Quantitative easing by the European Central Bank is likely to have global capital market implications, including real estate. We are now contemplating a period in which real estate yields/cap rates may well trend even lower in many markets in the short term.
Important changes to the macroeconomic and financial outlook have emerged over the past six months:
· The ECB’s quantitative easing programme (QE) has changed the landscape of monetary policy worldwide as other countries try to adapt to the weakening euro and the global influence of very low (in some cases, negative) interest rates in Europe.
· An accelerating US private-sector economy has delivered more than 250,000 net new jobs per month over much of the past year and brought the US unemployment rate down to 5.5 percent. This allows the US Federal Reserve Bank (Fed) at least to contemplate the first steps toward normalisation of policy interest rates at some stage in 2015.
· China’s weakening economy has provoked a government response, boosting investment and easing monetary policy. Doubts over the Chinese economic outlook remain a headwind for many countries in Asia Pacific.
Disparate policy directions
We expect divergence in economic and monetary policy to continue to be a persistent theme for the next two or three years. During 2015, the Fed is likely to embark on a process of normalisation of monetary policy as the US economy continues to exhibit strength, despite a wobble in the monthly data in March. At the same time, the ECB and many other central banks, such as the Bank of Japan and the People’s Bank of China, are moving in the opposite direction, loosening monetary policy as they seek to support their economies and weaken their currencies. One likely consequence is a period of further financial market and currency volatility.
What are the implications for real estate markets? Generally, we expect even stronger capital markets than we previously thought and strengthening market fundamentals. QE should create liquidity that boosts asset prices, including real estate. The scale of the new European measures is likely sufficient to have global consequences. Yields/cap rates, already at record lows in some markets, are likely to remain firm and may well trend even lower in the short term.
Part of the support for real estate pricing comes from the attractive spread of real estate yields/cap rates over long-term government bond yields, and other types of fixed-income investments. At the same time, strengthening economies should lead to stronger market fundamentals, which should help boost real estate values in many markets in 2015–2017. Nevertheless, there is clearly a growing risk that the lower yields/cap rates fall, the larger the potential fall in capital values would be once yields/cap rates start to rise.
Longer cycle changes views on risk
What are the implications for real estate investment opportunities? We believe that the potential for a headwind for capital values when interest rates eventually do increase has been deferred deeper into our forecast period. We believe that the length of the real estate capital cycle has probably been extended by at least a year. Careful consideration of the likely duration of the real estate cycle in each market is an important theme, particularly for higher-risk strategies. The “Risk levers to pull” chart on page 28 illustrates four broad categories of risk levers, which may be appropriate to use at different stages of the real estate cycle:
· Location (prime/secondary, gateway/next tier, CBD/suburban, established/emerging)
· Asset (lease length, re-tenanting, refurbishment, forward funding/full development)
· Portfolio (asset concentration, tenant/sector/market exposure, cash, return composition)
· Financial (loan-to-value, fixed/floating, hedge/unhedged, currency, term, recapitalisation).
We consider it prudent to think of a two- to three-year window in which to execute strategies. On this basis, generally we consider it likely more appropriate to take asset level risk than location, portfolio or financial risks.
Stronger fundamentals boost returns
What of the outlook in each region? 2014 was a strong year for listed and unlisted real estate. Strengthening economies in the United States and Europe and parts of Asia Pacific should lead to improving real estate fundamentals, which in turn should help boost values in many markets in 2015–2017. We believe that the outlook and opportunities in each region are:
United States: There is a tailwind behind the US economy, with job growth increasingly expected to fuel wage growth. We expect tenant demand to broaden by sector and geography. With the exception of certain multifamily and industrial submarkets, new supply remains generally moderate, supporting the outlook for rental growth.
We now expect US 10-year government bond rates to rise more slowly than we previously thought and to remain low for even longer. Capital flows are strong and are expected to strengthen further. Pressure on yields/cap rates is expected to continue over the next two years. Core pricing is approaching historic peaks on an absolute basis but remains attractive relative to 10-year government bond yields. Location and functionality remain critical in asset selection. One of our most important strategic emphases is to position portfolios today, while conditions are favourable, for the potentially more challenging times that may emerge at some point in the next five years.
Asia Pacific: Several major economies have joined the interest rate–cutting cycle since late 2014. As a result, sovereign bond yields are likely to stay low for even longer, maintaining relative pricing appeal for commercial properties. We expect further yield compression in 2015, particularly in Japan and Australia where the spread between real estate yields and bond yields is still above the historical average level. Vacancy rates remain low, with limited new construction in prime markets. Thus far, tenant demand appears slow to respond to the stimulus measures. Strategically, this suggests that we should focus on quick execution in liquid markets to capture the near-term capital gain, or focus on those markets expected to have stronger net operating income (NOI) growth prospects in the longer term.
Europe: Real estate yields/cap rates look attractive compared to sovereign bond rates, which are now negative for a number of durations in a number of countries. The weaker euro might attract further global capital inflows. Financing costs are favourable and debt is more readily available. We expect real estate yields/cap rates in Europe to fall materially over the next 18 months. If QE leads to greater economic confidence and activity, then real estate market fundamentals are also likely to improve sooner and faster than we previously thought. One of the greatest risks to our forecast, however, remains the ability to translate prime headline rental growth to an increase in NOI for existing properties.
By geography, we expect a wide variation of total returns in 2015–2017, with strong performance in Spain and Italy, for example. In the United Kingdom, strong rental growth in London is accompanied by growing evidence of speculative development, which may trigger a cyclical correction, perhaps in 2018–2019.
A wide variety of options
How are investors responding? Cross-border investing has become an important factor in real estate markets. Over the long term, global listed real estate and global unlisted core real estate both provide a diversified exposure to the underlying income stream from real estate. Once an investor has decided to invest non-domestically, there are a number of alternative approaches. Some may choose multiple routes. The appropriate vehicle varies from investor to investor, based on their objectives and constraints:
· Only the largest investors — for example, sovereign wealth funds or large pension funds — are likely to be in a position to assemble and manage a diversified global portfolio of directly-owned properties that offers the advantage of control but involves significant management time and cost.
· Even the smallest investor can invest in a fund of diversified global real estate securities providing indirect exposure to more than 25,000 properties with the added advantage of daily liquidity and the divisibility of holdings but involving potential daily volatility.
· Unlisted funds provide large and medium-sized investors access to specialist or generalist vehicles with different characteristics (open-end or closed-end) and styles (core, value-add or opportunistic).
Difficult timing, right time
Is this a good time to invest? Many long-term investors overcome this by adopting a steady level of new investment over time to accumulate assets. Market timing is tempting but notoriously difficult. On many absolute metrics, the price of real estate looks high compared to long-run averages or previous peaks. But on one key relative metric, real estate pricing appears to be competitive: the spread of real estate yields/cap rates over local long-term government bonds is at or well above the long-term average in many markets, particularly now in Europe. With local government bond yields expected to remain low for a considerable period in many countries, it suggests that real estate pricing is likely to continue to be attractive for many investors looking for income (with some growth prospects). Consequently, global strategies are in favour:
· Global listed real estate: At present, the total return outlook for listed real estate indices reflects a generally positive fundamental environment along with opportunities for growth that result from acquisitions, debt refinancing and select development/redevelopment opportunities. Present valuations across the regions tend to reflect the fundamental growth outlook. It is important to note that listed real estate companies typically use leverage, which can increase the volatility of returns. In our global listed real estate portfolios, we are likely to maintain a bias to companies with higher-quality assets in supply-constrained markets, emphasise operating leverage over financial leverage and focus on companies with above-average earnings growth prospects.
· Global unlisted core real estate: In 2014, the MSCI/IPD Global Property Fund Index recorded a 12.0 percent total return for open-end core funds, one of the strongest years in the index’s short seven-year history. European core open-end funds (15.5 percent) outstripped those in North America (11.7 percent) and Asia Pacific (9.2 percent) for the first time since 2010. Looking forward, strong market fundamentals and strong capital markets suggest potential for strong performance in the United States in 2015–2016. Consequently, at this stage for a global core strategy through unlisted core funds we adopt a tactical overweight to the United States and a mild underweight to Europe and Asia Pacific.
· Global unlisted higher-risk real estate strategies: We believe that interest in higher-risk strategies has increased, particularly in Europe. Our emphasis continues to be selective execution themes at the asset level, focused on a two- to three-year execution window, with the end product a functional, well-located core asset. For example, we believe that there is scope for leasing, refurbishment and repositioning value-add strategies. Development of institutional assets for sale or long-term hold may be attractive in markets with rising occupancy and rent. There may be opportunities to recapitalise or refurbish assets in quality locations through structured investments particularly in the United States, Ireland, Spain and, increasingly, China.
In competitive real estate capital markets, investors face a challenge: should they accept lower returns from core real estate than those that they have traditionally looked for, or should they migrate up the risk curve in order to try to maintain returns? There are no easy answers but we believe that a focus on execution duration helps draw attention to the appropriate risk levers to consider at different points of the cycle.