Challenging times ahead for global real estate

Global Real estate August 2017

2 minute read

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 – the IMF expects global GDP growth to reach 3.5% 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.

Diminishing returns

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. We expect returns to be front-loaded, and they are likely to deteriorate across the majority of markets between 2018 and 2021.

Figure 1 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, capitalization rates are already edging higher. CoStar data suggests more than half of national office markets saw yield expansion in Q1 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 12 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 we believe the window of opportunity to find value in European real estate is closing fast amid a clamor 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 – toward the end of the decade. The performance of real estate assets in the region over the next five years is likely to depend to a large degree on the rate of growth of the Chinese economy and the direction of Chinese capital flows.

Strategies

While short-term performance may 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 should 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 2). 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 should appear especially attractive.

Figure 2: Total returns by sector, per annum

Notes

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.

Important Information

Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as of August 10, 2017. Opinions, estimates, forecasts, and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but has not been independently verified by Aviva Investors and is not guaranteed to be accurate. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations. Past performance is no guarantee of future results.

The name “Aviva Investors” as used in this presentation refers to the global organization of affiliated asset management businesses operating under the Aviva Investors name. Each Aviva Investors’ affiliate is a subsidiary of Aviva plc, a publicly- traded multi-national financial services company headquartered in the United Kingdom.

For Use in Canada

Aviva Investors Canada, Inc (“AIC”) is located in Toronto and is based within the North American region of the global organization of affiliated asset management businesses operating under the Aviva Investors name. AIC is registered with the Ontario Securities Commission (“OSC”) as a Portfolio Manager, an Exempt Market Dealer, and a Commodity Trading Manager.

For Use in the United States

Aviva Investors Americas LLC is a federally registered investment advisor with the U.S. Securities and Exchange Commission. Aviva Investors Americas is also a commodity trading advisor (“CTA”) and commodity pool operator (“CPO”) registered with the Commodity Futures Trading Commission (“CFTC”), and is a member of the National Futures Association (“NFA”). In performing its services, AIA utilizes the services of investment professionals of affiliated investment advisory firms who are best positioned to provide the expertise required to manage a particular strategy or product. In keeping with applicable regulatory guidance, each such affiliate entered into a Memorandum of Understanding (“MOU”) with AIA pursuant to which such affiliate is considered a “Participating Affiliate” of AIA as that term is used in relief granted by the staff of the Securities and Exchange Commission allowing US registered investment advisers to use portfolio management and trading resources of advisory affiliates subject to the supervision of a registered adviser. Investment professionals from AIA’s Participating Affiliates render portfolio management, research or trading services to clients of AIA. Investment professionals from the Participating Affiliate also render substantially similar portfolio management research or trading services to clients of advisory affiliates which may result in performance better or worse than presented herein. This means that the employees of the Participating Affiliate who are involved in the management of strategies and other products offered to US investors are supervised by AIA.

AIA’s Form ADV Part 2A, which provides background information about the firm and its business practices, is available upon written request to:

Compliance Department

225 West Wacker Drive, Suite 2250

Chicago, IL 60606

2017-0515_AIA/AIC_AUG2017