Alarm bells are ringing
Consider the humble pumpkin. Unseasonably warm temperatures reduced their size in the UK by 30 per cent in 2018. Similarly, prime real estate yields withered to record lows in Europe this year in a financial climate still warmed by the effects of quantitative easing and near-zero interest rates.
Our central view is that this benign environment of modest capital growth and low but stable yields should continue for another year or two. There’s been little evidence of the excessive borrowing and speculative building you’d expect to see at this late stage in the real estate investment cycle and economic forecasts haven’t been too bad despite risks from the world of politics.
However, it would be prudent to seek protection from some growing risks in 2019:
- Firstly, prime real estate yields have little room to move lower, especially as the spread to low-risk bonds starts to tighten over the course of the year as central banks taper asset purchases. If prime yields do move, it is more likely to be up than down, which is negative for valuations. At a yield of 2.5 per cent, a small 25-basis-point rise equates to a 10 per cent fall in asset value. Prime sounds safe, but the market is looking very exposed.
- Secondly, $70 billion of dry powder is waiting on the sidelines of the European real estate market. This is cash that has already been raised from investors but not yet invested, marking a record high. In 2007, the previous peak of the cycle, the number was just $40 billion. This indicates the market may be approaching a new top.
- Finally, publicly listed markets have been pricing in large falls in rents for listed retailers for some time. The private markets are starting to catch up, with some segments of retail property now out of favour and experiencing falls in value in the second half of 2018. This trend will only intensify in 2019.
These factors could destabilise different real estate sectors next year, and we are watching closely for any signs of cooling in hot markets.
Source: JLL, September 2018
Source: CBRE, September 2018
Stable returns in an unstable world
A direct consequence of central bank tightening will be increased volatility in equity and fixed income markets as investors take stock of changing financial conditions. Instability is likely to be stoked further by political risks, coming from sources such as Brexit, European state budgets and the US-China trade war.
Real estate assets offer diversified protection, and, against that unsettled backdrop, a stable yield. As real estate capital growth will be limited in 2019, picking out assets that offer the most solid sustainable returns is paramount. At the same time, limiting foreign exchange exposures within property portfolios will help protect against political risk, which often causes sudden dislocations in currency markets.
The ‘right kind of exposure,’ or picking tenants with good prospects, will matter as never before. For example, in the retail sector, one has to be wary of threats from online shopping. Shops selling products that cannot be easily bought online, such as furniture or heavy DIY products, are less at risk to continued growth in internet retailing than traditional fashion or department stores.
Sustainable rental income depends on sustainable corporate cash flows. In the office sector, the growth of co-working firms has been a phenomenon in the past two years, with WeWork becoming the largest occupier of offices in London in 2018. However, the business model has not yet been tested in a downturn and such assets may not be the best source of sustainable income in a property portfolio.
Finally, and perhaps most importantly, environmental, social and governance factors will become ever more central to investment decisions in 2019. Buildings contribute around 40 per cent of global carbon emissions and companies are placing an increasingly high monetary value on properties offering reduced energy use. Such assets are attractive to companies that want to help staff meet their own ESG goals.
So, while carefully chosen property assets will stand out in 2019 as sources of stable yield in an uncertain world, risks are rising in some of the hotter prime markets where downside potential exceeds the upside.
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