Publications

- January 1, 2019: Vol. 31, Number 1

What’s in store for 2019? Plenty of thunderclouds are on the horizon in the new year; here’s how to keep yourself sheltered

by Alex Frew McMillan

Festering trade wars, frenzied populism, faltering U.S. stocks, China’s bureaucratic fiddling, plummeting emerging-market currencies, geopolitical tensions — the list of hindrances to real estate performance in 2019 is long.

“2019 offers not just one wild card but a full deck,” says Chris Macke, managing director for research and strategy at American Realty Advisors.

This is a trying time for anyone in search of capital gains. Growth in values has slowed significantly, says Scott Crowe, chief investment strategist at CenterSquare Investment Management. “We expect growth to be near zero in 2019.”

Investors who cherry-picked prize assets in the wake of the global financial crisis have seen those opportunities vanish. Investors say the low yield on blue-chip property makes core purchases hard to justify, while the risk from buying at the peak is high.

“Goldilocks” is still at home for the global economy, according to Jacques Gordon, global strategist at LaSalle Investment Management. Not too hot, not too cold — but several bears are due to arrive sometime in 2020 or 2021.

“These bears will show up in different countries at different times,” notes Gordon. “Fully leased real estate will survive bear visits well. Investments in the middle of a lease-up, development or some other transition will get hit harder.”

This transitional real estate should make it through 2019 before pessimism sinks in. After that, “value-add could flip to value-negative,” he warns.

Prolonged downturn

Exports in Asia have tumbled as trade tensions tightened. Nomura’s leading index of Asian exports, assessing eight forward-looking factors, fell to its lowest level in two years for December 2018. The signs point to a prolonged downturn — three China-linked factors are propping up the index due to front-loading ahead of higher tariffs.

The pace of Asian economic growth is still the envy of much of the rest of the world, but it is slowing. The forecast by the Asian Development Bank is 5.8 percent for 2019, which would be the slowest pace since 2001.

Global economic growth remains steady for now. Should stocks and other riskier assets take a continued beating, it would likely prompt a retreat into the safety of real estate. Strong economics make good grounds for rental growth in real estate, even if values do not budge.

That leads Richard Barkham, chief global economist at CBRE, to predict “real estate will perform moderately well and probably better than the other main asset classes.” He envisions returns in the 4 percent to 6 percent range for 2019.

Canada over the United States

The United States has very low unemployment, coupled with solid and steady growth. But it is likely core properties already in a portfolio will outperform new investments, according to LaSalle research, due to the lag on valuations and the high prices of pure core assets.

That means it makes sense to look elsewhere in North America. “We like Canada because the big institutional investors there are selling great assets as they diversify internationally,” explains Gordon.

For those intent on playing U.S. property markets, it may make sense to do that through listed vehicles. REITs should accelerate earnings in 2019, says Crowe at CenterSquare. Funds from operations per share should rise about 5 percent, a full 200 basis points up from 2018. The gap between the high values of private real estate and the low valuations commanded on public markets could also provoke mergers and acquisitions.

“While rising rates could result in slightly more-competitive alternative yield investments, the current spread of REIT dividend yields remains attractive,” says Crowe. “REITs could also benefit if market sentiment continues its rotation into defensive sectors toward the end of the cycle.”

There is good reason to think the outlook for listed real estate may be positive, agrees Timothy Bellman, global head of research for Invesco Real Estate. The healthy spread between earnings yields for listed vehicles over local government bond yields is “a sign that real estate is still fairly priced.”

Secondary cities

Real estate investors have responded by seeking riskier or less-tested strategies. That may involve unfashionable neighborhood submarkets in gateway cities, or secondary markets such as Osaka, Japan; Hamburg, Germany; and Seattle. Prime markets such as Munich and Paris appear fully priced, posting initial yields of only 3 percent.

That is not sufficient reward. Berlin and central London also fall in the camp of markets that look “cooked”, investors say, with the pricing requiring a very optimistic ask. “You’d have to be very bullish about your exit to be able to buy assets there,” one investor told the Urban Land Institute.

LaSalle is looking for cities that offer “high-quality human capital”, a recurring trend among investors, as well as affordable housing and good infrastructure. It finds those particular qualities in places such as Portland, Ore.; the British university town of Cambridge; and Stuttgart in the industrial heartland of Germany.

Private equity leaseback specialist ElmTree Funds is scouring the U.S. Southeast and Midwest for markets with a skilled workforce, competitive wages, strong transportation infrastructure and a good business environment. It finds those in places such as Raleigh, N.C.; Charleston, S.C.; Nashville; Austin; and Denver.

“The continuance of capital moving out of gateway markets into primary and secondary markets will be an interesting trend to watch in 2019,” says ElmTree founder Jim Koman. “We expect this trend to continue, as interest rates have risen moderately over the [past] couple years, which should make the additional yield in primary and secondary markets even more attractive.”

At the same time, ElmTree avoids tertiary and rural locations, for fear buildings will be hard to re-lease if the initial tenants leave. Investors put less-mainstream markets under greater scrutiny, explains Koman. Secondary cities near gateway locations can cut it; tertiary markets are best left alone.

Macke would add another factor to chase: college degrees. “We would underweight markets where growth expectations are not driven by the educated workforce necessary to support those businesses that experience the highest overall growth and profit margins,” he says.

Not alternative anymore

Investors also are looking beyond the traditional asset-class breakdown. They are moving into alternative sectors, such as co-working and co-living spaces, as well as data centers.

In fact, such sectors are hardly alternative anymore. More than half (52 percent) of institutional investors in Asia already invest in co-working space or plan to do so, according to the 2019 Asia Pacific edition of PwC and the Urban Land Institute’s Emerging Trends in Real Estate survey. Another 46 percent are active in data centers, and 46 percent invest in student housing, or want to do so in the year ahead. Rates are also high for affordable housing (42 percent) and senior housing (41 percent).

In Europe, expect strong performance for alternative sectors, such as self-storage, assisted living, student housing, co-working space and data centers. North American investors favor senior housing, affordable apartments, medical office and student housing as sectors for likely strong returns.

“Needs-based” alternatives are most attractive, it seems. But when they favor alternative asset classes, investors revert to norm on market selection. They look to play those niches in the most-liquid, largest, mature markets in developed countries. So this dalliance may indicate dithering.

“Investor confidence hasn’t really materialized in this cycle,” says Peter Hayes, global head of investment research at PGIM Real Estate. “The increased talk about flexibility, residual value and dry powder in portfolio management speaks to an investor mindset focused on preparing for a downturn.”

Globally, Hayes calculates $300 billion of equity is lined up to invest in real estate right now. “Will there be enough motivated sellers to accommodate that capital?” he asks. There may well be a “meaningful drop” in transactions in 2019, with fewer one-off deals, and that buyer-seller spread on prices remains a problem.

Retail on hold

Retail is, it seems, everyone’s pick for worst performer in the near future. E-commerce is clearly a disruptive force for retail and industrial real estate already.

“The risk is that it is a bigger, faster trend than presently anticipated,” Bellman cautions. Invesco Real Estate has moved to underweight the retail sector, focusing on a narrow range of top-quality assets in very strong trade areas. “If some retail assets prove surplus to future needs, higher-return strategies to densify or change to a more productive use may be appropriate.”

U.S. retail arguably faces the greatest challenge because the nation has an outsized amount of retail space per capita. The public markets have responded already, pricing mall and strip-center REITs at a sizable discount to gross asset value.

ElmTree’s Koman believes healthcare property is set for a boost in the United States, where the medical system is moving toward value-based reimbursement that emphasizes a higher quality of patient care. That will reward new-build healthcare facilities over large, old-fashioned hospitals.

It may pay investors to seek out contrarian plays. “Specialty sectors like self-storage and data centers are in great demand [from] investors. Investment performance could be the flip of this, though, since fundamentals are so efficiently priced by both private equity and investors in listed securities,” explains Gordon. “A lot of retail is not as bad as the headlines suggest, yet investors are avoiding the sector.”

Logistics and other top picks

Logistics is, essentially, everyone’s top traditional pick. With rental growth and further movement in yields, logistics is “set to be the best-performing mainstream sector,” according to Alice Breheny, the global head of research at Nuveen Real Estate (formerly TH Real Estate). “However, it will be [unestablished] sectors, such as student housing or other subsectors in the living space, that are poised to perform best overall.”

Rising interest rates are a prime concern virtually around the world, with the exception of Japan and Australia. Breheny believes demand is still improving in those two nations, but pricing is already elevated. The bid-ask spread on purchases is likely to widen.

“More-modest income and value growth will lower total returns in the medium term, with core strategies making most sense,” says Breheny. Construction costs are high and moving higher in Tokyo, where there is competition for skilled workers in the final flurry of preparations for the 2020 Olympics.

In the West, rising interest rates will drive mortgages higher, which is likely to discourage apartment renters from moving out and buying their own homes. Rental growth is accelerating in the United States, meaning multifamily property should continue to experience better-than-expected demand, believes Bob Faith, founder, chairman and CEO of rental-housing firm Greystar Real Estate Partners. Overall, Greystar anticipates prices are likely to be flat, with total return made from current income.

A city such as Houston looks attractive because of its reduction in multifamily supply, coupled with increasing demand. Faith is also watching other late-recovery markets such as Phoenix, Orlando and Las Vegas. He would beware markets with extensive new supply, such as Chicago.

For the long term, the U.S. markets that deserve the most attention are those propelled by strong tailwinds from healthcare and tech-sector jobs. Such trends have driven gains in residential real estate in Austin, where home prices have risen 85 percent since the start of 2012, according to Zillow Group, and 9.1 percent in the past year alone.

High-end residential property is in store for tough times in Australia and the United Kingdom, says Faith. Tighter lending has seen the highly unaffordable housing markets in Melbourne and Sydney turn down throughout 2018, with a peak-to-trough decline in prices of 12 percent to 16 percent likely until a trough in 2019, according to HSBC Bank.

Faith is upbeat on Spain. Having taken one of the hardest beatings during the financial crisis, Spain’s economic growth is set at 2.1 percent for 2019, predicts Societe Generale Group, compared with the 1.7 percent average expected for the euro zone as a whole.

Underweight Europe

European demographics, similar to those in the United States, should reward investment into medical offices, CBRE’s Barkham indicates. In terms of overall real estate performance, European and U.S. markets will likely see capital values remain steady but not strengthen, while income provides the returns.

Invesco Real Estate remains underweight Europe, waiting for clear signs of rent growth that should translate into net operating income later. The U.S. cycle is farthest advanced, so the company anticipates returns to taper in 2019 to 2021 after a stronger-than-expected 2018. Bellman is positioning his portfolio to “lean into markets and sectors that have historically offered enduring value and stable income, while supplementing with selective growth-oriented opportunities.”

Trade will likely tell the tale in Asia. China was slow to react to the Trump administration’s tariffs, but the shock will cause Beijing to inject fresh stimulus, says Barkham. The trouble selling into North America will strengthen trade ties within Asia, with China now the world’s biggest consumer market, one U.S. companies will struggle to serve.

Asia is following the lead of the U.S. Federal Reserve in raising rates, but investors should watch for weakness as sellers emerge — the next 12 to 24 months will provide opportunities to bolster portfolios. “The period of tightening and opportunity will not last long,” Barkham predicts.

Pacific markets that are recovering and countercyclical offer promise to PGIM Real Estate. Office space in both Seoul and Brisbane, Australia, appear to be in the early stage of expansion. Singapore and Osaka also appeal as markets in the early stage of a recovery cycle.

Emerging markets in general “offer more risk than reward,” says Hayes, “so it would take a big call to go in now.”

The wild card

With that card deck of troubles in mind, the queen of spades for Gordon is Brexit. The uncertainty over Britain’s painful and prolonged exit from the European Union has shattered confidence in what is Europe’s most-active market, by far. That is reducing London’s overall prospects to the level of politically and economically shaky cities such as Rome, Athens, Moscow and Istanbul, according to the Emerging Trends report.

“Peak uncertainty is likely still to come,” Bellman cautions. Frankfurt and Luxembourg office space have benefited as the finance industry looks for alternative euro-zone locations. Both are favorites for Nuveen Real Estate, which notes Amsterdam also is establishing itself as an international hub, winning the European Medicines Agency from London.

European cities to avoid are either those with a history of overbuilding, such as Oslo, Warsaw and Dublin, or those without reforms occurring at a national or local level, a dubious distinction claimed by Athens, Budapest and the cities in southern Italy.

For a city such as London, it may now pay to watch and wait. Should Brexit fears dissipate, the British capital’s star would reignite. If there’s a card game to be played, Gordon says, “it might be possible to shoot the moon.”

Alex Frew McMillan is a freelance writer based in Hong Kong.

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