Income to drive real estate returns as yield cycle nears end

The prospect of robust global economic growth in the coming years should prove positive for occupier demand, but could present fresh challenges to real estate investors as interest rates rise around the globe.

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Income is the key driver of long-term total returns in real estate, as markets are highly cyclical and inefficient. For a start, investor flows in and out of the sector exert a critical influence over short-term movements in capital values. Various factors, including the vagaries of the economic cycle and the relative value of yields in real estate and competing assets such as fixed income, influence these flows. Over the next five years, the supportive global economic backdrop should support rental income but will also cause interest rates to rise, heightening the appeal of other asset classes. Consequently, yields in the property sector are likely to rise gradually.

Strong global growth

We have revised our global growth forecast for this year upwards to four per cent. In 2019, we anticipate a slight moderation in global growth to 3.7 per cent as the major economies slow modestly towards their long-run sustainable rates. However, with growth expected to remain well above trend in all major economies in 2018, labour markets should continue to tighten as spare capacity is eroded. That is expected to put upward pressure on wage growth and inflation. We have revised up our expectation for inflation in advanced economies to two per cent in 2018. 

Given the growth and inflation outlook, we expect most central banks around the world to be biased towards tightening monetary policy. The Federal Reserve (the Fed) is furthest along the path, having raised rates to 1.5-1.75 per cent in March. We now expect a total of four rate hikes from the Fed in 2018 and another four in 2019, taking the policy rate to over three per cent.

That is a more rapid pace of rate increases than we had expected at the end of last year and reflects the combination of stronger-than-expected underlying growth momentum, the material boost from tax cuts and increased fiscal spending, and the increased likelihood inflation will overshoot the two per cent target in 2019. In the euro-zone, we expect asset purchases to end in late 2018 (with a first rate hike in 2019), while in Japan, the Bank of Japan could review its policy of yield curve control if core inflation continues its recent steady rise to above one per cent. The outlook for the Bank of England remains dependent on developments in the Brexit negotiations, but the current balance of risks suggests at least one rate hike this year.

Positive background for income growth but yields set to rise

Rising economic activity will fuel occupier demand for prime commercial space in major markets around the world as the number of new start-ups increases and existing businesses seek to grow further. This should result in healthy increases in rental income in the coming years across most sectors.

However, the tightening of monetary policy is likely to prove less positive for capital values in real estate. Yields on commercial property should increase as the income from risk-free assets, such as treasuries, become more appealing to investors. Indeed, the bottom of the current yield cycle is likely to be reached over the next 12-18 months as funds flow out of property towards other asset classes. That said, yields should remain below historic averages.

Figure 1: The end of the yield cycle is nigh
Figure 1: The end of the yield cycle is nigh

The US and UK will lead the wave of pricing corrections, mainly because they have led the advance in the global property cycle in recent years. The fact that interest rates will rise fastest in the US will also exert downward pressure on capital values across the Atlantic, while Brexit will add a further degree of uncertainty to the UK’s economic outlook. Price declines should prove particularly marked in areas where the rise in rental incomes is weakest.

The industrials/logistics sector has the strongest outlook in terms of total returns, followed by retail and office space. Global growth is boosting industrial production around the world, while, logistics is benefiting from fierce online demand for retail goods: modern warehousing close to cities that can accommodate new technologies should continue to enjoy robust demand. The US and Benelux markets are expected to do particularly well.

Asset management initiatives, such as refurbishing or adding floor space to properties, will provide another means to boost income growth and capital values. Careful selection at the individual property level will prove critical, requiring expertise in specific locations, such as emerging neighbourhoods in key global cities. These are areas that are benefiting from gentrification or becoming technology hubs.

There are also opportunities for capital growth in certain areas, including European retail which has been buoyed by increased consumer spending and the growth in Asian tourism.

It is also possible to pinpoint global cities primed for growth. Singapore office space and Hong Kong retail are both poised for a cyclical recovery in rents, where they have been re-based. Hong Kong has suffered significantly from a decline in visitors from mainland China. Reasons behind the decrease include Beijing’s crackdown on luxury spending and Europe’s increasing allure as a destination for Chinese tourists. Singapore, meanwhile, has a highly-compressed property cycle and the island republic is poised for recovery, with rents still significantly lower than in 2007.  

Figure 2: Total returns to decline as yields gradually rise
Figure 2: Total returns to decline as yields gradually rise

Total returns fall, pricing at pre-crisis levels

Overpricing in global real estate markets is moving to levels last seen prior to the global financial crisis, with capital pricing likely to come under pressure over the next five years. Investors will continue to enjoy positive total returns over our forecast period of 2018-22, but they are likely to prove lower than in the recent past and be increasingly reliant on gains in rental income, rather than the robust capital growth seen in recent years.

Figure 3: Global under over pricing analysis by market size, 5 year investment horizon
Figure 3: Global under over pricing analysis by market size, 5 year investment horizon

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