Open-ended real estate funds' returns and ratings remain under pressure, says Scope

Scope has updated its ratings on 15 open-ended real estate funds. Six funds were downgraded, mainly due to lower returns while nine funds were able to keep their rating stable. Further economic development is the most relevant risk factor.

While most asset classes experienced a hard slump last year followed by a strong recovery, open-ended real estate funds were stable across the board. The average volatility of the funds was below 1 per cent.

Investors rewarded this stability last year, with high net inflows of EUR7.8 billion (compared to EUR10.4 billion in 2019). This led to comparatively high liquidity, averaging 17.2 per cent of fund assets (2019: 20.2 per cent) and significant real estate purchases totalling EUR8.3 billion (2019: around EUR8 billion).

Nevertheless, the funds were not fully immune to the effects of the pandemic. While a large number of funds were downgraded last year due to pandemic-related risks, a key driver of current downgrades is a deterioration of return profiles.

The 15 funds averaged returns of 3.2 per cent in 2019, which fell to 2.1 per cent in 2020 (the spectrum ranged from 1.0 per cent to +5.1 per cent). For 2021 as a whole, Scope analysts expect an average return of around 1.5 per cent.

“The change in the funds' return profile shows that the risks that already led to rating downgrades last year are now materialising,” says Sonja Knorr, Head of Alternative Investments at Scope Analysis. “Especially those funds with large holdings of hotel properties and shopping centres suffered revenue losses and value corrections.” The average rating of the 15 funds is “a-AIF” – which still suggests a good risk-adjusted return for investors. The current rating spectrum ranges from a+AIF to bbAIF.

Looking forward, the medium- and long-term impact of the pandemic on economic development and real estate markets will remain the most relevant risk driver. The strength and sustainability of the economic recovery in the second half of the year, particularly in Europe and North America, will have a significant impact on the funds' letting activities (especially for project developments), potential loss of rental income, and property valuations.

The funds’ average occupancy rate already fell noticeably last year, by around 1.7 percentage points to 94.3 per cent. This ended the upward trend in occupancy rates, which had been sustained since 2011. In response to Scope’s annual survey, 44 per cent of asset managers said they expect occupancy rates to fall or stagnate in 2021, while only 12 per cent expect them to rise.

The trend toward working at home established by the pandemic could also have a lasting negative impact on the profitability of office properties. However, Scope does not currently expect vacancy rates in the Class A office segment (which accounts for a large proportion of the portfolios) to rise permanently. This expectation is supported by the segment’s relative price stability. Properties in less attractive locations are most at risk of suffering rising vacancy rates.

EU taxonomy and disclosure regulation determine funds’ ESG orientation
The requirements of the EU taxonomy and disclosure regulations are increasingly shaping the strategic orientation of fund managers aiming to future-proof real estate portfolios. Most open-ended real estate funds aim to be classified as “Article 8 funds” and thus as sustainable funds. So far, seven funds for private investors have already attained this classification.

CO2 emissions are one of the most important indicators of the sustainability of open-ended real estate funds. However, asset managers were only able to provide Scope with data on CO2 emissions for 72 per cent of their properties. Although this is a significant improvement on the previous year (54 per cent), it shows that a lack of available data is one of the key challenges for funds’ ESG alignment and strategy.

Background: Scope’s ratings on open-ended real estate funds reflect their risk/return ratio. Scope assesses all relevant risk drivers and performs a detailed, granular analysis of the real estate portfolios in particular: click here to see the full methodology. The 15 funds whose ratings were published on 9 June 2021 currently manage a combined total of around EUR 102 billion. The funds' portfolios consist of office (54.5 per cent), retail (23.2 per cent), hotel (8.3 per cent), logistics (5.6 per cent), residential (3.5 per cent) and other properties (4.9 per cent). However, the mix of types of use and industries varies considerably from fund to fund.

All assessments, analyses, rankings and ratings are provided in the comprehensive market study (over 700 pages), available on ScopeExplorer from EUR 900. Professional investors can receive a free short version of the study (over 100 pages) after registering on ScopeExplorer.