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Despite an improving economic outlook, global real estate is likely to offer lower returns over the next five years. But opportunities remain for discerning investors, writes Chris Urwin.
The outlook for the world economy is rosier than it has been for some time. With broad-based growth becoming entrenched – global GDP growth is expected to reach 3.5 per cent in 2017 – and inflation making a comeback, monetary policy has reached a turning point. The removal of extreme policy stimulus is now appropriate, and we expect interest rates to rise modestly over the next five years.
What does this mean for investors in prime real estate? Although stronger GDP growth bodes well for income growth, it is likely to diminish the relative attractiveness of real estate over other asset classes. We expect global property yields to rise from 2018 onwards as monetary policy stimulus eases, albeit at a slow pace.
Overall, global real estate investors should be braced for lower returns over the next five years compared with the period of robust performance the asset class has enjoyed since 2010. Returns will be front-loaded, and they are likely to deteriorate across the majority of markets between 2018 and 2021.
Figure one shows our pricing analysis over a five-year investment horizon, based on the hurdle rate – the required rate of return required to compensate for risk – in each market. It indicates the growing scarcity of good-value assets. Nevertheless, the outlook varies considerably across markets and sectors and discerning investors should be able to identify pockets of opportunity.
Figure 1. Global over-under pricing analysis by market size, five-year investment horizon
US and UK: yield expansion
The markets that led the real estate cycle – the US and the UK – are edging towards yield expansion. In the US, capitalisation rates are already edging higher. CoStar data suggests more than half of national office markets saw yield expansion in the first quarter of 2017. Yet the impact of stronger growth on capital values has been minimal thus far, with rental growth offsetting the effect on yields.
The UK has experienced some pricing volatility over the last twelve months, partly due to the ongoing uncertainty surrounding Brexit (although the real-estate cycle was already at an advanced stage before the referendum). Economic headwinds will continue to affect UK real-estate performance over the remainder of 2017 and beyond, and the short-term impact on rental growth will be most acute in the more structurally challenged parts of the retail sector.
Europe and Asia
Compared with the UK and the US, relative pricing in European markets looks attractive, and spreads to government bond yields remain well above the long-term average. But the window of opportunity to find value in European real estate is closing fast amid a clamour for prime assets; we expect little further capital growth.
Retail assets in Germany, and retail and office assets in the Netherlands, offer decent prospects of return. Spanish retail and Italian industrial assets also offer good value, but come with much higher macroeconomic risks than northern European markets.
Investment demand remains robust in Australia and Japan, where decent relative pricing is coupled with a positive rental outlook. Demand also remains strong across other Asia-Pacific markets despite weaker fundamentals, although strong rental growth is expected in some sectors – including Singapore offices and Hong Kong retail – towards the end of the decade. The performance of real-estate assets in the region over the next five years will depend to a large degree on the rate of growth of the Chinese economy and the direction of Chinese capital flows.
While short-term performance will be dragged down by rising yields, global real estate still offers good value for long-term income-seeking investors, particularly compared with the returns available on fixed-income investments in the current low interest rate environment.
Selecting the right location will be key to effective investment over the next five years as value deteriorates. Cities with strong demand dynamics are likely to benefit further from strengthening business confidence and increased private investment, and investors should consider adding exposure to income risk in these locations.
Across global sectors, logistics boasts the strongest outlook, especially in the US and northern Europe (see figure two). The continued rise of e-commerce, combined with a shortage of modern logistics stock in many markets, is underpinning global demand for these assets. For investors seeking income, the relatively high level of yield on logistics properties will appear especially attractive.
Figure 2: Total returns by sector, per annum
1. To carry out this analysis we calculated hurdle rates (required returns) for global markets for the beginning of each year from 2001 to 2017. By comparing the hurdle rate at the start of the year with the total return over the subsequent five years for each market, we developed an over/under pricing estimate for each year for all markets. For the 2017 period we used our in-house prime total return forecasts. We assumed the property premium – which consists of the volatility, liquidity and transparency premium, and in selected markets, the currency premium – remains constant through time, so the only variable that changes in our analysis of the historic hurdle rate is the adjusted risk-free rate of return. We also incorporated in-house real estate stock estimates.
2. All markets are based on data for prime assets, apart from the US.
Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at August 7, 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.