The future of core real estate

Managers rethink core real estate portfolio strategies amid cyclical and secular headwinds

Turmoil in the office sector and increased competition from higher-yielding fixed-rate investment products is forcing fund managers to take a closer look at the future of core portfolio strategies. Does core have a future? The answer is yes, but there are changes ahead.

Core real estate strategies that have traditionally been heavily weighted on the four food groups – office, industrial, multifamily and retail – were already transforming well before the pandemic. Fund managers have been increasing concentrations in outperforming multifamily and industrial, while also expanding holdings into “other” property segments, such as hotels, life sciences, data centers and self-storage. The rise of hybrid work has triggered a bigger pullback from office real estate along with some rethinking of portfolio strategy.

“The role of core and the concept of core remains the same. However, it's how core is defined and getting the characteristics that are sought with core that are changing,” says Omar Eltorai, Research Director at Altus Group. Eltorai was among a group of panelists exploring the Future of Core at the 2023 Altus Connect conference.

Despite headwinds, institutions remain committed to real estate allocations. In fact, allocations to real estate across many groups are continuing to climb for a variety of reasons, including the income-producing characteristics and the role that real estate and real assets play in stabilizing portfolios and helping with overall portfolio metrics. However, while target allocations to real estate are holding firm, there is going to be greater focus on the selection of core assets, as well as the selection of managers and GPs who can deliver on core returns. “The concept of core might not be changing at the high level, but how capital is deployed and how you actually capture those core returns is an element that everybody’s thinking about,” says Eltorai.

Core real estate strategies are responding to both cyclical and secular shifts that are impacting longer term strategies. The whole world has changed – from demographics and migration trends, to the preference for work from home and the subsequent evolution of office space. Managers also need to account for higher interest rates and inflation. “What’s worked in the past based on core has really changed. Before, with the low interest rates, and basically almost free money, you could afford to make a mistake and still produce half decent returns,” says Ray Wong, vice president, Data Solutions Delivery at Altus Group. “Now you can’t really buy core assets at cap rates of 3 to 4% and borrow at 7 and 8% and expect the returns to hit 20 or 30%,” he says.

Reducing office real estate exposure

BentallGreenOak is one real estate investment manager that has made big changes in terms of its asset allocations in both its Canadian and US portfolios. Specifically, office holdings in its Canadian portfolio have dropped from the mid-40s to around 20% in lieu of increased allocations to industrial, multifamily and niche sectors. One of the drivers behind that shift for BentallGreenOakis a desire to move to a “cap-ex light” approach, which also applies to how the investment teams are thinking about all assets, including alternatives, notes Phil Stone, Principal and Head of Canadian Research at BentallGreenOak.

Institutions across the board were making moves to reduce office real estate holdings even before the pandemic. However, the rise of remote working along with concerns about a recession is creating heightened focus on the downside risk of office. GPs tendency to prefer core office real estate in a gateway market presents an added challenge, as they typically need to go in at scale, which can result in high exposure to one asset and greater risk if that asset starts to underperform. In some cases, problems with one or two assets can introduce risks into a portfolio that can be dramatic.

Unsurprisingly, the higher interest rate environment is creating more challenges for offices, and GPs are likely going to face some difficult decisions ahead. The math has changed in terms of financing, and more equity will need to be added to deals. With this in mind, GPs are going through the analysis and starting to make decisions on assets. “Which assets do we want to keep and reinvest in? Which are winners, and which are those that maybe we can see how they just pan out by themselves, and others let’s kick out? We'll likely see a number of GPs make those tough decisions,” says Eltorai.

On the positive side, when looking only at core office assets, Class A buildings are about 90% leased for most of the major pension funds, adds Wong. The availability gap is occurring in the sublet space where there are generally two to three years of term left. To a certain extent, that sublet space “buys some time” so to speak for institutions to make strategic decisions on holdings, including looking at other alternative sectors to shift into, he adds.

A new definition of core real estate?

If you were starting a core real estate fund today, what would it look like? Panelists agreed that future core strategies will likely include some of the traditional sectors. Despite the headwinds for office, the reality is that there's still a lot of demand for prime and ultra-prime assets. Residential real estate has good supply and demand dynamics, with a housing shortage continuing to be a factor in many markets. A core strategy also would include industrial, such as last mile or heavy storage, and particularly those areas of industrial that are not priced to perfection, as well as retail on a select basis.

Niche sectors also have a place within core real estate portfolios, and aging demographics are driving notable demand for sectors such as life sciences and seniors housing. The challenge with alternatives, such as seniors housing, storage and hotels, is that many are operating businesses. So, a key theme for institutions, especially as it relates to operationally intensive sub-sectors, is to find the right partner and have conviction on the strategy.

“I don't think the core label is going away anytime soon. Investors in core still expect 70 to 80% of their returns to be steady, stable cash flows,” says Stone. Expectations have probably shifted a bit in terms of greater expectations for capital appreciation, but income remains a key component, and that income helps to define core relative to other strategies, he adds.

One of the important considerations for the future of core real estate strategies is caution around style drift. “It’s great to try and get into some of those higher growth sectors and geographies, but I can’t stress enough that you have to have that expertise both with your investment partners and your operating partners,” says Stone. “A lot of times that's going to mean in-house expertise, and how you think about how you scale that team in-house.”

Tools and techniques to navigate market risks

Moving forward, the ability to deliver performance on core strategies is going to rely more heavily on data and analytics that provide good insights into property sector and market dynamics. Synthesizing the data and understanding what the real drivers of asset-level performance are in an area is going to be something that managers really need to be thinking about in the future. Data solutions are helping clients to better understand markets, submarkets, neighborhoods and individual asset performance drivers.

“When you look at pricing and data, the value that the researchers bring in is understanding some of that background data,” says Wong, who notes that it’s not just knowing that a property sold for a 5% cap, but rather, understanding the underlying story behind it. “That's the value of the data, and you can't just take the data verbatim,” he adds.

Being able to provide those granular answers is going to be more important in a market where investors are going to be asking better questions of real estate and asking better questions of core portfolio managers in particular, he adds.