Global real estate returns likely to moderate in 2017
Deploying capital effectively will make the difference to real estate investment performance this year in a crowded market.
Global real estate performed relatively strongly in 2016 in an environment of low returns. We estimate that prime real estate delivered returns of eight per cent (on a total return basis) globally in 2016. The European market, excluding the United Kingdom, saw the most robust performance of around 12 per cent (total return) as global capital continued to target core opportunities in the region.
Late-cycle indicators confirm we are at an advanced stage in the capital market cycle. For example, pricing is stretched, with many markets more expensive than their pre-Global Financial Crisis (GFC) peak. Secondly, in 2016 we saw a spate of M&A deals focused on the real estate sector, with Chinese capital a driving force. There are also increasing examples of investors paying a premium for larger assets and portfolios as a way to invest capital quickly, a characteristic of the later stages of the cycle.
Demand is expected to be robust in 2017 as institutional investors remain committed to the asset class. Surveys suggest that institutions remain under invested in real estate relative to their target allocations. There is plenty of dry powder, but with pricing stretched and the market place crowded, deploying capital efficiently will become more difficult.
Performance in 2016 was not as stellar as in recent years and we expect returns in 2017 to moderate further. The strongest phase of the investment cycle is now over, with yields unlikely to compress much further. Instead, investors should be positioning their portfolios to focus on strong income dynamics. Income stability should take priority and lease expiries should be managed in markets where property dynamics are less favourable.
Occupier markets generally look healthy but are lagging the investment cycle. While underwhelming, economic growth remains reasonable. Expectations of increased fiscal support in 2017 are promising from an occupier perspective as it should encourage business investment. Developers remain cautious and consequently we have not seen a strong supply response in much of the developed world. Where pockets of supply do exist, the outlook is less positive as much of this will take time to be absorbed, especially in structurally-challenged markets such as Perth and Houston.
The year ahead is likely to be just as eventful as 2016, if not more so. Below we outline six key macro themes for 2017, the risks surrounding them, and the implications for real estate.
1) Shift from austerity to fiscal stimulus
A fiscal boost is arguably least needed but most likely in the US as the new Trump administration embarks on tax cuts and higher public spending. While the exact size, shape, or timing of this stimulus is unknown, it should provide a strong tailwind for domestic growth in 2017. If fiscal policy is perceived to be working in the US, pressures may grow for it to be pursued more actively elsewhere.
Indeed, if sluggish growth continues in Japan the government is likely to roll out its own renewed fiscal package. Fiscal support in the euro-zone is constrained by Germany’s reluctance, yet austerity measures have already been relaxed in several countries, where a blind eye has been turned to “excessive deficits” in Portugal and Spain. The UK is expected to modestly reduce its pace of fiscal tightening post-Brexit as the new chancellor looks to make room for greater public expenditure.
A shift away from fiscal austerity bodes well for occupier sentiment in the above markets. Greater business confidence leads to greater expansion. With supply still limited in most developed markets, this should equate to higher net property income as vacancy rates improve and rental growth gains momentum.
2) Reflation to triumph over deflation
Deflationary fears have faded in recent months. Inflation data has looked more promising and GDP growth has continued at a reasonable pace. One exception to this rule is Japan, where deflation is still a real threat. We expect headline inflation will continue to drift higher in 2017, aided by the increase in aggregate demand from fiscal spending.
It is important to remember ‘reflation’ has a growth aspect as well as an inflationary one. Signs of wage inflation are emerging in the US, where the recovery is most advanced. A resilient labour market, along with real wage growth, should lead to robust consumer spending in the world’s largest economy. Elsewhere, rising producer price inflation (PPI) in China is interpreted as a positive for corporates, as PPI tends to have a positive correlation with profits. Improvements in the real economy should reinforce business confidence and support occupier demand.
With the best part of the real estate cycle now over and inflation on the rise, real estate is likely to deliver lower real returns than we have seen in recent years. That being said, real estate is still considered a reasonable hedge against inflation, especially in markets where inflation-linked leases are the norm.
A key risk stemming from greater inflation expectations is the potential for a sharp re-pricing of credit markets. Sovereign bond yields have been moving higher since mid-2016, particularly at the long end of the curve. This re-pricing accelerated post the US presidential election as the market latched onto the inflationary story associated with a Trump presidency. Risks from here are biased towards US bond yields moving higher still, further steepening the yield curve in the short-term. As demonstrated in the global bond market sell off last year, the impact is not confined to the US. Markets closely linked to the US dollar such as Singapore and Hong Kong could be most affected.
This would significantly affect the attractiveness of real estate from an income-seeking perspective. A cross asset investor will be more likely to consider increasing allocations to fixed income if the spreads achievable on real estate are diminished. Inflation break-evens will need to be watched closely.
3) Monetary policy – limits being reached
Ample monetary accommodation has engineered an environment of extremely low interest rates since the GFC. The ensuing search for yield has increased appetite for real estate given its strong income-producing credentials. This has pushed property yields to historic lows, generating strong capital growth in the process.
We expect the monetary environment to remain accommodative over the next year. Our base case is for major central banks to maintain their current policy stances, with the Federal Reserve expected to tighten at a gradual pace of three hikes in 2017.
With unconventional monetary policy slowly reaching its limits, scope for further yield compression is now minimal and the period of strong capital growth is over. The movement of yields is now biased to the downside as we feel pricing has bottomed out in many markets.
That being said, the relative pricing argument remains compelling for now in most markets. Even in the wake of the Brexit vote, UK real estate still looks attractive compared to other asset classes. The same can be said for commercial real estate in Europe. US cap rates are initially expected to remain stable before coming under pressure by the end of the year.
The Bank of Japan is expected to keep pursuing its current regime, targeting the 10-year sovereign bond yield at zero per cent. Real estate is likely to appear less attractive than in a world of negative rates; however, the spread available on property still looks appealing to a domestic investor. In markets closely linked to the US dollar, investors are expected to demand higher real estate yields when faced with increased borrowing costs.
4) China growth prioritisation
China has thus far managed its decline in economic growth through a range of credit and fiscal policy measures. We expect China to continue to prioritise growth over structural reform for the time being, at least until after the 13th National People’s Congress in 2017/18.
Looking at the domestic market, we expect a slowdown in residential prices heading into 2017. Rental growth in China’s Tier 1 commercial real estate markets is likely to be subdued over the near term due to increased competition from decentralised submarkets and high levels of supply under construction. These headwinds are to be expected as Chinese cities continue to evolve. Overall, we have a positive view on the benefits of China’s transition to a service economy and believe this will be supportive of commercial real estate markets in the long-term.
There is a risk the Chinese authorities become either unable or unwilling to support growth further. While in the near term we see this as a tail risk, we believe medium-term risks have risen given the recent increase in private sector debt. A sharper slowdown in growth would have important ramifications for neighbouring economies given China’s regional economic influence. Prospects for Singapore and Hong Kong’s industrial property markets would degrade further under such a scenario. Prime retail pitches that have recently been supported by visitor spending could be adversely impacted if a deceleration in growth is accompanied by a reduction in Chinese tourism.
5) Continued regulatory headwinds
The GFC has led to a more stringent regulatory environment for the financial services industry. The subsequent retrenchment of the banking sector has led to a reduced level of take up from financial service firms compared to history. Office markets like Singapore that are dependent on the financial sector have weathered this change particularly poorly. It is difficult to foresee a change in direction from the authorities; Basel III banking regulations are being phased in over several years, with full implementation in 2019.
Ultimately, while the headcount for risk-taking activities by banks has shrunk, middle office departments in compliance and risk management have expanded in order to meet new business needs. Even this trend could be facing long-term headwinds, however. Technology looks set to disrupt the way firms meet their regulatory obligations. A growing ‘RegTech’ industry offers automated solutions to the most basic and labour intensive compliance tasks, further reducing the need for desk space.
Attention in the banking industry is focused on whether Donald Trump follows through on his campaign promise to “dismantle” the Dodd-Frank legislation. Since the election, bank stocks have rallied in anticipation Trump’s administration will foster a more hospitable regulatory environment. A meaningful change in legislation could see the financial sector expanding again rapidly. Global office markets such as London, New York, Switzerland and Singapore would benefit from a boost in occupier demand.
6) Geopolitics: national over collective interests
2016 will be remembered as a year where populism dominated the headlines, and 2017 could well be remembered for the same reasons. This year brings plenty of political hurdles. We expect the recent trend of voters supporting domestic priorities over international interests to continue.
The election of Donald Trump has escalated the risks of greater trade protectionism. This comes at a time when open economies are already hurting from chronic growth in global trade. The Asia Pacific region looks especially vulnerable to any deterioration in trade relationships, with the economies of China, Hong Kong, Singapore and South Korea heavily reliant on global supply chains. As any action from the US is likely to be met with reprisal from China, the eventual winners and losers are difficult to predict. Nonetheless, any semblance of a trade war would have adverse impacts for global demand fundamentals in the industrial sector, while currency volatility would make hedging expensive for international investors.
The South China Sea dispute is another source of concern. Increased militarisation in the region, coupled with the new US administration’s hawkish stance, makes for a potential flashpoint. Additionally, rising civil unrest in Hong Kong and South Korea poses a threat to consumer sentiment.
Meanwhile, there are downside risks facing European property markets due to the rise in populist politics across the continent. Key elections in France, the Netherlands and Germany could see a move towards a more nationalist agenda. Given recent experiences, the possibility of Le Pen coming to office in France or Merkel losing power in Germany cannot be completely discounted. Disharmony in the euro-zone could adversely affect foreign investor sentiment and deter businesses from making long-term investments. A surprise result in one of the founding nations of the EU would likely rock financial markets, leading to a risk-off environment.
Lastly, the UK is on course to trigger Article 50 of the Lisbon Treaty in March. Brexit-related uncertainty weighs on the outlook for the UK’s property sector, notably in the Central London office market. Our view remains that UK real estate prospects are weaker post-referendum, despite the relatively limited impact observed to date. As a result, we expect return prospects to remain moderate in the near-term with some further capital decline likely. There is downside risk if negotiations with the EU turn sour. In this scenario, occupiers are likely to be deterred from making long-term commitments to the UK and London’s status as a global financial centre would be challenged.
Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 31 January 2017. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.