bfinance: Investors should pay attention to risks in emerging asset class

7 september 2022

Independent investment consultancy bfinance has released a new report on ‘impact real estate’, providing insight on the different types of strategy available and key risks within this fast-growing sector.

The report looks at this burgeoning asset class through the lens of a recent search for ‘impact real estate’ managers on behalf of a UK Local Government Pension Scheme (LGPS) fund. This pension scheme was introducing a dedicated allocation to ‘impact’ investments—a step that many other pension funds in the UK and internationally have been taking in 2021-’22. Their hunt for an external manager partner revealed well over fifty strategies offering impact—particularly social impact—in UK and European real estate, many of which have been launched within the past year. In addition, the report reveals additional managers keen to launch new funds with the appropriate seed capital.

Many of these ‘impact’ real estate strategies claim to provide investors with financial returns that are commensurate with conventional real estate strategies while also tackling issues such as poverty, regional deprivation, social housing shortages and insufficient social care provision. For pension funds, the appeal is enhanced by long-term contracted cashflows, government backing on many of the relevant contracts, and a considerable degree of inflation sensitivity.

bfinance’s report lists six varieties of impact real estate strategy: three with a focus on housing and three with a non-housing or broader remit. The housing strategies include (discounted/affordable private rental sector housing, ‘multi-tenure’ social/affordable housing, and supported housing. The ‘non-housing’ strategies include community regeneration, social infrastructure and healthcare. Over time, the report notes that there has been a shift from social housing strategies (which dominated launches in 2016-17) to more varied strategies (more popular among the launches in 2021-22). This shift coincides with a change in the investor base: more financially-oriented institutions (such as pension funds) have entered a space formerly dominated by entities that were prepared to accept lower returns (such as certain charitable foundations).

Core and core-plus ‘impact real estate strategies’ are targeting overall returns of 5-10% p.a. net of fees and yields from 2-6%. These expectations are broadly in line with conventional real estate strategies. However, returns can be affected by factors such as forward funding, specialisation and the level of leverage used. In comparison against the broader real estate market, the MSCI UK Property Index has delivered a 6.4% p.a. net total return over the past five years, while the ODCE PanEuropean Core Index has delivered a 5.7% return. Investors can also expect fees for impact real estate strategies to be slightly higher.

The report also lists five key risks that investors will face in core/core+ ‘impact real estate’ strategies that they are unlikely to encounter—or, at least, not to the same degree—in conventional real estate strategies seeking similar levels of return. These include: development risk, regulatory/policy risk, partner/counterparty risk, capital raising risk and ‘impact delivery’ risk. Investors that may tend to avoid or minimise development risk in their mainstream direct real estate equity investments, for example, will be far more likely to take on development risk in impact strategies in order to demonstrate ‘additionality’ (a positive impact that would not have happened without that investment).

The report also considers the subject of inflation, which is proving increasingly crucial to analysis of investment opportunities in 2022. In an inflationary environment, investors can find some comfort in the inflation-linked characteristics of many of the income streams in the housing and healthcare sectors, once yields are in place. Yet, while managers can try to bolster the inflation-sensitivity of returns, those shifts should be weighed against the impact being generated. For example, managers can move towards more traditional PRS-style housing (where rent rises are more likely to be linked to CPI), but this can arguably dent the social benefits of their investments. High levels of inflation may also exacerbate tensions with regulators: while rents may be linked to inflation, housing benefits (in the case of ‘social’) and wages (in the case of ‘affordable’) may well fail to keep pace. Rising interest rates can also create challenges for strategies that employ a greater degree of leverage, and inflation can exacerbate development risks as raw materials and labour become more expensive.

Nikki Howard, Associate at bfinance and the report’s co-author, said: “We are excited to be able to share this analysis, which really showcases the dramatic growth in the number and variety of real estate strategies that deliver impact alongside credible financial returns. We see more and more financially-oriented investors across different parts of the world, such as pension funds and endowments, that are entering dedicated ‘impact’ strategies in 2022 – not just in real estate of course but in private equity, listed equities and more. The roster of managers is far deeper and more credible than it was even three years ago, which is a great thing. But it is extremely important to apply sharp scrutiny during manager selection in order to manage the risks involved. We’ve dedicated the second half of this report to a discussion of some of the distinct risks in this sector: these risks have already tripped up a number of asset managers and their investors, as shown in some instructive anecdotal examples.”