What is the best route for investors in real estate in 2019? Steady as you go or all change? The outlook for real estate fundamentals globally in 2019 remains generally positive, although the pace of improvement appears to be moderating amidst a slowing global-economic-growth backdrop. A slowing in the pace of monetary-policy normalization appears set to provide an extended window of opportunity for execution of existing strategies in the capital markets. Taken together, this suggests promising conditions for investors to keep moving forward steadily on their existing route.
Considerable macro uncertainty exists, however. Technology continues to be a disruptive force in retail and industrial real estate. Trade tensions between the United States and China threaten to break out into full-blown trade-war hostilities. In Europe, the extension of the Brexit deadline has further extended the period of uncertainty in the United Kingdom. Such risks suggest the road forward may have a few surprising bumps along the way.
With an eye to the year ahead, we consider how investors in real estate can account for today’s driving conditions, navigate these unfamiliar roads and hopefully avoid potholes.
The speedometer suggests global growth is easing off the pedal a bit as we come around the curve, though there are still plenty of laps to go. Expectations of global growth in 2019 have been revised downward relative to forecasts in second half 2018. The deceleration is only for 2019, however; the outlooks for 2020 and 2021 have little or no change, and the outlook is modestly higher for later years of the forecast period. This suggests slower growth this year actually may serve to prolong the current global business cycle. In any event, even the slower near-term forecast pace of economic growth is consistent with expansionary tenant demand for real estate.
These “slippery-when-wet” conditions have prompted the deferral of monetary policy normalization on behalf of the various central banks in an effort not to trigger a more-severe slowdown. Although the impetus for such a move was accentuated concerns about the looming possibility of a recession in the United States, prompt action seems to have averted that risk for now. It also should provide real estate investors with more time to execute asset-specific strategies.
In the unlisted core fund space, Asia Pacific funds have been the standout in recent quarters, having been the strongest regional component of the MSCI Global Property Fund Index for the past 13 consecutive quarters. Over the 11-year history of the index, Asia Pacific core funds have been the best-performing region more than 40 percent of the time, and the lowest-performing only 20 percent of the time.
Real estate delivers a hybrid total return comprising income and growth. Since 2001, on average worldwide, real estate has delivered a return of 7.4 percent, of which 80 percent came from income and 20 percent from growth. And that income has come with relatively little volatility because it ultimately derives from contractual rent paid by tenants to landlords. Looking forward, it seems likely in the near term the balance may change a little in favor of growth due to active asset management.
Over the past decade, real estate prices have risen to high levels relative to historic norms; the “lower-for-longer” interest-rate environment has been an important capital market context for this, and it seems likely to be sustained for some time yet. Investors continue to compete for yield-bearing assets. This, however, also implies the period of cap-rate compression is largely in our rear-view mirrors, as buyers may not be willing or able to make deals pencil out at much lower yields/cap rates. As a result, it is increasingly difficult to deliver returns without an asset-specific growth story. This is particularly the case in countries where yield/cap-rate spreads relative to long-term government bonds have moved nearer to minus-one standard deviation.
Around the world at the moment, real estate pricing relative to local long-term government bond yields has started to show some differences. Spreads remain within normal ranges, defined as within plus or minus one standard deviation of the long-term average spread, in all major countries. In major European countries, the spread is well-above average. In the United States, it is now below average. On this basis, pricing in Europe appears more favorable but with lower growth prospects. In the United States, pricing is less favorable but with stronger growth prospects. Asia Pacific is more balanced. Relative pricing is close to the long-term average spread in several major countries with continuing strong growth prospects, particularly Australia and Japan.
Pricing is only one source of fuel to drive total returns — rent growth is another. Differences in the rental outlook suggest road conditions vary by region; investors are likely to see total-return patterns diverge in the year ahead, as regions progress through different stages of the rental cycle.
According to Invesco Real Estate forecasts, rents are expected to rise in a larger share of market-sector combinations in North America and Asia Pacific than in Europe this year. It is noteworthy, however, that in North America the pace of rent growth is expected to be slower in 2019 than in 2018. Europe appears to be earlier in the cycle, with more varied market conditions.
It is the combination of pricing and growth that drives our current regional tactical allocation in our global unlisted core portfolios; we believe the balance in Asia Pacific warrants a mild overweight position, while the mixed growth outlook in Europe suggests a mild underweight is appropriate for now. Late cycle, we adopt a neutral position for the United States.
SELF-DRIVING AROUND POTHOLES
What bumps may lie ahead? Those that have been slowly building over time we can identify — a rise of national populist politicians and parties, and their accompanying unpredictable policy consequences; and pricing pressures on for-sale residential markets around the world, a key component of many countries’ GDPs and an important context for the multifamily sector. And there are those that yet seem much farther down the road.
One need only think back to the disruptive impact e-commerce has had, and continues to have, on traditional brick-and-mortar retailers to appreciate that “objects in mirror are closer than they appear.” The rate of innovation is exponential; real estate investors with longer-term hold horizons should consider the impact of tomorrow’s technologies today, and craft strategies around defensive and offensive positioning.
One such emerging technology is autonomous vehicles. With driverless vehicles being tested on the open road in several countries, they may become a very real influence in the not-so-distant future. The effects on real estate can be dually categorized as either value-additive or -erosive. Autonomous vehicles may erode the underlying values of parking lots and garages, as fewer people feel the need to own and park vehicles; alternatively, they may drive up the value of parking garages that can be adapted into higher and better uses. Cars that can take us to work while we have our coffee, read our emails and rest on the way home may make longer commutes palatable, shifting demand back to the suburbs and exurbs, while fewer cars on city streets could drive density further still in the urban core. The potential effects are wide and varied. Change creates opportunity.
Investors may wish to evaluate the potential impact to their portfolios from autonomous vehicles based on where autonomous-vehicle adoption may occur more imminently. The latest results from KPMG’s Autonomous Vehicles Readiness Index suggest the Netherlands, Singapore and the United States reflect the greatest combination of policy and consumer attributes, making autonomous-vehicle adoption more likely than in places such as China or Brazil.
Real estate demand is essentially driven by two main factors: growth and change. Each creates opportunity. Growth tends to drive opportunities for “more of the same.” Change tends to create opportunities for something new. A considerable amount of change is going on at the moment.
Demographic and technology trends are the source of changes that are leading to the reshaping of portfolios in three ways:
- Logistics, both state-of-the-art regional facilities and urban-infill last-mile facilities, is increasingly taking the place traditionally held by retail in many countries.
- Multifamily residential is emerging as an institutional asset class in more countries, often underpinned by for-sale housing shortages and affordability challenges.
- Specialty sectors, such as co-living, data centers, healthcare/medical office, self-storage, senior housing and student housing, are all now increasingly integral to portfolios, but the opportunities vary from country to country because of regulation and level of sector maturity.
A SUCCESSFUL JOURNEY
The ingredients for a successful journey include careful preparation, a good road map, a well-maintained vehicle, limited congestion and favorable weather conditions.
The present driving conditions suggest that with real estate fundamentals sound but moderating globally, patient investors with attention to detail may do well. Asset-level execution is likely to be the key to driving performance.
Timothy Bellman is managing director, head of global research, at Invesco Real Estate, and Sabrina Unger is global research analyst at the firm.