In a market where fundraising remains challenging, Principal Asset Management recently closed on a new $3.6 billion megafund dedicated to developing hyperscale data centers across the United States. The Principal Data Center Growth & Income Fund is the company’s third data center-focused investment vehicle and exemplifies the growing investor appetite for alternatives to the typical real estate portfolio of office, retail, industrial, and apartments. The search for new growth and potential out-performance is shifting real estate allocations toward niche sectors such as cold storage, medical office, single-family rentals (SFR), and senior housing.
“Within private equity real estate, investors are increasingly pursuing alternative or niche sectors with strong occupancy and core-like characteristics,” says Arthur Jones, senior director of real estate research at Principal Asset Management. Data centers, in particular, have moved to the top of the list for many investors due to explosive demand from AI that is resulting in exceptionally low vacancy, now hovering just above one percent in the North American market.
The focus on niche-oriented sectors is unequivocally one of the top themes within the real estate investment universe, and it’s a theme that appears to have staying power, notes Michael Byrne, chief investment officer and head of private equity and debt for North America at AEW Capital Management, a global investment management firm with about $100 billion AUM globally. “The reason for that, at a really basic level,” he adds, “is that the business of charging rent to users of space is shifting to a more purpose-oriented business.”
For example, users of industrial warehouse space don’t want just an empty box. They may require certain temperature and humidity controls for bulk commodities like food and pharmaceuticals. That has fueled investment in sub-sectors such as cold storage and life sciences. As space has become more purpose-oriented to the consumer, it’s also showing up in the level of service and expertise needed from all the people that touch real estate—the developers, operators, and property managers. “That’s where these niches have come from,” Byrne says, “and the niches that are aligned more clearly with powerful sector themes, such as the aging demographic in the U.S., are the ones that have done the best.”
Emerging megatrends drive shifts in strategy
Investors are increasing allocations to align more with emerging megatrends, such as demographics and the aging population, technology and digitization, decarbonization, and the impact of deglobalization on manufacturing and supply chains. Such megatrends are underscoring where and how real estate gets used.
“We’re thinking about real estate from the perspective of how we’re using the built environment,” says Maggie Coleman, chief investment officer for real estate equity in North America and global co-head of portfolio management at Manulife Investment Management. “Then, from a bottom-up perspective, you have this ability to diversify across those asset classes that are being supported by these trends and how we use the environment.”
For example, investors are no longer just checking the box on an allocation of their portfolio to apartments. Rather, they’re looking closely at how people are choosing to live through the various demographic changes, and how those trends impact the supply-demand dynamic for a particular type of living space.
AEW’s Byrne agrees. “The market has shifted away from pursuing just thematic ideas,” he says, “meaning bet on the industrial sector and be allocated there and capture growth. Instead, it’s shifting in favor of a more bottom-up approach to underlying assets.”
Evolving allocation strategies
Investors are showing an increased appetite for alternative property types, with a narrow focus on niche sectors. For example, Harrison Street closed on its Harrison Street Real Estate Partners IX fund last fall, raising more than $2.5 billion in capital commitments. The fund will target a variety of product types, including student housing, senior housing, and data centers.
The public REIT universe has been helping lead the charge into alternatives, with roughly 60 percent of market cap now represented outside of the main four property types. A recent move that could further accelerate the flow of private capital into alternatives is the reconfiguration of a key benchmark for core private real estate performance—the NCREIF Fund Index Open End Diversified Core Equity (NFI-ODCE).
NCREIF announced last year that member funds in the index can now allocate up to 25 percent of their portfolios—up from 20 percent—to non-traditional property types, such as self-storage, hotels, and data centers. In addition, the four main categories have been expanded to allow for the inclusion of six different subcategories, such as medical office that could be allocated to either office or industrial depending on certain specifications. The apartment category also has been redefined as “residential” with investments that also now include SFR, manufactured housing, and student housing.
Lack of confidence in legacy sectors?
The member funds in NFI-ODCE now have significantly more leeway to invest in alternative property types. “I think the door was opened to alternatives last year with the NCREIF change,” says Ben Maslan, a managing director at RCLCO Fund Advisors, “and I think that door will widen as greater allocation is deployed over time.”
The adjustments from NCREIF were a response to changes within allocations and investment strategies that were well underway. Retail and office, which had traditionally represented the two largest sectors in the benchmark, have shrunk considerably. For example, office that once represented about 40 percent of the ODCE benchmark is now 16.4 percent, while industrial has grown from 15 percent to 34 percent over the last several years.
Several factors are pushing the shift in allocations within fund and investor strategies. According to Maslan, one reason is a lack of confidence in the legacy sectors. If investors are losing confidence in office and certain segments of retail, they need to look at alternatives to build a diversified portfolio. “What you’re seeing is that there is a greater willingness to invest in these alternative property types because of the changes to NCREIF standards,” Maslan says, “but also because of a conviction among investors that these property types don’t have the demand headwinds that two of the major four property types within ODCE have today.”
Capital targets growth sectors
Certainly, data centers are a hot sector attracting a lot of capital, and AI has only fueled more interest in digital infrastructure. Data centers remain a top focus for Principal Asset Management, both in the U.S. and globally. The sector’s assets are stabilized, with rental growth exceeding 20 percent annually in most markets, according to Jones. “While AI will play a key role in shaping the sector,” he says, “its largest impact may be in accelerating advancements in industries such as health sciences and autonomous vehicles. Simply put, data will continue to create demand for more data.”
AEW has a high conviction on seniors housing. “The fundamentals and the demand drivers that we see in that sector are incredibly powerful,” Byrne says. Investors have been talking about the looming “silver tsunami” for decades, and now that wave is on the doorstep. The oldest baby boomers are turning 80 this year, which is setting up 20-plus years of strong demand ahead for the cohort born between 1946 and 1964.
Additionally, under-capitalized operators within the seniors housing space have been hit by a number of challenges in recent years, including COVID, higher operating costs, labor shortages, oversupply in certain markets, and higher interest rates, which are contributing to some attractive buying opportunities. Although property fundamentals are moderating across many property sectors, seniors housing is continuing to generate positive rent growth, and according to Byrne, NOI growth is two or three times that of other sectors in some locations.
The housing shortage is driving demand across the broad spectrum of sub-sectors from manufactured housing and SFR to market-rate and affordable apartments, student housing, and seniors housing. “This idea that there is a chronic under-supply throughout the residential ecosystem,” Coleman says, “is driving capital to not only traditional apartments, but institutional capital also is looking for ways to diversify.”
These sub-sectors have nuances, and because of those nuances, they were not historically attractive to institutional capital. However, institutional investors are becoming more comfortable with these niche sectors as they build longer track records and generate more data to support the investments.
“It’s a really fascinating time to be an investor,” Coleman says. “There’s the story of enhanced yields that I think is quite palpable, but it’s also just a really interesting time to see how capital has been flowing into these sectors and how innovation has been driving a lot of change within real estate. So, I think this phase of the cycle is going to be really exciting.”
Plenty of options to deploy capital
For investors, the issue is not only choosing which alternative sectors to invest in, but how to do so and with whom. Investors are finding plenty of options for entry points, including investing directly or indirectly through various sector-specific funds. However, some sectors require not just capital but acumen, vertical integration, and a depth of operating experience. The operating expertise needed is driving some investors to invest alongside a general partner or engage in joint ventures with operators.
For example, Manulife IM engaged in a strategic partnership with Foundry Commercial last year to acquire, develop, and lease industrial outdoor storage (IOS) sites in key infill markets throughout the Southeast. “We like this sector with certain parameters around site selection,” Coleman says. “So we elected to enter with a specialist operator who has the vertically integrated leasing and management team to manage the sites that we felt would optimize our ability to deliver performance within that sector.”
Capital flowing to alternatives will continue to be a dominant theme as investors continue to adjust their portfolio allocations and search for higher risk-adjusted returns. For example, based on the NFI-ODCE benchmark, allocations to industrial are at 34 percent, which is likely close to peak, Maslan notes, because there is less conviction that industrial will continue to outperform as much as it has in the last several years.
“What that means is that there’s greater interest in investing elsewhere,” he says. “So, you will see more dedicated funds for these specialty property types that will pop up as the capital demands that they do.”
