Borsen Zeitung (Germany) - Global Real Estate: Diversification to underpin attractive long term real returns
During the course of the last five years, global real estate markets have demonstrated the importance of diversification. Immediately after the collapse of Bear Sterns and Lehman Brothers, very few economies escaped economic contraction. Of the major global economies, only China, India, Poland and Australia managed to avoid a technical recession in 2009, while steep and painful contractions were felt in most countries. However, it is becoming increasingly clear just how differently the real estate markets have behaved in the wake of the economic turmoil. The gulf in real estate performance is a stark reminder of why it is important to take a broad view.
From a macroeconomic perspective, the range in GDP growth between the top 50 economies in the world was a modest 14% in 2007, between the best and worst performing economies. However, this margin nearly doubled to 27% in 2009, which reflects the significant difference in the rate of recovery experienced across the world. Since then, the gulf in performance has remained elevated. Southern European economies remain dogged by recession, while the US, Canada, Asia and South America have witnessed a faster recovery. Given the importance of economic performance as a driver for real estate returns, this broad range in economic conditions has had a profound impact on relative performance.
Having now accrued five years of data since the downturn, it is possible to take a look at how global real estate markets behave during a correction. According to IPD, between 2007 and 2012, All Property capital values fell by 11.4% across Europe. However, the average headline level does not paint a full picture. For example, in Ireland, values fell by 67% over the five year period and Spanish values fell by 29%. Contrastingly, during the same period, capital values in Canada increased by 11% in total, while Swiss values have gone up by 9%. This broad range underpins the importance of diversification. Indeed, when you examine the correlations between market performance in the build-up to the peak of the market in 2007, the global market was becoming more synchronised, fuelled by an insatiable appetite for real estate and the abundance of low cost debt. However, since the global downturn began, the synchronicity has broken down, with some markets proving far more resilient than others.
The broad range in performance has largely been driven by market liquidity, particularly in a European context. Investors have been seeking prime income-producing assets in core markets. Such has been the weight of capital chasing these assets, that values have been protected from falls in the London and Paris office markets, despite subdued levels of leasing activity. In the first half of 2013, 75% of European investment activity was focused in just four markets – the UK, Germany, France and Sweden. This is a trend that has held firm since the onset of the crisis, while it is only now that investment activity is starting to return to the southern European markets as well.
While the underlying fundamentals have been weak in most global real estate markets, the attraction of the asset class has been its relative pricing against competing income-driven asset classes, such as government and corporate bonds. This trend continues to play out with the margin between prime office real estate yields and 10 year government bonds at around 200 to 350 basis points in the second quarter of 2013, depending on the market. This margin has narrowed slightly after the US Federal Reserve announced it would look into tapering quantitative easing, while forward guidance from central bankers globally, has pushed forward interest rates up. Five year Euro swaps leapt up from 87 basis points to 125 basis points in reaction to the change in interest rate outlook. The general consensus is that this forward interest rate movement was too hasty and since then, the short end of the interest rate and bond yield curves have stabilised. With the economic recovery still fragile in some European countries, interest rates are expected to experience a much more gradual rise than was anticipated.
Nevertheless, even a gradual rise in interest rates will have an impact on real estate pricing. Concerns over pricing bubbles across Asia are of particular concern, with yields as low as 2.5% in some markets. London, Paris, the key German markets and the provincial Canadian cities are also arguably over-priced, particularly in the context of higher interest rates and higher government bonds.
Given that interest rates are at record lows across much of the developed world markets, the only way is up. So how does real estate perform in a rising interest rate environment? Historically, for the mature markets, a rise in interest rates has led to a rise in prime real estate yields, and there is nothing to suggest that this time will be any different. Prime Paris CBD office yields are touching 4% according to brokers in the market, which could look expensive if bond yields hit 3% and interest rates begin to creep upwards. However, what we must remember is this scenario is only likely to occur if we see a material improvement in the economy. We know from even the most basic models, that this will be beneficial to the underlying occupier markets and therefore to the net operating income landlords can expect.
At the present time we are still facing strong deflationary pressures in many markets, with unemployment across much of Europe at record high levels and spare capacity in Europe’s factories proving persistent. However, a rise in interest rates would also suggest a jump in inflation expectations too. In this scenario, the indexation of rents present in lease terms in most European markets will act as a cushion against the erosion of rental value by inflation. It will also reflect stronger occupier market conditions which should push rental growth beyond inflationary levels too. Real rents at this current point of the cycle are as much as 50% below their previous peak, so affordability issues are few and far between in most mature markets.
Taking this approach forward, the principles of diversification still hold firm. We are now in a very different phase to that seen in the bull run prior to the market crash. Both equity and debt have been highly selective in recent years and this has left the markets in a state of polarisation: polarised, not just in a sense of location, but also in terms of asset quality, covenant strength, debt availability and, crucially, the underlying occupier market conditions.
This is expected to drive the evolution of three distinct cycles. Firstly, prime markets in North America, Asia and the key European markets of Munich, Paris and London, will continue to attract capital and experience stronger net operating income, which will lead to solid real returns in the near term. When these markets begin to look expensive against other income producing asset classes in a higher interest rate environment, the second cycle is forecast to kick in. This comprises a recovery in southern European markets. The third cycle is playing out in the emerging markets. Asia, especially China, faces challenges now and in the future, but stronger long term economic growth should drive strong returns through the cycle at the market level. In nominal terms, ungeared global real estate total returns are forecast to average high single digits annually over the next three and five year periods.
With real returns from real estate looking so attractive at this point in the current cycle, it is unsurprising that appetite for the asset class is so strong globally. However, the current interest in real estate is not just driven by the attractive relative pricing, but by the broader appeal of the long term income and growth prospects for the asset class. Real estate is becoming increasingly transparent and investors are beginning to understand the role of real estate in a mixed asset portfolio. Indirect and listed real estate strategies are also developing on a broader scale, as we enter an increasingly global phase for the asset class, further driving its appeal in a multi asset context.
Craig Wright – Real Estate Investment Analyst, Standard Life Investments
First published in Borson Zeitung on 10 October 2013