"Good real estate is not always a good investment"

Published on: 9 October 2023

Many headlines these days talk of a crisis in commercial real estate. Offices especially are hard hit. The narrative is often straightforward: people working from home leave offices empty, rising interest rates increase return requirements and make refinancing more expensive, and property valuations decline as a result. We asked Rutger van der Lubbe, APG's Head of Global Real Estate Investment Strategy, how APG is affected by developments in commercial real estate and how it responds to these.


In summary:

  • APG has long held the view that office real estate in general is not a very attractive asset category.
  • The Covid pandemic has accelerated the polarization that was already going on in commercial real estate markets; even more than before properties must now have a pull factor.
  • Current market conditions in commercial real estate offer various opportunities for investors who can put extra capital to work.


Does the crisis in commercial real estate keep you up at night?

"No, it doesn't really. Most stories about the crisis we're in are much too general. True, office real estate is troubled in many places, but these problems don't automatically extend to other subcategories. The dynamics on the ground are also much more diverse and nuanced and they vary from location to location. Where before it was standard to commute to work five days a week, working patterns now vary across regions, industries and companies, and depend on office facilities and accessibility, commuting times, housing situations, and so on. The work from home trend in general means that to be attractive to employees and investors alike, office real estate must now more than before have a pull factor. So the main story in my view is about the polarization of the office market, where some locations are becoming more attractive and others less so. That trend was already going on and has only been accelerated by the pandemic."


How does that affect APG's investment policies and decisions?

"To begin with, APG's exposure to office real estate has historically been very limited. And our investment policy hasn't changed in the aftermath of the pandemic. It continues to be essentially about understanding the quality of individual objects in detail. That's not rocket science. First and foremost, it's about location and whether a pull factor exists there, but it's broader than that. Our investment strategy is strongly rooted in a number of well-known megatrends, like demographic shifts, technological advancements, climate change and the rise of the experience economy. A good example is retail real estate. In retail the polarization that is now going on in offices has mostly taken place already. When new technology made e-commerce possible you could have foreseen that undifferentiated retail would suffer. On the other hand, in the experience economy the shopping public does like to spend time at locations that offer an exceptional assortment as well leisure and good food & beverage opportunities. So, with these megatrends in mind, we were able to identify early on that we had to reduce our exposure to retail real estate in general. On the other hand, we also concluded that objects that do have a unique proposition, like The Mall of the Netherlands and the Batavia Stad Fashion Outlet to name two Dutch examples, were attractive investment opportunities for us."


That still leaves the question of why APG's exposure to office real estate has been limited.

"One reason is that historical data shows that the growth of rental income in offices generally doesn't keep up with inflation. That's because at even the most attractive office locations there are in fact few supply constraints. Wherever you look, along the Amsterdam Zuidas or in Midtown Manhattan with a development like the Hudson Yards, new office space can be constructed. This creates a dynamic that leaves building owners with limited bargaining power. It's a hard sell to increase the rent when someone else is building a new office tower next door. Secondly, office space ages quite fast in an economic sense. It has to fulfill new and more stringent requirements all the time, be it for sustainability, ergonomics or other reasons. That means capital expenditures required to keep office space up to date have historically been severely underestimated. If you take all this into account properly, office real estate valuations in general have historically not been very attractive from our perspective. We don't exclude it a priori, but we tend to see it as a tactical rather than a structural play. We've been acting on that view for at least ten years, and that view has only been reinforced by recent developments."


You say real estate investing isn't rocket science, but you do reach different views than other institutional investors. How come?

"What distinguishes us may be our entrepreneurial, data-driven and open-minded approach to real estate investing. It is this approach that made us early investors in so-called alternative real estate segments, like student housing or outlet stores. These niche markets present higher operational risks than more traditional segments, but we thought these risks were overpriced by the market. Rental contracts for student housing for example are typically only for a year, which indeed makes it a somewhat more operational risky asset than common housing. On the other hand, there is a huge and almost universal shortage of good quality student housing. The potential returns weighed against the additional risk as we saw them, made this an attractive niche market to us. So, the ability to develop a view on what makes users or visitors want to spend time in a certain piece of real estate, instead of merely viewing it as an investment object, is something you need to have as an investor."


You also mentioned the ability to determine in detail the quality of a property as essential for real estate investors. Do you have an edge there?

"We manage a portfolio of around 55 billion euros with a team of around 55 people. So obviously we need an intermediate structure in place that allows our team to focus on the key aspects of the investment decision process. That said, for practically all our private investments we play a very active governance role in the entities that manage the day-to-day operations. Also, our local teams have a thorough understanding of the markets they cover, and before every acquisition we typically do site visits to inspect the situation on the ground. But a good real estate object is not necessarily also a good investment object. What you want is a more objective view that substantiates our personal opinion on the quality of a certain property. This helps us to better determine how we should prize specific risks and thus the returns that we require. That is why we've put a lot of effort in the development of an AI tool that we recently launched. We've unlocked a great number of data points on all input factors we consider relevant. Like ChatGPT, the tool has an interface that lets us ask questions, for example what climate related risks are for a specific object. So instead of us searching through all kinds of dashboards, the tool can tell us directly what the risk of pluvial flooding, wildfires or sea level rises are for a certain property. From the signals I get I understand that this use of advanced technology really distinguishes us and places us ahead of most other real estate investors."


Does a time of crisis also offer opportunities?

"We certainly think that current market conditions in commercial real estate create very favorable opportunities for investors that are able to put extra capital to work. The combination of rising interest rates and banks that are reducing their traditional role as lenders makes real estate financing less available and more expensive. We're starting to see that some investors who aren't capitalized well enough will be unable to refinance their positions. Particularly in the U.S. this will become an issue because in the U.S. the debt component in real estate financing is generally larger than elsewhere. It comes down to the saying that one man's ruin is another man's treasure. So for APG the current situation also creates opportunities."


Last year APG invested almost €600 million in Australian commercial real estate debt. Is that an example of the opportunities you're trying to seize?

"Yes, but that investment is also a play on a more structural shift we observe. We've concluded that in certain cases elements across the capital structure of real estate are mispriced. In other words: equity could be expensive while debt is attractive. Although our mandate is primarily to have equity exposure, in such situations it's more attractive to be lender to real estate than an owner of real estate. That's why we've committed additional capital to our debt strategy. The transaction in Australia last year is a result of that. We also pursued this strategy in the U.S., specifically to benefit from the dislocations I just described. And while real estate loans will remain a small part of our portfolio, we are becoming more and more convinced that this is a structural rather than only a cyclical opportunity for our clients."


Coming back to the importance of pull factors you mentioned earlier: are there investment opportunities in creating new pull factors for existing real estate?

"Absolutely! I'm convinced there is an incredible opportunity, throughout the entire real estate sector, to make existing properties more sustainable and at the same time more attractive. Our APG office in Amsterdam is a prime example of that. But this will further enhance the polarization I also talked about. Simply put, making a square meter of existing office real estate sustainable costs just as much on the Amsterdam Zuidas as in for example Zoetermeer. Rental income from that square meter in Amsterdam however is a number of times higher than in Zoetermeer. This means that in many secondary locations, such transformations cannot be made in an economically viable way. That brings up a number of questions: Can a higher-valued and better use be found for office space in such locations, for example by converting it into residential units? Where will the required investments to make our built environment 'Paris Proof' come from? The answers are by no means clear yet, but that APG as a responsible investor with a long-term focus has a logical role to play in this is absolutely clear to me."