Shelter From The Storm

David Paine, head of real estate, Standard Life Investments

Weaker investor confidence over global growth has resulted in a hasty retreat from risky asset classes in recent weeks. However, such indiscriminate selling has also created opportunities for investors to exploit inconsistencies and uncover value.

One area that we continue to regard as an attractive component of a diversified, multi-asset portfolio is global real estate. Good quality commercial property is likely to remain resilient despite the global economic slowdown, which we expect to result in a period of weak growth rather than outright recession.

Real estate also benefits from a relatively secure and sustainable yield compared to other assets. In addition, the weight of money looking to invest in commercial real estate remains reasonably strong and we do not foresee this changing for higher quality ‘safe haven’ exposure.

On a fundamental basis, a modest recovery is materialising in most global real estate markets. This is consequently leading to improving tenant demand as occupier confidence and business investment increases.

Although confidence has taken a few steps back in the recent market volatility, vacancy rates have generally been falling globally and strong rental growth has been recorded in some of the highly cyclical, supply-constrained office markets such as Hong Kong, London and Paris. Elsewhere, there are signs performance is becoming more polarised between the Asian markets, where reasonable economic growth is expected to continue and the weaker Western markets, where recovery remains muted.

Amid the recent market turmoil, Asian markets remain resilient. Real estate markets are a product of the underlying economy and, despite signs of a slowdown in Australia, the Asian economies generally remain buoyant. This should translate into healthy future demand from tenants. Concerns about a slowdown in activity in Singapore and an increasingly tight labour market in Hong Kong have emerged. However, the region’s robust underlying growth dynamics are expected to continue to underpin real estate markets.

The story is more complicated in western markets where recent fears of a ‘double dip’ have weighed on investor sentiment. In North America, while most indicators are not pointing towards the US moving into recession they do foreshadow slower growth. Occupancy gains are expected to slow in most markets as firms take a more cautious tone about future expenditure. In addition, investor assessment of future growth is likely to become more conservative and shift towards stronger tenants. That said, relatively low borrowing costs are set to continue to aid the US residential markets with mortgage rates falling to the lowest level (4.15%) in more than 50 years. This in turn should benefit the depressed retail market. There are also signs of a pick-up in rental segments with construction of multi-family units bolstering housing starts in July.

In the UK, a supportive interest rate environment looks to have been cemented by a unanimous Monetary Policy Committee vote in July to keep rates at record-low levels. These historically low rates continue to support the real estate asset’s risk premium. Two full years of capital growth for the IPD Index reflects investor’s positive sentiment towards commercial property.

However, with only a small improvement in capital values in July the performance of prime assets versus the more challenged secondary markets is increasingly polarised. Recent volatility and ensuing elevated economic weakness are likely to have an accentuated effect on investor sentiment towards riskier poorer quality assets. While yields on gilts remain low and with further uncertainty in the equities markets, real estate continues to hold its own against other asset classes. In contrast, UK commercial real estate income yields are currently 6.3%.

In Europe, concerns over the strength of the real estate outlook have deepened. The softening in underlying drivers and widespread GDP downgrades suggest returns will be lower than previously thought.

The trend of investor focus towards prime real estate is expected to continue as lower yielding ‘safe haven’ assets continue to appeal. Liquidity is expected to remain restricted for the foreseeable future as tighter regulation and bank deleveraging continue. However, European real estate still looks attractive on an income yield basis, relative to government bonds and cash.

Overall, with interest rates generally anticipated to be lower for longer, yields on global real estate remain attractive in comparison to other asset classes. The key drivers for real estate are favourable, unless a major recession appears, so investors can reasonably expect positive total returns over the coming two to three years.

However, investors need to be discerning; within each global region there is a degree of polarisation and the fundamentals of demand and supply vary markedly within the sub-markets that make up each area.