GI 50: Looking through the cycle

This article is sponsored by Macquarie Capital Real Estate Advisors.

Solid global GDP growth and tightening labor markets are supportive of healthy near-term real estate fundamentals across regions. Although growth has diverged somewhat this year, with the eurozone slowing from multi-year highs, key developed markets continue to grow above their 10-year averages. Solid rental growth will underpin investment performance for the rest of this year and into the next, particularly in the fiscally stimulated US market.

Over the medium term, the combination of faster than expected US rate rises alongside the withdrawal of European monetary stimulus is likely to be the trigger for the next pricing downswing early next decade, presenting a short window of opportunity for investors.

Shifting investment strategies

Long-term structural trends – urbanization, globalization, technology and demographics – will continue to impact how and where real estate space is used and located over the coming decades. By investing in these long-term themes, investors will be well positioned across cycles.

Industrial and mid-market rental housing will continue to be key beneficiaries of big cities getting bigger, stretched housing affordability for first-time buyers in gateway markets, millennials moving into their peak spending years as they progress with their careers and start families over the coming decade, and the ongoing shift to e-commerce spending as consumers become comfortable with purchasing a wider variety of goods across different platforms.

Technological gains are supporting the latter, with automation of logistics facilities and real-time GPS tracking speeding up the delivery of goods to consumers. Over the longer term, the introduction of driverless trucks will reinforce these trends.

Retail strategies are also evolving. Forward-looking owners are supplementing their traditional store activities by increasing their exposure to services retailers, food and beverage offerings, click, collect and return facilities, and boosting their last-mile distribution capabilities to take advantage of the shift to online spending.

By geography, fundamentals of population and economic growth remain crucial in driving investment returns. In advanced economies, we look to regions and markets with solid GDP growth prospects and, importantly, strong population growth supported by a combination of urbanization and/or net overseas migration.

In emerging economies, we prefer markets with robust demographics and economic growth potential, alongside low macro volatility and political stability.

Positioning through cycles

Real estate investments focused on sectors supported by long-term structural themes and defensive cashflows will outperform for the rest of this cycle and into the next.

Macquarie Capital has anticipated these global long-term themes for some time by partnering with world-class logistics and rental housing management teams in developed and emerging markets where these trends are most pronounced.

As these platforms prepare their portfolios for a through-cycle period, including taking advantage of any softening of development sites and core asset pricing early next decade, we expect these sector specialists will continue to attract the interest of key investors with a focus on gaining cross border exposure.

Global transactional activity

Despite tight cap rates, investors continue to put capital to use. Annual global sales of commercial real estate assets, excluding development sites, have remained elevated at around $900 billion over the past 12 months. Increasingly, large investors are looking offshore for access, scale and diversification. Cross-border now represents in excess of 30 percent of global real estate sales, having recovered steadily from post-crisis 2009 lows.

With dry powder for closed-end private real estate funds rising to all-time highs of $294 billion in 2018, compared with $250 billion in 2017 and $176 billion in 2009, global transactional activity is expected to remain solid into next year as managers deploy cash.

Unlike the 2010 to mid-2015 period though, where transaction volumes recovered more or less to the same extent, investment activity is shifting across markets and sectors.

Globally, industrial and multifamily activity has lifted at the expense of secondary shopping centers and non-prime high-street locations. This is clear for cross-border investors, which are increasingly favoring beds and sheds investments given the positive structural drivers of underlying demand.

By geography, US transactions remain well above historical averages but volumes have cooled from recent peaks, largely driven by a pullback in secondary retail and CBD office in oversupplied gateway markets. Liquidity remains solid in other US sectors and geographies.

Following Brexit-related disruptions, UK activity has recovered supported somewhat by a rebound in transactions outside London and a number of large trophy office sales to Asian-based investors in the capital. Broadly, ongoing strength of the industrial and build-to-rent sectors is offsetting subdued investment activity in the office and retail sectors.

Elsewhere in Europe, volumes have lifted, supported by an improving macro environment, strengthening fundamentals and easing credit conditions. Low interest rates and elevated cap-rate spreads against local government bonds are also supporting activity.

In Asia, transactions in China are volatile but the long-term trend is positive. Recently, controls on outbound capital have boosted activity. Sales of Chinese development sites continue to rise sharply, accounting for just under 90 percent of global sales over the past 12 months. In South-East Asia and India, cross-border investment is boosting sales with investors attracted to the relatively strong growth potential in these markets.

Transaction volumes have stabilized at above-average levels in Australia over the past 12 months supported by a combination of domestic capital and cross-border investors looking for yield spreads relative to other Asian markets.

Conviction on the cycle

With large investors increasingly allocating capital across asset classes and markets, shifts in global interest rates impact relative investment returns.

Consistent with previous cycles, we think that financial centers around the world are set to come under some pricing pressure early next decade. The combination of faster than expected US rate rises and gradual reduction in European Central Bank balance sheets (as a percent of GDP) is likely to impact pricing and liquidity of risk assets, including commercial real estate.

With manageable property leverage, private credit growth modest relative to previous upswings and banks holding more capital against loans, any downswing is likely to be relatively subdued. Elevated real estate spreads over government bonds and high levels of dry powder will also cushion any softening of cap rates.

Nevertheless, any pullback will present a short window of opportunity for investors to acquire core assets and development sites. Portfolio positioning now will ensure investors are well placed to take advantage of any pricing dislocation early next decade.

Of course, if the Federal Reserve judges that US GDP growth will slow sharply as a result of elevated financial volatility or slowing growth (for example, driven by trade disputes and increased geopolitical tensions), then its tightening cycle may be delayed or even reversed. This would potentially provide another leg up for real estate pricing and delay any downswing.