Structural polarisation: The day of reckoning approaches for thematically misaligned investors

The terms structural change and polarisation have been widely banded about to describe some of the long-term impacts of COVID-19 on real estate markets. The prevailing wisdom is that the pandemic will accelerate thematically driven structural changes that were occurring anyway, such as the consumer shift away from the high street towards online retail. This will lead to widening polarisation in performance between the assets, sectors and locations that are positively aligned to these changes, such as well-located logistics stock, and those that are negatively aligned such as high street retail.

This logic is well founded. What receives less attention is the rate of acceleration at which these changes may occur and what that means for investment strategies. The impacts wrought by the pandemic and its aftermath are likely to condense changes that may have taken five or ten years to play out into perhaps 18 to 24 months. That means that the divergence between those assets that will benefit positively and those that will lose out could occur as soon as market conditions normalise. The divergence will be much faster and far more pronounced than many investors expect.

The reason for this is that the structural direction of travel is now highly visible to all the main real estate actors – developers, investors, consumers, businesses, employees. Take the office sector. Companies that did not realise how much the working world has changed and the impact this has on successful office locations and buildings have now been made to understand by enforced remote-working. Companies that were reluctant to pay rental premiums for the best offices in the best locations will now be more prepared to do so, taking a smaller footprint in the process. Companies occupying out-dated offices in weaker locations will see their space is no longer fit for purpose and does not meet the requirements of a post-pandemic world and rush to adapt their occupational strategy.

These changing dynamics will play out across all sectors concurrently, leading to significant, rapid performance divergence. There will be an occupational rush away from assets aligned to the old ways of occupying real estate towards those aligned to the new ways. Investors holding assets positively aligned to change will be sitting pretty; those holding assets negatively aligned to change will face higher capex-costs under a best case-scenario or unstoppable value erosion under a worst-case scenario.

Real estate investors should use this hiatus in market activity to ready themselves. They should review their existing portfolios to determine if it contains misaligned assets, whether they can be actively managed to prevent value loss or whether they should be offloaded as soon as possible. Opportunities to double-down on assets and locations which will benefit positively from change should be taken, whether that means bringing forward refurbishment plans or enacting new acquisitions.

Given the potential flood of secondary assets hitting the market when more normal trading conditions resume, mispricing may occur. This will be especially true for assets that have repositioning potential or for which long-term demand will endure. It takes bold action to buy against prevailing market sentiment but investors with a solid thematically-based investment strategy who have the conviction stand to see strong upside returns.

Of course, this assumes that investors had not already adapted their portfolios to align with structural change prior to the pandemic. Investors that have already done so should now see their labours bear fruit. Those that have not may find that the time to adapt to structural change has almost run out. As Warren Buffet famously quipped, ‘only when the tide goes out do you discover who's been swimming naked.’

Tom Duncan

Senior Associate – Investment Strategy and Risk