Outlook 2016: Accepting Risks in the Right Areas

• Real estate returns are likely to slow in 2016, as yield declines come to an end
• Develop and refurbish real estate in the short term to maximise the moderate recovery in tenant demand
• Low-risk income is needed for the long term, which is likely to encourage more investment in alternative sectors

Off to a bad start

It is natural to approach each New Year with optimism, but markets had faltered just one month into 2016. Global equities stood around 12% down from their peak¹ and oil had slipped to under USD30 per barrel – the lowest price since 2003. Many have already conceded that their wish for a prosperous New Year will not be granted.

The harm to investor confidence is understandable but investors should resist the temptation to portray 2016 as wrecked. That said, there are some trends that need careful consideration. Volatility is likely to remain high while monetary policies diverge. The UK is likely to increase rates this year, while the US could tighten further. Meanwhile, the European Central Bank, Bank of Japan and People’s Bank of China are each undertaking various forms of monetary loosening. The uncertainty around the relative speed and strength of policy changes may create rapid currency movements and phases of asset price adjustment.

Investors’ focus is likely to fix on China’s structural slowdown and its effect on both emerging and developed economies. Our outlook for China can be summarised as a gradual slowdown of annual GDP growth between 6% and 6.5% in the coming years. Other emerging markets, particularly commodity dependent nations such as Brazil, are likely to face a greater struggle, with GDP growth remaining weak and commodity prices remaining low.

Companies hesitant to invest or re-leverage, and governments unwilling or unable to plug the gap, are likely to curb growth, moderating what would otherwise be a stronger recovery. Despite this, the rate of global economic growth should be positive.²

Trends are reversing

For real estate investors, such an environment is a testing one. Moderate economic growth and high financial market volatility may leave investors in two minds as to whether to reduce real estate risk, or increase risk – seeing real estate as relatively calm compared to equities and fixed income markets,  albeit a consequence of real estate assets’ infrequent appraisals. For context, European real estate markets have seen returns improve in recent years. In 2013, returns were 6%; in 2014, they were 9.4%, as shown in Figure 1. In 2015, returns are likely to be confirmed at a similar level. The decline in yields pushed up returns. RCA data confirmed that the average transaction yield in Europe fell over the last two years, from 6.7% in the fourth quarter of 2013 to 6.3% in the fourth quarter of 2015, although the pace of those falls slowed in the second half of 2015. The slowing of yield declines may make 2016 a very different year to those in the recent past and real estate returns are likely to slow, being driven, increasingly, by rental growth.

There is more to Europe than the UK

It is worth stressing that our views for the UK and the rest of Europe continue to differ. The UK has comfortably outperformed the rest of Europe over the last three years, with returns averaging 14.1% each year between 2013 and 2015. However, as Figure 2 shows, returns from yield declines in the UK have been slowing since late 2014, despite rental growth accelerating. We expect the UK to see returns slow further over the next three years, averaging 5.6% each year. In comparison, we expect the eurozone markets to average an annual return of 7.1% over the next three years, thus outperforming the UK.

The UK is likely to remain out of sync with the rest of Europe – but now to its detriment – largely due to the belief that uncertainty surrounding Brexit would cause investors and tenants to postpone major decisions, where possible. This is likely to cause a reduction in investment and letting volumes, particularly in London. It is worth noting that our base case assumes that the UK remains within the EU following a referendum around the summer of 2016.

In addition, the UK is likely to raise rates over the next three years, commencing towards the end of 2016, creating upward pressure on real estate yields. Within Europe, only the UK would experience this pressure, as the rest of the region is likely to see interest rates remain low for the duration of this period and beyond. As such, investors should treat the UK differently in the coming years, compared to the past.

Complementary strategies

At two opposing extremities – short-term, high-risk investments and long-term, low-risk investments – there is less competition among investors, and returns for the risks taken look relatively attractive, when compared to more traditional core assets held for five-to-ten years. Therefore, we split our themes for 2016 into two categories, based on risk appetite and holding period. For short-term holds, we believe that taking on asset and tenant risk through developments and refurbishments is likely to reward investors with strong returns.

Meanwhile, 2016 is an opportune time to reposition portfolios with a long-term view. As real estate’s phase of re-pricing completes, a large component of future total returns should come from the income received, not from rising prices. Investors should seek secure sources of long-term, low-risk income across the main property types (offices, retail and industrial), but that search should extend to alternative real estate sectors, where there is less competition among buyers. Investors should view the two themes as complementary, rather than contradictory. By undertaking both types of investment, an investor’s risks and returns should equalise at a point that most investors would target.

Stay active

The outlook for rental value growth across the main markets is positive, but moderate – a reflection of the economic environment. Investors should look to enhance mild growth through active management – refurbishments and developments – to improve the quality and value of the asset.

Since 2008, an average of 0.8% of net additions were made to the office stock of the top 10 European markets3 each year. This figure is half the annual rate of the previous seven years, as developers cut their pipelines due to the declining availability of development finance in the wake of the financial crisis.

The sustained lack of new office supply and a moderate recovery in demand creates an opportunity. The top location for development and refurbishment strategies has been central London and ongoing schemes in London still look well timed, given the positive momentum in the occupier market. However, new schemes starting in 2016 would likely have to compete for lettings with a greater number of schemes with similar completion dates.

The search for new refurbishment and development schemes is likely to move on from London to Madrid, Berlin and Paris. These markets should see occupier demand strengthen. In Madrid, a continued lack of new supply has left the amount of available Grade A space at very low levels. The market is in great need of new or refurbished stock, particularly in the CBD and A1/A2 corridors.

In Berlin, tenant demand has increased, largely thanks to a blossoming tech and media industry: sectors that generated around a third of take-up in 2015, having previously been more minor contributors. Refurbishment and development opportunities lie to the east and south east of the city centre, in areas such as Friedrichshain and Kreuzberg.

In Paris, the occupier market has been far weaker and lease deals have tended to be more tenant-friendly. Our outlook is for occupier demand to improve in Paris, generating gradual rental growth and a reduction in tenant incentives. The opportunity in Paris is geared towards pre-let development, limiting the tenant risk, in central and western areas of the city.

Short-term strategies require liquidity

Even though liquidity is high and investment volumes are above long-term averages, investors should not take such conditions for granted. While we feel comfortable with taking on asset and tenant risk in the main cities, location risk (investments in second-tier cities) is not worth the drop in liquidity.

Investors may move on from the main cities in search of higher yields in 2016. However, as markets subsequently slow, illiquidity is a threat to their ability to successfully exit from the short-term strategies suggested.

When considering our second theme of long-term income, a higher yield for more illiquid assets, such as alternative real estate sectors, is an attractive attribute. Given that investors should aim to hold such assets over the long-term, liquidity is less of a concern.

Investing for the future

Investors’ long-term focus should be on income, which can be steady at the portfolio level over the long term and form a large part of cumulative returns. This is a key characteristic of core investment, which should become more attractive as prices stabilise.

Alternative sectors – hospitals, hotels and data centres, for example – are often a good source of long leases, up to 25 years in some cases. In each of the alternative sectors named, the operator is often entrenched in the location, far more so than an office or industrial tenant, and is likely to see out the lease term. Operator risk is, therefore, an important consideration with alternative investments.

The additional benefit of adding alternatives to a portfolio is that tenant demand for alternatives has structural, often non-cyclical, drivers. For hospitals, ageing populations and an increase in acute and chronic illness creates a long-term need for healthcare; hotels are enjoying an increase in demand from a boom in global tourism; and data centres are in high demand, as businesses and consumers create increasing amounts of data.

Accepting risk in the right areas

Investors should resist the temptation to shun all risky activities or sectors just because returns are likely to slow. Short-term active management in liquid markets with strong occupier demand should reward investors with good returns.

However, that is only part of our suggested strategy and investors should pursue a range of investment styles and holding periods, keeping in mind that the asset class’s most defensive, and arguably most attractive, attribute is its ability to produce income. Alternative real estate sectors are likely to be the best source of that long-term income, with the potential to reduce portfolio risk, thanks to a diverse range of underlying demand drivers.