic, if not stronger, because we've now survived, if you like, another crisis. But it's just about understanding the type of real estate you own in that city and how you're going to benefit.

[00:12:30.290] - David Brett

And are there certain subsectors, as you were talking about, that are more interesting than others, or certainly more attractive than others?

[00:12:35.460] - Tom Walker

Yeah, absolutely. I mean, obviously, kind of offices is going to be in the less attractive camp, and then something like data centers or logistics assets are going to be in the more exciting camp. And so one of the interesting things for us last year was the democratization of artificial intelligence and how that became a thing. Now, we've always known that kind of whether it's edge computing artificial intelligence was always going to drive data center demand at some point in time. And it came true last year. So we have seen demand for data centers increase dramatically, completely game changing. Rents, therefore, for people who own data centers, are climbing very fast. And so that was the strongest subsector last year. So that's clearly a very interesting place to be invested right now. And we think that artificial intelligence will probably lead to an increase for data center demand of between four to eight times. And we could be massively kind of underplaying that because we just don't quite know how sort of strong artificial demand and how much it's going to impact our lives. But that's our early estimations so that's very interesting. Another subsector I would call out would be kind of aging demographics and health care.

[00:13:47.000] - Tom Walker

So retirement communities, memory care, independent living, assistant living, everything that kind of plays to that kind of elderly demographic is really seeing very strong demand. Again, back over in the states, I think you've got 10,000 retirees a day moving into kind of the plus 65 age bracket, and that's really leading to very strong demand for age restricted communities, those retirement communities at a time when supply is at an almost all time low. So again, rents are moving quickly.

[00:14:18.230] - David Brett

Okay. So got lots of interesting themes there. If you could sum it up, the outlook for the next twelve months, maybe eighteen months, what would you tell investors?

[00:14:25.580] - Tom Walker

Yeah, so I think for investors, you've got a sector that's been repriced, you've got a sector that is priced in a recession, I would argue as well. And I think that unless you believe interest rates are going to increase dramatically, it's an interesting time from a valuation perspective to look at the sector. Plus, you add to that those management meetings I was referring to, the structural trends, compounding leading to extra demand for particular subsectors. You're going to get earnings growth. So we think that the sector, even heading into a recession, looks quite attractively priced for a sector that has earnings growth as well.

[00:15:01.200] - David Brett

Let's hope that all plays out for you and hopefully all your investors as well. Tom Walker, thank you so much for joining us.

[00:15:07.240] - Tom Walker

Thanks for having me.