From Bricks to Bytes: The New Frontiers in Real Estate Investment

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Intro - Welcome to “Fixing Your Interest.” In this episode, we’re joined by Lalantika Medema, Alternative Credit Strategist at PIMCO, and Kirill Zavodov, Portfolio Manager and Head of European Real Estate Equity at PIMCO. Together, they discuss the transformation of real estate markets—from operational intensity and sector evolution to the rise of data centers, and the convergence of infrastructure and real estate. They share insights on investor trends, financing models, and how institutional portfolios are adapting to a new geography of investment across Europe and beyond.    

LALANTIKA MEDEMA: Hi, my name is Lalantika Medema and I am in the PIMCO studio today, joined by Kirill Zavodov, head of our European Real Estate Equity Team. Kirill, let's get right into it. You've been in real estate markets for the last 14 years. You now lead the team on the European real estate equity side. What are the big themes that you've seen in terms of markets changing?

KIRILL ZAVODOV: Well, certainly a lot has changed over the last couple of decades. And I guess if I were to pick just a couple of key themes, number one, real estate has become a lot more operationally intensive. So whereas in the past you had 20, 25 yearlong leases. Now the leases are getting shorter, and actually, as a landlord, you need to do a lot more work in order to unlock the value from the assets.

The second big theme was the emergence or institutionalization, of certain sub-sectors within real estate. And, for example, over the last 15 years, one of the big themes has been industrial / logistics. It went from the sector that very few institutional investors wanted to invest to becoming one of the main food groups that is, essential part of all of the core allocations.

At the same time, you had completely new sectors emerging, and becoming, really significant in the context of real estate portfolios like data centers, life sciences and other parts of the alternative sub segments.

And maybe the third theme that I would highlight is a greater convergence between, infrastructure and real estate over the last couple of decades. Why? Because there has been increasingly greater focus amongst investors on income and not just any income, but the higher quality income that both sectors are looking to capture.

LALANTIKA MEDEMA: Perfect. It's really interesting too, Kirill, because alongside those changes, the dynamic I've seen is that a lot of investors, post COVID, were much more cautious on real estate, definitely waiting to see what unfolded, how their portfolios performed, and where that uncertainty and volatility ultimately went.

Whereas today, with valuations resetting with a much more attractive entry point, that income focus that you highlighted, we're starting to really see real estate becoming top of mind and an area of focus for them within their portfolios.

KIRILL ZAVODOV: Yep. Definitely that is absolutely the case. People are increasingly more focused, not just on how much upside I can get from this investment, capital gain; they're more focused on how much of my return is actually coming from income, and how certain am I that I will get that income over the course of the next five to 10 years.

LALANTIKA MEDEMA: That's absolutely right. So I want to go back though to those big changes that you had mentioned and spend a bit more time unpacking each of those. You talked about operational intensity and how some sectors you've really seen the shift into much more operational intensity that's required on the part of the managers.

Tell us a little bit more about where you're seeing that. And also, compare and contrast what you've seen in the US versus Europe

KIRILL ZAVODOV: Yeah, certainly. So in terms of increase in operational intensity, you have essentially two strands here. Number one, have more traditional sectors like office, retail, industrial becoming increasingly more operationally intense. Why? Because the lease terms are reducing. Why they're reducing, number one, tenants are requiring greater flexibility, and they really want to make sure that landlord is working for the rent that they're paying.

Therefore, they're looking for, in offices for greater amenity, greater quality, of maintenance, greater engagement with the landlords throughout the lease term, as opposed to just handing them over the keys and disappearing.

Similarly, in retail, landlords have to work together with the tenants in order to optimize the footfall or drive the footfall to their stores.

So all of that is happening with traditional real estate. On the other hand, you have greater allocations towards alternatives, like multifamily sector, where your leases are by default very short. You're dealing with the consumers whose personal circumstances change and they move to another property.

You deal with hospitality, again, people stay there only overnight. So active asset management and operational intensity become very, very important. And if you don't have that skill set in house, you just cannot unlock superior returns in real estate. Which has been a fundamental change versus let's say a couple of decades ago.

LALANTIKA MEDEMA: So one thing that, I've heard you talk about in the past is the triple net lease opportunity in Europe, relative to the US where it's a much more established market there, but you're starting to see more activity.

Does this align with that same theme of operational intensity and how tenants are working with landlords and with partners in terms of establishing the best situation for their own footprint and their own opportunity set?

KIRILL ZAVODOV: Yeah. So in that one, I think Europe versus US and net leases is a great opportunity. It is actually quite interesting in real estate because if you are in Europe, you typically look at what's happened in the US and probably three to five years from now, it'll be happening in Europe. So you can almost, front run that opportunity to the extent. Net leases is not an exception, historically, a lot of corporates used to own their real estate, and then at some point they realized that's not very efficient. It's better to have professional landlords owning that real estate and them using capital for more value additive activities, which is the core of their business. But the other element that's important in terms of how the net lease model has evolved is that there is a greater focus on build to suit facilities.

So it's not just any building that you can put on a long term lease and get an investment grade credit in the return. No, you actually need to work with tenant proactively on the specification that they need, on the location that they need in order to create the property in which they will stay for a long time.

So whilst once you sign the lease, it becomes very close to a bond or indexing bond, there is actually a lot of work that needs to be done with the tenant ahead of time in order to get there.

Data centers is one great example of that. A lot of the technology companies, they need digital infrastructure in the form of data centers, and they need facilities that have built to their specification that have built to suit in order to unlock their AI or cloud ambitions . There’s been a lot of that in the US and we expect to see a lot more of that in Europe.

LALANTIKA MEDEMA: Perfect. That actually ties really well into the next area that you had highlighted, which is new sectors or the institutionalization of certain sectors in the past today. Talk about that maybe starting with the AI segment, and then we can go to some other areas that you also think fit in that, fold.

KIRILL ZAVODOV: Definitely. So if you look at AI theme it's part of a broader digitalization theme, right? Which includes increasing connectivity, that includes increasing cloud service presentation and more recently AI.

Now, in order to unlock the AI opportunity set, you need digital infrastructure. So, which are basically data centers, because that's where the training of the model happens, and that's where inference of the customer requests happening in order to produce the insights that we get from the apps that we all know very well.

In the past data centers play was a relatively small market because it focused more on a connectivity in us interacting with internet rather than doing compute heavy applications.

That all started to change with cloud, and now it's a big steps change, with AI, because you need much larger facilities, you need many more of them. You need a lot of them being built locally, because without that the corporates will not get the right level of service. Governments will not get comfortable with the digital sovereignty of the applications.

And because of that great capital need, the model of data centers has changed. It used to be very short term agreements where somebody used to have racks and a lot of different retail tenants. Now it's large tech companies that are taking that capacity.

Many of them are not just investment grade, but a AAA or AA credits, and they need infrastructure built to suit to their needs for AI, for cloud, for inference. And here, because the model has changed, it has attracted a lot more institutional capital.

That's why we've seen greater reallocation of portfolios towards, towards that theme, which often is associated with institutionalization of the sector.

LALANTIKA MEDEMA: That's definitely true. I mean, I think about the conversations we've had in the past year, I think more and more of our clients across the board have been focusing on data centers, and particularly on the opportunity in Europe, maybe for some of the reasons you highlighted the idea of the fragmentation of the different markets, the need for localization of data centers on the ground, three to five years behind that Europe is in terms of that data center development relative to the U.S.

So I think a lot of the themes that you've alluded to are ones that have really played out in terms of investor interest and allocation. Now, one thing I do want to have you talk about a bit more is, you know, how do you think about that opportunity set in AI and in digital infra, it's not just on the real estate side, it's not just in private markets, but how do you think about it across the capital stack, across public and private markets?

KIRILL ZAVODOV: Yeah. That's a great question because if you take just data centers, not every data center is the same. There are different types of data centers that may serve low latency requirements, high latency requirements, and may be geared towards connectivity, or cloud, or towards the training of the large language models.

And, because that opportunity set is so varied and the type of tenants that you would have on the backend is so varied, you really need to have a broader perspective when evaluating them. Because in some cases, if let's say it's a data center in infill location of a key gateway city that can be used for cloud, it can be used for a training, can be used for inference, and therefore has a lot of alternative use, and you can get a high quality tenant as part of the pre-let before you can construct, you will want to take the equity risk.

And, on the other hand, if it's a facility where there is very limited alternative use, and therefore if something were to go wrong at the end of the lease, you don't really know what you're going to be doing with that asset. Maybe it's a lot better to take the risk on the debt side because that debt is underpinned by the contractual cash flows from the underlying tenant, which you can only do if you have both sides of the capital structure to play with both equity and the debt side.

LALANTIKA MEDEMA: Okay. Makes sense. So the last thing which I wanted to touch on in terms of those areas you unpacked was that convergence between real estate and infrastructure. I think that's actually a really big theme that we're seeing play out, particularly in Europe, where things like data centers, for example, I think are a great representation of how an asset can fall in that gray space between those two areas.

What are the other segments or the other asset classes that you see? And you had also highlighted the focus from investors on the quality of income, the consistency of it. I think that's something else that's really underpinned by investments in this particular area. So how should investors think about that opportunity set?

KIRILL ZAVODOV: Yeah, generally, the infrastructure and the real estate when it comes to the high quality income, they are underpinned by probably three big themes. One, we talked about digitalization, so that's digital infra, data services is a huge part of it. The second one is demographic change.

And here social infra is becoming increasingly big theme, and includes a lot of specialized real estate like student housing, affordable housing, senior housing, hospitals, education facilities, etc. In all of these cases, you either have very sticky demographic that will stay in the assets long term.

And you can move that income in line with inflation. And the third area that is a big secular theme is deglobalization. And, it impacts a couple of areas. Number one is defense spending. That has a lot of characteristics close to infrastructure. As part of increased defense spending, but you also need to create infrastructure to support it.

And that includes things like military housing, it includes warehousing to support surge capacity in the event of conflict. And all of that area is at the intersection of both real estate and infrastructure investments.

LALANTIKA MEDEMA: Excellent. It's definitely, I think on the European defense side at least, that given the headlines and, the commitments that we've seen different countries make to the segment, it's an area that we are hearing more and more interest in.

Maybe the last question, Kirill is, you know, we started this discussion, with view on the past, you know, how have things changed in the past 15 years. As you look to the next five years, what are the, big changes that you might see in the real estate market or in real estate allocations

KIRILL ZAVODOV: Yeah. Well definitely, I think the biggest shift as you see new sectors emerging and some sectors that are very capital intensive, like data centers, the big shift is going to be a change of portfolio composition of large institutional investors. Because on one hand, a lot of them are probably more exposed to office, and other traditional real estate sectors than they would like.

And historically it was very difficult to move away from office because it used to be the most capital intensive part of the real estate segment. And logistics, for example is not right. So you cannot build enough logistics assets replace city center offices. But now with data centers, you suddenly find an asset class that shifts that allocation away from office more towards digital.

We expect to see great allocation away from traditional sectors and more towards alternative sectors within real estate. And those alternative sectors are those assets that are at the intersection of infrastructure. So that includes social infra like student housing, senior housing, affordable housing, etc. As well as, areas like net leases that provide high quality income and better liquidity in the event of market downturns.

LALANTIKA MEDEMA: Excellent. As I think about where investor conversations are going, a lot of the focus is also how do we diversify our real estate exposure.

And I think that's where these alternative sectors that you've highlighted can really serve a role, not just because of the increasing opportunity set, but also the diversifying characteristics relative to where investors have historically been allocated.

Kirill, thank you so much for your time. Really enjoyed the discussion. I certainly learned a lot about, where real estate markets have shifted and where they are today and how you're thinking about the future. So thank you for your time.

KIRILL ZAVODOV: Thank you.

VOICE-OVER: From servers to sustainability, data centres are fast becoming the backbone of the AI economy—and a new frontier for investors. As Europe and the UK adapt to a more fragmented world, infrastructure is no longer just physical—it's strategic. Thanks for listening to Fixing Your Interest. Subscribe for more episodes that connect the dots between macro forces and market opportunities.