Insurers make sharp downward adjustments to return expectations

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The annual "Trendbarometer Real Estate Investments for the Insurance Industry" by consultants EY Real Estate was published recently, the study that asks insurance companies about their real estate investment plans. One clear takeaway was a likely reversal in the trend whereby insurers and pension funds have been continually increasing the proportion of real estate in their portfolios in an unbroken pattern now going back 14 years.

Further key conclusions of the study are: Europe and Germany are becoming less attractive as investment locations, with the USA and Asia gaining in popularity; Yield expectations have dropped significantly; Logistics remains in focus, while residential is sliding; sustainable transformation is seen as more of a priority over portfolio streamlining; There remains a lack of available data to really develop robust ESG strategies.

For 2022 however, the ratio of real estate in insurers' and pension funds' portfolios continued to rise to 12.1%, and is now at 13%, largely due to deals already in the pipeline. But currently only 14% of those surveyed (32 separate companies) said they plan to increase their real estate ratio, down from over 50% last year. 68% said they would hold it at current levels, while 26% plan to lower it. EY suggests that current holdings could prove to be the high watermark, before a noticeable trend reversal.

According to EY partner Jan Ohligs, who authored the report, "Insurance companies have a very long-term investment horizon with regard to real estate, and their equity strength is supporting the currently fragile market. Although they anticipate declining overall returns, they continue to refrain from disinvesting on a large scale and are still buying selectively in some cases. No less than before, the cash flow yield, i.e. current income from rental income, is still very much in the foreground for insurers. The situation is only likely to become problematic if the yield spread over risk-free investments does not increase again, even in the long term."

Those problems might indeed lie ahead, with Europe in general and Germany in particular having not yet sufficiently digested the impact of the interest rate shock. Write-downs and new price visibility are still way behind other continents. So far insurers haven't really been deterred from buying, not fully pricing in the risk premium compared to fixed-interest investments such as bonds, which is surely too low.

Ohligs indicated that the required yield spread for residential is at least 2% to 2.5%, for commercial it is more like 3.5% to 4%, and for healthcare, hotels, retail and logistics it is even higher. In the short term, this gap may not exist, but the insurance companies are still taking long-term expectations into account and assume that in one to two years, interest rates will fall again noticeably.

Although 65% of respondents feel that lending practices are becoming more restrictive, this rarely poses a major challenge for insurance companies, which have a strong equity base as part of their business model, as 60% indicated. However, return expectations have dropped significantly: for direct investments from 4.5% in the previous year to 3.8% now, and for indirect investments from 5.5% to 4.2%. Direct holdings remain the preferred form of investment for 57% of respondents. In the indirect segment, closed-end funds have now overtaken open-ended real estate funds at 72% percent (2022: 52%) to 24% percent (2022: 53%). Alternative real estate investments such as debt funds (40%) or private equity companies (31%) also remain popular. Project developments, on the other hand, are declining significantly: from 45% last year to just 14% now.

Shift in regional focus of insurers

The already pronounced shift in regional investment focus is becoming even clearer. North America, already the preferred location last year, is rated most highly by 59% of respondents (up from 55% last year). Europe is losing attractiveness, now favoured by 39% compared to more than 50% last year. Even Asia and Oceania are currently more popular, at 41%. Even if Germany remains the most popular investment location within Europe for local insurers, the country's attractiveness is also in relative decline: in 2022, 90% of insurers had still set their focus here - today it is 77%.

"The dominant perspective among insurers is that the German and European markets do not yet offer sufficient adequate purchase opportunities. This is due, among other things, to the long valuation cycles, which make it difficult to adjust the market more quickly and thus to find prices, said Christoph Haub, Director at EY Real Estate and also a co-author of the study. "In the U.S., for example, the markets are already further along, which, however, also gives us hope that adjustments will soon be made here in Germany to ease the transaction rigidity."

Haub was talking at an online presentation of the study's findings, and he made no bones about the implications about the absence of such an important group of buyers and investors from the marketplace, along with the sharply lowered return expectations. "In view of the billions in portolios, this is a landslide. We're talking about millions of euros less being distributed. Insurers actually need these for their guaranteed distributions to their customers," he said.

But he did also stress that insurers and pension funds DO still currently make up among the ONLY buyers in the market, even acknowledging that the market may see even lower prices ahead. "Long-termism is outweighing the desire to get in at the absolute bottom. Insurers are the ones still buying - while everyone else is just strategising how to strike next year when the bottom is expected in prices," he said.

As sellers, insurers are generally only selling on an isolated basis to generate liquidity, where banks are applying pressure to inject further equity. Mostly these are in indirectly-held portfolios, where yield advantages could be gained via leverage, but where those yields were being "eaten up by interest rates". For insurers' direct investments, there is generally little leverage as the insurers have access to their own funds in the form of customers' premiums.

Shift in type of property favoured

The long-term investment horizon of the insurers is also leading to a shift in the type of property favoured. Residential is losing out - whereas last year residential was being targeted by 95% of respondents, that's now fallen to 68%. Logistics remains the most popular asset class, with 77% of respondents looking favourably at the sector. Investments in infrastructure (64%) and renewable energies (70% percent) are also favoured.

Retail real estate is gaining somewhat in the insurers' favour, with more than one in three (34%) now looking to invest again (2022: 20%), while hotel real estate plays only a minor role today, as it did a year ago (2023: 18%, 2022: 26%).

As for offices, Haub made clear where the shift was occurring. "Insurers want to avoid investing in properties that will only do well for 20 years." In other words, investing in a large property which has to find two good tenants each taking a ten-year contract, is no longer an attractive scenario. Instead, they prefer to focus on mixed-use neighbourhoods with daycare centres, schools, housing, local amenities, hotels of all kinds, small businesses - and only then investing in offices.