This article is sponsored by Savills Investment Management. It appeared in the Investor Perspectives 2019 supplement with the March 2019 issue of PERE magazine.
Commercial real estate (CRE) investors have largely enjoyed the benefit of good returns in recent years, but as we progress through 2019, many are wondering how long the momentum can last. To focus on slowing economic growth and an increasingly uncertain political climate, however, would be to overlook several positive themes in the real estate market.
Economic and political factors
This year marks the end of a decade characterized largely by the aftermath of the Global Financial Crisis (GFC). While the monetary kitchen-sink approach, which central banks instigated in response to the GFC, restored demand and output, the immediate future long-term average economic growth rates are expected to remain modest for some time.
The United States is now unwinding its quantitative easing program while the eurozone and Japan are expected to do so soon. Unless stimulated by extraordinary public actions, especially monetary and fiscal policies and/or unsustainable private sector borrowing, the private economy will be prone to sluggish growth caused by insufficient demand. At present, the long-term real rate of interest is still very low.
Investors also face uncertain times politically. The rise of populism, which has found expression with the elections of President Trump and right-wing parties in Europe, means political tensions constitute a substantial concern for investors, even in markets historically considered stable.
Positive themes are emerging
Against these factors, however, investors are weighing up the benefits of some strong positive themes emerging in global real estate.
A clear global theme is growing urbanization. Cities are developing fast, especially in Asia but in Europe, too. So much so that over the last 20 years, the top 10-listed cities in our Dynamic Cities Index have collectively outperformed the EU-28 overall in terms of GDP and employment growth, providing a backdrop for stronger commercial real estate investment performance.
The index ranks cities across six categories: innovation; inspiration; inclusion; interconnection; investment; and infrastructure. It highlights those cities able to attract and retain talent, spur innovation and increase productivity, which encourages the wealth and population growth that drives successful commercial real estate markets.
London notably ranked first for a second consecutive year, followed by Cambridge, Paris, Amsterdam, Berlin, Dublin and Munich, newcomers Oxford and Basel, and then Stockholm. The majority of 2017’s top 40 cities consolidated their places in 2018’s index by increasing their scores, underlining their continued progress.
The index predicts that all commercial real estate sectors will benefit over the long run from several key trends: rising employment will help support the office sector, wealth creation will benefit the retail sector; and the explosive growth in e-commerce will drive demand for urban logistics and warehouse facilities.
Nor is this just about size. While some ‘super cities’ such as London and Paris are clearly established, there are some smaller cities that have what it takes to attract investors, namely infrastructure investment projects, fast-growing knowledge networks, high-quality universities, innovative businesses drawing from a global talent pool and strong cultural amenities to help retain that talent.
On average, Savills Investment Management expects cities to outperform countries. And within cities, we like markets that have lagged the current European property cycle. We see, for example, selective opportunities in the office sector in Brussels, London, despite short-term Brexit concerns, Lisbon, Amsterdam and Frankfurt.
Technological changes are particularly hard for investors to ignore, especially in relation to the logistics and retail sectors. Technology has, for example, driven the rise of online retail. This has created the need for distribution centers but also a shift toward ‘omnichannel,’ which integrates the different methods of shopping, including online, physical and phone, in one place, such as a retail warehouse.
Major retailers now focus on core markets that not only support sales activity but also aid product, showcasing and helping to project their brand. This has resulted in increased demand for mega distribution centers, last-mile urban cross-docked logistics and prime high-street shops. The UK, Sweden and Germany are ahead in the curve and momentum is building in the rest of Europe. In pure-play retail, we like lifestyle, user experience, outlet malls, value, retail on infrastructure hubs and convenience formats.
Investors’ appetites are changing
Real estate investors are now changing more than just their asset allocations. Their approaches to choosing investment management partners and types of products have undergone dramatic shifts, too.
Before the GFC, investors were often more open to approaches from new managers. This situation has certainly changed: it now takes much longer to develop relationships with them. After the dramatic losses sparked by the GFC and the successive layers of extra regulations that followed, they have become much more cautious and prefer to concentrate on fewer relationships with managers they know and trust.
This has made it difficult for new entrants into the market. It is more important than ever to be a recognized brand, especially with institutional investors that are saying ‘you are great but I have managers in place and do not need another.’ They have strict processes and must check every manager to fulfil their due diligence, which can be elongated by up to a year before a decision is taken.
The rise of debt products
The last decade has seen the rise of debt products, which are a direct consequence of the GFC. Before 2008, bank lenders dominated CRE due to the Basel I framework’s favorable regulatory capital environment. Banks provided roughly 95 percent of all outstanding debt in the form of traditionally funded bilateral loans held on their proprietary balance sheets, according to the Cass UK Commercial Real Estate Lending Report.
Europe’s CRE lending landscape changed dramatically after the GFC because high leverage CRE lending became very expensive for banks under the Basel II regulatory capital rules. This trend has continued as regulators have introduced further reforms under Basel III and IV.
Such regulatory activity forced banks to retrench, resulting in a massive reduction in both the amount of debt and leverage available for European CRE, creating a funding gap that has been bridged by alternative lenders. Today, according to the Cass report, banks hold approximately 75 percent of outstanding CRE debt in Europe, with alternative lenders and insurance companies holding less than 25 percent.
The European debt market is likely to continue to evolve into a more balanced and efficient lending market similar to the US, where according to the Cass lending report, the banks hold approximately 40 percent of all outstanding CRE debt versus a far greater proportion provided by alternative lenders. The role of alternative lenders in Europe should continue to expand for the foreseeable future, providing much needed diversification from the historically bank-dominated landscape. For investors, the opportunity to diversify their portfolios with debt investment products has been welcome. They like the asset class because it comes with income and less risk than equities.
Furthermore, a shortage of available debt means the current recovery will not match the highs of the previous economic cycle, when debt was more freely provided by banks. This supply-demand differential allows alternative lenders to achieve higher income returns for investors while taking less property risk, which is increasingly important as we enter the later stages of the current cycle.
Responsible investing is a growing requirement
Another major global phenomenon occurring among investors generally, but which we will see more of in coming years in real estate, is responsible investing. The integration of environmental, social and governance (ESG) factors into investment processes is gaining momentum worldwide, but whereas until recently responsible investing was more about avoiding investments associated with harm, such as oil and gambling companies, there are growing requirements among investors to go one step further and make a positive impact.
Investors are looking for evidence that their ESG commitments are being fulfilled by their asset management partners and key hallmarks of this include signing up to the United Nations-supported Principles for Responsible Investment, which we joined in 2014, and seeking the Global Real Estate Sustainability Benchmark, the organization committed to measuring and reporting the ESG performance of real estate portfolios globally.
Measuring, monitoring and improving are the foundational steps for having a positive ESG impact.
The last stage of the market requires prudence
Reliable indicators continue to signal that developed economies have the stamina to keep growing through 2019. This suggests any market outlook should be more about assessing opportunities that would benefit from an extension of the global business cycle but are insulated against the possibility of a more pronounced downturn in the next few years.
But after several years of good growth, Savills Investment Management does believe that prudent investors should position themselves for the last stage of the market cycle. Lower yields may tempt some investors to move further up the risk curve and outside their defined fund style. However, we strongly advise investors to consider the intrinsic value of an asset versus chasing yields, particularly when assets are underwritten on a five-year hold. Historically, this has resulted in underperformance, as downsides are most acute in markets and assets that do not have the support of fundamental demand drivers.
High rates of return are unrealistic
In a low growth, low-interest rate environment, delivery of what would be high real rates of return, considerably higher than in the past, can be considered as too unrealistic.
Something has to give; either those target returns are reduced or the property market has to see a severe correction in capital values to improve entry prices.
As we feel the property market is not so imbalanced, fundamentals do not support a major correction in prices. Therefore, we would advise against high value-add and opportunistic strategies that are dependent on economic growth but would instead target location or asset-specific investment cases.
The focus should be on income
The focus should be on preserving income streams. Demand for core property – investment-grade income streams – in core cities has remained strong. Based on our ‘market momentum indicator’, a coverage of over 100 sub-markets, average European core property yields, including the UK, continue to remain under downward pressure, although we expect yield compression to moderate over the next 12 months.
Investors can also focus on longer-term trends such as demographics, urbanization and technology and their continued impact on occupier demand for new micro-locations and real estate segments.
Asia is growing stronger than Europe
There are still highly promising investment opportunities, particularly in the overlooked retail sector, and the logistics sector, which is seeing positive structural changes. In Asia, which is growing stronger than Europe, there are highly attractive longer-term fundamentals in terms of population growth as well as faster-growing prosperity and urbanization. This is leading to increasing occupier demand, while a growing middle class also drives demand for retail space and logistics via growing e-commerce.
Whatever investors decide strategically, it is important to work with a commercial real estate investment manager that has local knowledge and expertise to help investors navigate these uncertain times.
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