Aided by extremely loose global monetary policy, capital values have experienced a strong recovery since the crisis. We believe this period of very strong capital growth has largely run its course and the window to capture significant yield compression is passing quickly, says Sandip Bhalsod.
- Positive near-term outlook for real estate, driven by capital growth
- But we expect returns to be driven by income over the medium term
- It is key to recognise the nuanced distinctions between markets at different stages of the cycle
We believe that the strongest part of the cycle is largely behind us, however, our near-term outlook for real estate remains positive. We believe that core real estate will continue to attract investor demand in 2016 for the following reasons:
- Unprecedented monetary stimulus is supporting real estate investment, and will continue to do so. Despite property yields currently being at very low levels, spreads over long-term sovereign bond yields are still substantial in most markets due to extremely low interest rates. This is particularly true in Europe. A lot of concerns have been aired about the tightening of rates and the potential impact on commercial property. Rising bond yields will put upward pressure on property yields in the US and some Asian markets over a five-year period. But the gradual likely pace of interest rate rises, along with solid rental growth, should prevent a sharp increase in US yields in 2016.
- The occupier outlook is generally favourable. Developers have acted with more caution than in previous cycles, waiting for occupier demand to show stronger signs of expansion before committing to new projects. As the occupier recovery continues in 2016 restrained supply should drive decent rental growth. Notable exceptions to this are US apartments, central-eastern European offices, Singapore offices and resource-dependent Australian cities, where supply risks are prevalent.
Our view is that capital growth will still be a sizeable component of returns in 2016, but investors should expect returns to be primarily driven by income over the medium term. It is crucial that investors recognise the nuanced distinctions between markets at different stages of the cycle.
Some markets are starting to exhibit signs of being in the more mature phase of the cycle. Pricing signals in the US are being watched closely. Real estate investment trusts are trading at wide discounts to net asset value and property looks expensive relative to comparably-rated corporate bonds.
Late-cycle characteristics are also evident in other markets that are further along in their recovery. Central London yields look incredibly expensive and the UK is seeing a strong appetite for portfolio deals as well as ‘alternative’ real estate sectors. In the rest of Europe we feel most markets still have further to go in the cycle and the occupier recovery is also strengthening.
In Asia, we foresee a softer economic outlook for 2016 compared to historic trends. Asian property markets were among the first to see recovery post-crisis. In markets such as Singapore logistics and Hong Kong retail, occupier weakness has led to falling capital values in recent quarters. The Chinese slowdown also looms over the region and will play a significant role in the fortunes of Hong Kong and Singapore real estate markets in 2016.
Below we outline the key macro risks that we are on alert for, and the ramifications these could have for real estate markets.
Potential upside risks
Global monetary policy becomes more accommodative
Despite the US Federal reserve’s recent rate hike, the monetary environment will remain accommodative for some time yet. Our view is that central banks will hold off on any further large expansion. However, there is a possibility that central banks may be spurred into action if pressure builds from weak data points.
Draghi assured the market at the end of 2015 that the European Central Bank (ECB) is poised to act should inflation and growth continue to disappoint. If inflation remains too low it is possible we could see an acceleration of the purchase programme in the second half of 2016.
The Bank of Japan’s balance sheet expansion is already very extensive. Yet the possibility of further stimulus cannot be discounted – especially if the upcoming ‘Shunto’ wage negotiations disappoint and evidence of demand-driven inflation fails to materialise. Monetary loosening elsewhere could hold back the pace of tightening in the US.
Looser monetary policy would be supportive of real estate valuations. In such a scenario we would expect investors to be more willing buyers of real estate even at historically low yields.
Strong economic rebound in Japan/Europe
Our central scenario is that both regions will see economic recovery continue at a sluggish pace. However, if companies become sufficiently confident to increase investment, or if previously reluctant consumers reduce saving significantly, then this could lead to a self-sustaining recovery.
In this scenario, domestic demand should strengthen and inflationary pressures will come through from wage growth. This would result in stronger occupier markets. With supply restrained in most developed markets, this would translate to higher income growth as vacancy rates improve sharply and rental growth becomes robust. Secondary cities where growth momentum is strong and real rents have not yet surpassed pre-crisis levels would outperform. A strong rebound in fundamentals would also make new construction viable and create opportunities for core development strategies.
Potential downside risks
A hard landing in China
China’s slowdown will continue for many years yet. Our view is that that the state will intervene where necessary in order to deliver a controlled slowdown towards a consumption-led economy. If the transition is managed poorly, or the slowdown is sharper than expected then the ramifications will be more serious. In extremis, expect property price collapses in major cities and/or a banking crisis.
A credit crisis could lead to a rapid cooling in the housing market and possibly a strong price correction in Tier 1 cities. Contagion would likely spread to the bond market where highly-leveraged developers heighten the risk of widespread defaults. Slower land value appreciation would also harbour a risk for debt-laden local governments which rely heavily on property revenues.
Outside of China a rapid slowdown would have a significant impact on risk appetite. Real estate markets in Hong Kong and Singapore would be hit hardest. Slower growth in China is
already affecting exports throughout the region, and trading economies are likely to bear the brunt of a sharper downturn.
Logistics assets in these markets will have markedly lower prospects, as a slower global trade impacts tenant demand.
Office sector demand would also be vulnerable as expansion by mainland financial institutions would likely decelerate,
especially in the event of a banking crisis. The Hong Kong retail sector, which is already facing both cyclical and structural headwinds, would become more vulnerable to capital losses and declining rents. This could present a window for opportunistic core investment for distressed assets.
Geopolitical risk in Europe
The migrant crisis is likely to persist and tension among EU members will intensify regarding appropriate action. In the long term, it is likely that the demographic boost to the continent will help ameliorate headwinds caused by an ageing population. There is upside potential for some property classes, such as the German private residential sector. However, the immediate impact could be a rise in political fragmentation across the region. Greater uncertainty could decrease foreign investor confidence and deter long-term occupier commitment.
Britain’s referendum over EU membership is also on the horizon. The likelihood of ’Brexit’ currently appears fairly low but it is a possibility. In the immediate aftermath of a ‘yes’ vote there are a number of macroeconomic risks that could emerge. These could have negative impacts on the investment performance of UK real estate in the short term, the direct being a period of illiquidity.
Over the medium-to-long term there is less cause for concern. Regardless of the outcome, the UK is likely to retain close ties to the EU. Central London offices appear to be the only occupier sector exposed to major risk from a UK exit, in particular the City, which could be impacted by weakening financial services.
A long-held fear is that the liquidity created by extremely loose monetary policy could gain traction and generate strong inflationary pressures. This could arise if bank lending increases rapidly and money aggregates rise sharply.
Bond yields would rise steeply and central banks would likely resort to aggressive interest rate tightening in order to rein in inflation. In this scenario investors would become highly risk averse. An increase in bond yields would weaken the relative pricing argument for investing in real estate. Real estate markets where current pricing offers the smallest buffer over government bond yields would be most vulnerable to capital losses.
Given that underlying fundamentals are weak across all economies, an unexpected increase in bond yields would be extremely damaging to the global recovery. Occupier markets would weaken significantly as businesses face higher borrowing costs. Income risk would likely become elevated as the probability of tenant default increases. In such a scenario, assets with strong tenant covenants will offer better income security and are likely to outperform.