Charities investing in real estate – challenges and opportunities

The management of direct real estate portfolios has become considerably more difficult for charities and endowments in recent years. The pandemic, high inflation and the rise in the cost of living have exacerbated the situation and continued to fuel a polarisation between sectors, most notably in the office sector, where we are seeing continued structural shifts due to the increase in hybrid working.

This constantly changing economic and social environment confirms the importance of investment diversification and the need to invest in areas of the market that can deliver a resilient and growing income stream through rental growth. It is very important for charities to look closely at how and where they invest in real estate. Does investing in direct property assets make sense, given the ongoing day-to-day management issues, or should consideration be given to an indirect pooled fund approach with a specialist manager who understands the complexity of real estate and the increasing requirements of operational asset management.

Prior to 2012, real estate sectors were highly correlated and tracked the prevailing economic conditions. However, from 2012 a structural shift occurred in retail, moving online to the detriment of shopping centres and the high street but to the benefit of warehousing and logistics (industrial), and this has been reflected in the corresponding investment returns from real estate in the retail and industrial sectors.

More recently, following the move towards hybrid working, a further structural shift is now occurring in the office sector, where there is growing polarisation between the prime, Grade A, quality offices with good light, space, amenity and ESG credentials compared to the more secondary office buildings unable to attract employees away from working from home. This polarisation is leading to a dramatic re-rating of office rents, and many secondary offices are in danger of becoming stranded assets, thereby losing significant value.

Diversification is therefore key to any real estate portfolio, not only across but also within sectors. In addition, an understanding of the structural changes occurring in society is required, which is driven by three overriding themes: technology, demographics and infrastructure. In this way, a thematic approach to investment research will allow a clear understanding of those areas of the economy and sectors of the real estate market that will drive future occupational demand which ultimately drives rental growth and long-term property returns.

A result of the above trends is the significant growth of investment in the Alternatives sector as investors move away from the traditional retail and offices sectors. The Alternatives sector (e.g. student accommodation, care homes, self-storage, residential, hotels, etc.) invariably requires a level of operational expertise, alongside that of property management, and this acts as a barrier to the market for direct investors with little experience in this sector.

For charities and endowments, ESG has never been more important. Firstly, to ensure any investment is aligned with the underlying charitable mission or objective, but secondly so that real estate can meet the Net Zero Carbon ambitions. Alongside the growing regulatory requirements to meet EPC (emissions) targets from 2027 for the letting of any commercial property, an EPC rating of at least “C” will be required and this is likely to be raised to “B” from 2030. These changes mean that charities need to carefully review their existing direct portfolios to ensure compliance. This may necessitate considerable capital expenditure and cash flow requirements to meet the required standards. Alternatively, assets could be sold on the market, however, many properties – particularly in the challenged office sector – face falling values and risk becoming stranded assets.

Professional advice is key to understanding the risks of a direct real estate portfolio as well as the increased expenditure required over the next five years to meet the new standards.

Until a few years ago, managing a property portfolio was relatively straightforward for charities. It was simple enough to collect the rent and manage the property through the terms of the lease. However, with the underlying economic conditions, heightened inflation, rising interest rates and increased CO2 reduction measures, owning property is now a very different prospect, compounded by increasing complexities of day-to-day property management and rising maintenance costs.

In addition, tenants have higher expectations in terms of fit-out. A landlord needs to understand exactly what tenants expect from a building, especially offices, and needs to consider what this means for the hybrid workplace. Another point to note is the lease term. Instead of concluding contracts for 10 to 15 years as in the past, landlords are having to compete with the growth e.g. in serviced offices, and are increasingly having to accept five-year leases often with a three-year break.

All these changes call for more technical real estate knowledge and for property owners to have better operational management skills. For many charities and endowments that own direct real estate, a transition period may be required in order to align with a professional real estate investment manager, re-position the portfolio and look at whether direct ownership is the long-term solution. The alternative might be to invest indirectly with a professionally managed pooled property investment fund – eliminate day-to-day management but retain exposure to the asset class through a portfolio of institutional quality assets that deliver a stable income and meet the charity’s objectives both for investment returns and ESG requirements.

What is clear is that the coming years will be challenging for charities investing in real estate. ESG and EPC requirements, changing working habits and inflation are all factors impacting structural change in the real estate market. There is no single way of dealing with this challenge. It is inevitable that strategies will have to be reviewed and difficult decisions made, but taking professional advice is key to considering the optimal route and delivering the best solutions to these challenges.