- May 1, 2019: Vol. 13, Number 5

Fighting on all fronts: With real estate sectors increasingly sitting at varying stages of the cycle, plotting out coherent defensive strategies has become harder than ever

by James Wallace

The real estate investment environment has changed markedly over the last decade. It has transitioned from crisis, to recovery and growth, to an era of disruption in which historical real estate demand drivers have been upended. All of this has taken place against a backdrop of eventual tightened monetary policy and lower global growth, which is expected to stretch into the years ahead.

European real estate transaction volumes are forecast to climb 2.5 percent in 2019 to approximately €300 billion, according to data from Cushman & Wakefield, driven by increased demand across a growing range of tier 2 cities and new sectors. Upon the release of the data, David Hutchings, Cushman & Wakefield’s head of investment strategy, EMEA Capital Markets, declared that “the day of reckoning on interest rates for corporates and investors has again been delayed”. Instead, he said, 2019 will see a further extension of the property cycle, offering investors another chance to get their portfolios into shape before an inevitable period of slower growth.

Other, weaker, confidence indicators are still pointing toward expansion, but at a slower pace. “The lateness of the economic cycle is evident in trendlines for a variety of forward-looking indicators across Europe and the world more broadly,” says Tony Smedley, Heitman’s head of European private equity. This is not to say, however, that there is a consensus as to what stage of the real estate cycle European markets now find themselves in. It is too simplified a question for such a complex issue. The answer ranges by sector, jurisdiction and differing interpretations of the fundamentals, headwinds and tailwinds.

“There are numerous different cycles,” says Mark Callender, head of real estate research at Schroders. “Whereas retail capital values are in decline, we believe that the upswing in office and industrial capital values has further to go in many cities — provided the euro zone economy continues to grow.”

Mike Brown, CEO of Prestbury Investments, the investment manager of the £2.3 billion (€2.7 billion) Secure Income REIT in the UK, offers a more detailed picture of market variance. “In the UK, institutions are continuing to try to reduce weightings in retail due to structural challenges — such as company voluntary agreements, rising voids, falling rental values and rising yields — which have led to poor returns [and] are forecast to continue.

“Prime London retail is more resilient but suffers the same valuation issue as central London offices with rental levels at cyclical highs and yields at cyclical lows. Overseas, investors still see London as better value than many other global cities, but UK domestic investors see better value elsewhere. The cash is being recycled into warehouses, the key beneficiary of the structural shift that is undermining retail property, and alternatives — both of which still offer the prospect of income growth.”

The benefits of alternatives

Many alternative sectors now offer a trio of benefits: the prospect for higher returns relative to other sectors, downside protection against an economic slowdown, and the routinely-championed idea of portfolio diversification.

“There is a strong consensus around the risks and rewards and where to be positioned,” Brown says, citing assets let on long leases to good tenants in defensive businesses as well as investment in non-cyclical subsectors, such as healthcare and student accommodation. “The challenge is all about execution — retail property is difficult to sell at any price whilst there’s intense competition to buy the best warehouses and well-let alternative assets.”

Smedley says that sectors that are more insulated from the economic cycle appear to be a better value: “Asset pricing is generally high and real estate does not appear to be overpriced relative to other assets.” This implies real estate will not be at the epicentre of the next downturn, he adds.

Global logistics is often cited as an example of a sector insulated from cyclical swings, although real estate demand in the sector is correlated to consumer spending. Ali Nassiri, head of European fund management at Prologis, says demand across Europe is also driven by supply-chain reconfiguration and e-commerce, which he argues minimises risk relative to the economic cycle. “The logistics real estate cycle in Europe still has some runway for growth, though returns are likely to be driven by rent growth over cap rate compression,” he adds. “What this means for investors is that downside protection should focus on securing superior long-term net operating income growth and price resilience, rather than chasing marginally-higher cap rates in slower-growth, less resilient markets.”

Simon Martin, head of research and strategy at Tristan Capital Partners, says that the manager has learnt to prioritise risk management first and foremost at this stage in the cycle. “We believe people will pick one of two paths; some will see solid fundamentals and the absence of destabilising speculative forces as a reason to take more risk to sustain returns in light of higher prices. Others will see higher prices as a sign that the cycle is ageing and seek to emphasise risk control and will therefore reduce their return targets in order to keep their risk discipline.

“I’m not sure you can pick both and still look your clients in the eye.”

Internal versus external threats

Unlike in previous cycles, high-risk executions such as speculative development and high-leveraged transactions have remained limited. This discipline, in itself, is a collective form of downside protection against a future market implosion. However, Justin Curlow, global head of research & strategy at AXA IM – Real Assets, is keen to remind investors that limited internal cycle risk does not mean zero risk. “There are increased signs that investors are willing to accept forward funding new schemes without necessarily being remunerated for the additional leasing risk, as it is a means to put capital to work.”

Curlow says there are evident pockets of investor “risk creep” both at the asset and location level. In the case of the latter, it comes in the guise of investment in submarkets to find deal volume without additional yield premium, compared to the established business hubs. Heitman’s Smedley makes a similar point: “Patient capital deployment is an important factor at this stage in the cycle; too often investment pressures have caused style drift to occur.”

Many investment managers agree that risk factors are more external, rather than internal, in nature. That said, investors are deploying capital carefully. In Europe, Smedley notes “a clear shift in investor behaviour is their focus on longer term economic and investment themes”. Examples of this thematic late-cycle investing are the living sectors, which include rented apartments, student, and senior housing. He explains: “This is not just a simple story of demand-supply shortage in a sector with in-built defensive properties. It also reflects a more mature appreciation of the sector’s nuances — navigating regulatory regimes, understanding structural trends that affect macro and micro markets within a country or a city, and exploring under-served sub-categories — all of which have combined to give rise to living-related strategies that are appropriate and timely for this stage of the cycle.”

Another thematic investing strategy employed in Europe is capitalising on rapid urbanisation, which manifests itself in prioritising CBD offices over non-CBD offices, a trend further supported by stronger liquidity in core locations in the event of a downturn. In retail, contrary to common sweeping generalisations about the sector’s demise, the picture across Europe is nuanced and polarised. Smedley says while retail appears to be out of favour in northern Europe, it is much less so in southern Europe, where e-commerce is still a long way from causing widespread disruption, adding: “subsectors that track broad demographic shifts may be unjustly undervalued.”

The balance investors have to find now is maintaining discipline on pricing levels while deploying relatively risk-adverse capital into a tight market. Zachary Gauge, European real estate analyst at UBS Asset Management, real estate & private markets, says managers need to be realistic with their investors about the returns that are possible in core strategies in the current environment, citing the familiar theme of “markets and micro locations with strong long-term demand drivers”.

He adds: “The risk comes from taking an absolute return level approach, which can become unachievable because of market movements, and then being forced up the risk curve even if it is against the risk profile of the fund or mandate.”

Ulrich Höller, CEO of GEG German Estate Group, suggests risks — such as the relationship between price and yield, adequate due diligence, leverage and its inherent link to cost of capital — “can be mitigated but never fully removed”. He warns that although flexibility is important, staying true to your core objectives is paramount. “It is undeniable that high quality investment opportunities are limited. Consequently, high costs for both land acquisition and development will result in modest yields.”

Tristan’s Martin says managers must always be cautious when prices are high. “Desire for extra downside protection is a known position. Modifying what we do right now is about figuring out what’s missing as the cycle progresses. Right now, the missing piece is development funded by a new source of capital that fails to understand that high prices are risky and thus allocates that capital unwisely.”

Unnecessary churn versus cutting your losses

The main argument against repositioning portfolios, says Prestbury Investments’ Brown, is that transaction costs, at 6.75 percent, are now so high that in a lower return world, all other things being equal, funds with low investment turnover will outperform.

However, these variables need to be considered in a wider context. Ongoing poor returns in sectors such as UK retail and secondary shopping centres ought to trump all other considerations, Brown argues. “Current retail weightings are a snapshot in the journey,” he says, pointing to a 50 percent allocation in days gone by — when retail property used to offer the longest leases and lowest volatility of the three traditional property sectors — to a zero percent allocation, which Brown argues is the ideal weighting for today’s market.

Brown continues: “Some investors may choose not to sell retail as they don’t like the prices being offered, but there will not be a recovery, and they will end up taking the valuation hit if they hold. There is no escaping the performance penalty for those with higher retail weightings, and we would argue that they’re better to grasp the nettle and reposition now.”

By contrast, the appeal of non-cyclical investment strategies is highly evident now, such as in the aforementioned living sectors, where little modification is required. “Diligent research may identify pockets of opportunity; however, geographic creep can often turn into yield-chasing and should be approached with caution. Investment managers must also be prepared to advise investors against deploying capital should no appropriate opportunities present themselves in a riskier environment,” warns Smedley.

For Prologis’ Nassiri, maintaining resilient income across cycles requires focus on high-barrier, high-growth markets that are supported by “increasing consumption, favourable supply/demand fundamentals and good demand velocity”.

Preparing for the unexpected

In the event that an unexpected scenario manifested in the near term, such as a euro zone recession, investment managers would have to respond in terms that they are not currently expecting, particularly those managers who are investing on a thematic basis linked to structural drivers of real estate demand. In such an event, says Schroders’ Callender, the two investment modifications his firm’s funds would make would be on leases and cash and debt policy.

“With regard to the former, we would be more inclined to prolong current leases, rather than wait for an occupier to leave and then try to add value through redevelopment, or change of use,” he says. In addition, fund leverage would be reduced, and cash conservation would be adopted in preparation for potential opportunistic purchases of quality assets from distressed sellers.

“I would expect the next real estate downturn to be triggered by an external shock,” suggests Brown. “It feels like the trigger will most likely come from some form of government action. In the UK via Brexit, or the consequences of a voting in a Marxist government, or globally perhaps via US-China trade wars or some other Trump miscalculation. Quantitative easing transferred the risk and leverage onto government balance sheets, so their actions matter more than ever.”

From a global standpoint, a major re-set in the level of rates triggered by a geopolitical, or large-scale macroeconomic event that shifted inflation expectations would matter, says Martin. “One other area to keep an eye on is leveraged loans. It’s less of a real estate thing and more a systemic credit concern.

“A lot of people who want yield have been taking on risk in this sector; it’s lightly regulated, and the leveraged loan market is closely interwoven with many of the PE firms that are raising and deploying significant amounts of capital in the wider corporate environment and, equally, in our sector.”


James Wallace is a freelance journalist based in the UK.

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