Commercial real estate (CRE) has a strong story at this later stage in the cycle. While investors need to be mindful of illiquidity, CRE is a diversifier of equities and bonds. It provides the relative stability that equities are lacking and the income that low yielding bonds are increasingly missing.

However, within CRE, there is temptation among some investors to move up the risk curve to maintain returns in this lower growth environment. Investors across the risk spectrum should not lose sight of their risk exposures and consider looking for return more defensively. The themes of Active Capital 2019 consider ways for commercial real estate investors to find alpha, i.e. return without the same proportional increase in risk, in such a late-cycle environment.

The story is local

We expect some investors to lock on to structural, demographic and technological shifts. The economic story is increasingly stronger at a local rather than country level due to urbanisation. Not all cities are enjoying urbanisation equally, however. It is important to look at the specific demographic trends of an area, to target the right city and the right assets for that city. This should also encourage movement into specialist commercial property sectors, such as senior living and healthcare where populations are aging, or private rented sector (PRS) where growth is coming from a younger cohort. The caveat is that accessing returns in these sectors often requires exposure to operational businesses and greater reputational risks, which may be unpalatable or even structurally impossible for some investors.

Targeting lower beta

We also expect investors to target economies and sectors less prone to volatility, i.e. lower beta. Even better if such economies and markets are also poised to benefit from innovation and urbanisation. Gateway cities with diversifying economies such as London, as well as new gateway cities with a foundation in strong universities, improving standard of living, good connectivity, culture and diversity are prime examples. For example, through the GFC, the office market in the lower beta university city of Cambridge (UK) enjoyed yield compression and rental growth.

Emerging core locations

Within the gateway cities, investors are moving to new emerging fringe locations due to tight pricing in the central business district and increasing lack of availability of assets to invest in. Having identified target locations, the potential for higher returns through reinvention and redevelopment will be attractive for some. Investors should be mindful that as demand for secondary assets and locations grows due to lack of prime product, there is a risk of yields compressing below their natural risk premium, reducing the gap between prime and secondary, and leading to mispricing.

Positioning through debt and proptech

Uncertainty over the position of the real estate cycle and the outlook for returns is also encouraging investors to target different types of real estate exposure. Real estate debt is one such approach supported by the change over the last decade in Basel regulatory capital rules for banks, which has created space for debt funds. This is a way to consider core and non-core real estate from further down the capital stack, therefore relatively more insulated from risk than a direct equity play. CRE investors are also seeking real estate exposure through proptech. Two thirds of investors are looking to invest 10% to 30% of their capital in proptech over 2019.

Adapting to a new normal of lower returns, amid other structural changes are key challenges for investors. The current environment is undoubtedly beneficial for commercial real estate. For investors, the danger is that expectations remain anchored in the days of higher returns, leading to the chasing of unrealistic performance at the cost of elevated levels of risk. However, for those undertaking appropriate strategies, we believe the cycle will continue to deliver.