Every time the global economy is on the verge of returning to a normal interest rate environment it is buffeted by an unforeseen shock. The latest chain of events in the EU will keep interest rates lower for longer and leave real estate investors grappling with innovative ways to build successful portfolios.
01 PRICING & PORTFOLIO REBALANCING
Commercial real estate has benefited from major capital inflows in an environment of low interest rates and loose monetary policy across many major global economies. Any interest rate increases in advanced economies (other than the U.S.) are on the back burner, following the U.K. referendum vote to leave the EU. It appears we have moved from the “lower for longer” environment into the “even lower for even longer” environment, with ten year bond yields negative in Japan, Germany, Switzerland, and under 1% in the U.K., France and Hong Kong.
Intermittent volatility in equity markets has bolstered real estate’s favoured status, as investors search for assets that deliver yield with some degree of certainty over the long- term. Consequently, real estate yields have fallen leaving pricing at historically high levels, but with sensible risk premia still in place (see graph below). Despite real estate in many large global markets being perceived as late cycle, there are a number of factors which make it unlikely that we will see yields rising dramatically.
Going forward, a muted supply pipeline and low vacancy rates in many cities is likely to keep property yields low. There has been far less reliance on debt finance in the current cycle when compared with the previous one. With the major pricing correction of 2007-2009 still in the minds of many investors these contradictory pricing signals are leading owners and managers to consider the balance of their portfolios, while maintaining a solid asset allocation to real estate in the region of 7%-10%. This portfolio rebalancing exercise should keep liquidity in the market in the short-term, as investors trade higher risk assets for lower risk, long income assets including healthcare and food stores.
Global investment strategies can also benefit from volatile currency markets, provided transactions are well timed. For example, the recent fall in the value of sterling following the EU referendum will be a factor influencing the timing of investment decisions into the U.K., particularly from capital sources outside Europe.
02 REAL ESTATE TO REAL ASSETS
Property has always vied with many other asset classes in competition for capital, but over the last ten years definitions have shifted. Property has grown in scale from a small number of core sectors to cover a wide range of asset types under the real estate banner. Now real estate is often viewed by investors as an asset type that sits within real assets alongside infrastructure, which incorporates toll roads and bridges, airports, railway lines, power stations, telecom networks, and a myriad of other physical assets.
Infrastructure benefits from many of the same characteristics that make property attractive to investors. It is scalable, and provides a steady income, which is perfect for asset-liability matching. It is local but portfolios can be diversified globally, and it exists in a physical sense. Due to the low yield investment environment, allocations to infrastructure are rising.
A BlackRock survey of EMEA institutional clients in early 2016 showed infrastructure was the asset class investors were most likely to increase exposure to, followed by property. In July 2016, Brookfield raised $14bn for the largest infrastructure fund ever, proving there is huge appetite for the asset class.
The cross-fertilisation benefits between infrastructure and property are very real, with infrastructure in many ways acting as the lines that join up the real estate dots, and neither can excel without the other. This can create a virtuous circle of investment and return as the built environment benefits. Global infrastructure investment should be a driver of real estate investment going forward.
03 BUILDINGS WITH BEDS
The days of building balanced portfolios around the tripartite of retail, office and industrial assets are over. Residential investment is moving into the mainstream in countries where it has not been in the past, through growth of the private rented sector. Additionally, understanding a multitude of temporary and permanent accommodation options is becoming a necessity for large investors, as both demographics and globalisation support the demand for hotels, student housing, senior living and healthcare.
Demographics favour investment in housing for those at the beginning and end of their adult life. University draws many people to new cities, increasingly in new countries, for the first time in their lives and the trend of increased enrolment into tertiary education doesn’t seem to be abating. A lack of appropriate product in many cities has drawn interest from developers and investors in recent years, creating a new institutional property asset class that is large enough to feature in balanced and specialist portfolios alike. This phenomenon is particularly obvious in Europe, where housing stock is older and typically built for single family use rather than modern apartment blocks which are a better fit for student purpose, but is also seen on the other side of the globe in Australia and many cities in between.
At the other end of the demographic spectrum, senior living and care home assets are experiencing similar supply and demand dynamics, as large ageing populations in the largest economies in Europe, North America and Asia-Pacific have the financial means to demand better accommodation and care as they grow older. UN world population projections predict a 12% increase in the number of people over 75 between 2015 and 2020, and another 18% growth by 2025.
Real estate needs to meet the demands of the growing number of people traveling for business and pleasure with a range of hotel product to suit all budgets (from new hostels in Europe to six star resorts in the Middle East) and duration (from basic single night business hotels to longer stay apart-hotels). IATA forecasts suggest global passenger numbers will increase by around 5% p.a. for the next five years, and the hotel sector in gateway cities should continue to benefit from this increase in travellers.