Tom Bill, Head of London Residential Research discusses the current investment landscape and the role of real estate with a number of leading fund managers:
The Federal Reserve’s interest rate U-turn is good news for real estate
The Federal Reserve adopted a more dovish interest rate policy in January and even raised the prospect of a rate cut in June. Other central banks have followed suit, which is likely to defer the next global economic recession.
“Our assumption is that in a world of low interest rates and perhaps no recession until 2023, property becomes more attractive,” says Andrew Milligan, head of global strategy at Aberdeen Standard. “There are an awful lot of investors who need a higher running yield and that’s why money will go into real estate.” “Do I hold real estate versus cash or lower-yielding bonds in this market? Absolutely.”
“We would say there is a 20% chance of a global recession in the next 18 months on the back of the Fed and Chinese central bank becoming more accommodative,” says Rory McPherson, head of investment strategy, PSIGMA Investment Management. “The Fed couldn’t have become more dove-ish and so the market has done a complete 180 and priced in a rate cut this year, which is good for higher-yielding assets like commercial real estate.”
The long-dated income stream of real estate is attractive
Real estate has attractions against the backdrop of an economic cycle that is nearer the end than the beginning.
“Equities can be volatile at the end of an economic cycle, which we saw with the big sell-off before Christmas followed by a strong first quarter in 2019,” says Kim Politzer, director of real estate research at Fidelity International. “Investors like the income return from real estate but there is no such guarantee with equities. If you hold real estate for a period of time you can ride through the cycle.”
“We forecast slower global growth and that plays well into the hands of real estate,” says McPherson. “The outlook is worse for fixed income because market interest rates will only rise, which means bond prices will fall. That makes the longer-dated yields of real estate more attractive.”
“I believe there will be a mild dip recession in the US but nothing too significant and not before the 2020 election,” says Thanos Pappasavvas, founder and chief investment officer of ABP Invest. “What does that mean for real estate? It depends on how geared you are and the length of any recession, but if we have a recession that is technical, in other words a couple of quarters of marginally negative growth, it won’t be destructive for real assets. What would be destructive is a prolonged and deep recession that hits unemployment and people’s ability to repay debt.”
“Late into an economic cycle, the thing policy-makers can struggle with is not enough inflation,” says McPherson. “If they get some inflation then physical assets will do well and real estate is seen as a good inflation hedge. I would say that allocations to real estate is ticking up as a result of this.”
“The other reason there will be a continued allocation to real estate because of the ageing population in many countries,” says Politzer. “There is a demand from pension funds to for a sufficient level of income return to ensure they meet their obligations.”
Could rates be lower for even longer?
Political concerns as well as a rethink of monetary policy could keep rates lower for longer. One such new idea is Modern Monetary Theory, which is based on the assumption that governments can create money to fund spending, achieve full employment and avoid defaulting on debt while using taxes to control any resulting inflation.
“Doing whatever it takes, the term coined by Mario Draghi, is a mantra that has become more and more entrenched. As such, it is becoming increasingly hard to wean investors off the notion of ongoing accommodative Central Bank policy,” says Alex Gunz, manager of Heptagon Capital’s Future Trends Global Equity Fund.
“Modern Monetary Theory (MMT) is today regarded by many as a deeply unconventional approach. However, ideas such as these often start off as seemingly outlandish but are voiced on the assumption that one day they will become more accepted. I sense MMT is perhaps going down that route at the moment.
“Central banks will maintain ample liquidity given the social and political unrest around the world,” says Pappasavvas. “A significant downturn could adversely affect social structures across Europe and the US and create a developed market crisis. Such socio-economic risks have resonated with policy makers. That’s why Trump will be keen to avoid any economic correction until after the elections in 2020. This period of low interest rates alongside broad shifts towards fiscal easing will benefit real estate.”
Investors are falling out of love with public markets
Higher returns may be found away from stocks and bonds in future
“We have a “stay rich” portfolio of public stocks and bonds but, whichever way you look at it, the likelihood is flat-lining markets and lurches downwards, as we saw in the final quarter of 2018,” says Rupert Edis, chief executive of JPS Finance, the Landon family’s London-based office.
“The Fed has calmed things down but it’s only temporary. Stock valuations look quite stretched and I just feel the public stock markets over the next five years will be low-return environments with the risk of volatility.”
“In terms of our “get rich” portfolio, that is made up of direct US real estate and private equity investments. Of course with real estate there are comparatively higher barriers to entry but our property investments have returned 23% per annum since 1994.”
“You now hear about all sorts of investments in the alternative space, for example music royalties, litigation finance and aircraft leasing, which are higher yielding but there is also an element of diversification,” says Pappasavvas. “Real estate is seen as one such alternative allocation. Given its qualities, investors can also approach investing in it from a currency perspective, for example the recent sterling positions adopted through buying UK real estate.”
“Another advantage of real estate is that it’s slow moving,” says Milligan. “Unlike the stock market, valuations won’t necessarily be affected by a tweet from the US President.”
Diversification is the name of the game
Uncorrelated, diversified portfolios may be the way forward over the next decade
“The returns in a conventional 60/40 portfolio split between equities and bonds have been exceptionally high over the last decade,” says Gunz. “But the starting point was low after the financial crisis and central banks have been accommodative.”
“So, logically, projecting out over five to ten years, it will be very hard to generate those same high level of returns with the same approach. So we have been advocating investing in uncorrelated and diversified portfolios of assets in a more creative way, an approach which would logically favour real estate.”
“To understand the appeal of diversification, you only need to look at the proliferation of specialist real estate funds that have listed on the London Stock Exchange,” says James Beck, a partner at James Hambro & Partners. “From generalist funds to warehouse, big box, retail, student accommodation, healthcare and the debt funds.
“In addition to the hunt for yield, investors are searching for assets with income streams that are less directly impacted by headline moves in the stock market. There’s a perception that real assets are less volatile, in addition you have the security of the yield and the fact that the ownership base tends not to be potentially short-term holders such as Exchange Traded Funds.”
The push into “real assets”
The rise of passive investing means better-valued assets may be found away from stock markets
North American family offices with a real estate exposure was 73% in April 2019 (up from 57% in April 2018), according to family office platform FINTRX. European family offices with a Real Estate exposure was 58% (48%).
“The trend is clear, family offices continue to value real assets as a core part of their portfolios,” says Russ D'Argento, founder and CEO of FINTRX. “Real estate plays offer diversity to their equity positions and provide stability contrast to their more volatile liquid positions."
“Real estate is associated with the push into real assets such as infrastructure debt, with investors looking for better-valued assets than the public equity markets,” says Milligan. “Directly held real estate gives you a diversification advantage and the ability to upgrade and enhance the capital value, although of course there is a management cost to that.”
“The impact and momentum generated by passive funds means that some stock market valuations look expensive,” says Pappasavvas. “For some investors these passive funds are designed to give them exposure to the broad direction of the equity market. Anyone can buy the S&P index now but as a fund manager and asset owner, you need other strategies to cover your liabilities. You need to generate ‘alpha’ and that is where real estate can form part of the strategy. Plus, with property, you now have a demonstrable track record of successful investors.”
“Investors realise that if an asset class gets more crowded, as is the case with passive investments on equity markets, then the more sophisticated investors will have to look for higher returns elsewhere including tangible assets like real estate,” says Gunz. “And what many investors want is an asset backed by a sustainable cash flow, which in the case of real estate is the rent.”
Real estate investing has become more sophisticated
The understanding of real estate as an asset class is improving
“Investors are getting more sophisticated in their approach to real estate,” says Milligan. “In the time I have followed real estate it has become much more global as disparate markets are more inter-linked. Signals from the Fed are global business signals.
“At the other end of the spectrum is greater granularity. There is an ability now to invest in a whole swathe of markets. Can you say for certain there is nothing in Rio or Cairo that is worth buying? Before it was primarily offices and retail but now logistics is more important. Housing is also becoming more institutionalised in Europe and the UK. The bucket of alternative assets that investors are looking at is growing and I’d put real estate in that.”
“Commercial real estate is one of the most ring-faced and inwards-looking asset classes and that’s what makes it so specialised and the nuances so great,” says Savvas Savouri, chief economist at asset manager Toscafund.
“A facsimile building in two different geographies will have very contrasting fortunes. As an investor you need to understand what rocks these markets, what is their USP.
“As such, I’d recommend infrastructure and real estate investments with a link to the ambitions of China. In particular countries recognised as being more transparent around provenance of ownership and regulatory frameworks. Other countries have the potential for growth but there isn’t the same safety net in place yet.”
Undersupply will underpin values
The drying up of the debt markets after the global financial crisis has averted the oversupply risk in many markets
“The restricted ability of banks to finance new lending has been an important factor,” says Milligan. “America has suffered more than other countries from the decline of the mall but nowhere in the world really stands out as being over supplied with commercial real estate, which will support valuations.”
“The challenge right now is investing wisely given we are late in the economic cycle,” says Politzer. “I don’t think anyone can say with any certainty or visibility on how much further the cycle has left to run but there are not yet many red flashing lights that I can see in Europe and the low pipeline of new stock coming through will support rental values.
“The same is arguably not true for bonds or equities given situations like we are seeing in Italy. So for investors it’s about trying to find pockets of value, supply shortages that create the opportunity for rental value growth.”