Leading fund managers and strategists assess the state of global real estate markets.
9/24/2019 | By Sarah Borchersen-Keto and Diane Rusignola
REIT magazine: September/October 2019
With underlying fundamentals remaining positive—despite the length of the current cycle—the U.S. continues to be a leader in the global commercial real estate market. At the same time, asset class performance across global markets is moving largely in step, with industrial real estate providing a striking example that consumer trends have no geographic borders. Trade tensions, interest rate moves, ESG performance, and potential supply and demand imbalances are all top of mind for global investors. REIT magazine spoke with five fund managers and investment strategists to assess their views on the state of the global real estate markets today, where they see growth opportunities, and the trends they are watching for 2020.
U.S. real estate returns are outpacing other global markets this year. Do you expect that trend to hold?
Ted Bigman: We expect that there will be some reversion to the mean and that parts of the global market that have lagged the U.S. will probably outperform the U.S. for some period of time, given that the U.S. is trading, on average, at or above its typical average price to NAV, whereas other regions are trading below their traditional price to NAV averages.
Nora Creedon: Investors view the U.S. as a relative safe haven. In general, U.S. REITs have improved their balance sheets tremendously over the last decade, well beyond other developed markets. So, if the global credit markets become more volatile, the U.S. looks relatively more attractive. We are quite focused on where we can find stronger economic growth and therefore stronger property cash flow growth, and by and large, that’s strongest in the U.S. right now. Lastly, the strength of the “niche” sectors are all differentiators for U.S. returns relative to the global returns.
Scott Crowe: We’re at the right part of the interest rate cycle for REITs to outperform, where the underlying fundamentals for commercial real estate are still pretty good. We are late in the cycle and likely to have a slower economic future in 2020—maybe a mild recession—but we’re not suffering from the three evils that normally cause a big problem at the end of a cycle—over-leverage, over-supply or over-valuation. That means that the real estate market is in a pretty good position to weather any economic slowdown, but you now have the tailwind of falling interest rates which will mean that cap rates remain very firm, even into a softer economic future.
Bernhard Krieg: Generally speaking, we believe U.S. real estate is in a “sweet spot,” with low rates, low inflation, and low-to-moderate growth. Fundamentals continue to remain strong with supply and demand dynamics allowing for positive rental growth rates. Additionally, balance sheets are healthy, and leverage is at near-record lows.
Sherry Rexroad: In the current lower-for-longer rate environment with more moderate global growth, I do expect the trend to hold. I think that real estate fundamentals are strong. The fundamentals, combined with that broader investor sentiment, is very good for U.S. real estate returns.
To what extent have global trade tensions impacted your view of investment opportunities?
Crowe: It’s certainly at the margin unhelpful as it relates to economic growth. We live in a world of global supply chains. What we’re doing is making investment decisions more uncertain and slowing down business investment. It’s certainly contributed to the economic slowdown that was already underway because the Fed had over-tightened, but the bigger area where it causes us concern is China.
Bigman: To date, global trade tensions have impacted sentiment more than they have impacted real operating performance. That can create an opportunity to access real estate cheaper because certain stocks have been beaten up as a result of negative sentiment. The biggest place that trade tensions specifically have had a negative impact in the U.S. is on the owners of retail properties as we have also seen the shares of U.S. retailers suffer from the expected imposition of tariffs on their goods. On a broader basis, to the extent trade tensions have negatively impacted the outlook for the economy, we have also seen weakness in the hotel REITs.
Rexroad: We build a multi-year financial model on every company we follow, and global trade tensions have caused us to bring in our economic growth as well as our earnings growth assumptions. As we have incorporated that more moderate global growth as a reflection of the global trade tension, that has resulted in a contraction of our forward AFFO (adjusted funds from operations) estimate. The U.S. is less impacted than Europe and Asia.Creedon: REITs are more isolated from this risk than many other sectors in the equity market, given they are more domestically tilted businesses.The tensions have been a driver in lowering interest rates, and that’s driven valuation expansion. But there are negative implications that could clearly arise; we sit in an already challenging environment for U.S. retailers, and the tariff situation is likely to make that worse. There’s quite a bit of impact in Asia, and Europe is not immune either; most obviously you have the effect of trade barriers in autos, which could have a meaningful impact on German real estate.
Are you seeing similar patterns in terms of asset class performance across global markets?
Rexroad: Global mega trends that are having an impact include technological disruption, demographic changes, urbanization, and climate change and sustainability. All of those trends are impacting our real estate companies globally. The companies that succeed are the companies that recognize those trends and build their businesses to accommodate, and profit from, the change. Technological disruption is the most important trend, because we see it in every asset class, whether it is WeWork in office, Airbnb in lodging, or e-commerce in retail and industrial. The next biggest trend is demographic change when you consider how the aging population is going to change our labor force and the demands for senior housing and skilled nursing.
Creedon: The most similar pattern is the relative weakness in retail and strength in industrial, driven by online sales growth. The retail struggle stemming from online spending trends translating to softening demand of bricks and mortar real estate is moving east from the U.S., and we are seeing that impact on U.K. and European retail landlords. Retailers in Asia are continuing to undergo structural adjustments that include shifts in the demand for physical space. Meanwhile, industrial strength is global. Thus far, demand is easily keeping up with supply, but this is something we vigilantly monitor.
Crowe: Industrial is a global phenomenon. Even if the economy slows down, industrial warehouse distribution is very likely to continue to have strong demand because it’s just more efficient and cheaper. Consumers are increasingly preferring to consume through digital means. This trend toward consumption through e-commerce is not going to stop anytime soon.In office, new space continues to see rent growth, old space does not. On the positive side for multifamily, there are also more renters—either by choice or necessity.
India’s first-ever REIT debuted earlier this year. How encouraging is that, both for India and other markets new to REITs?Krieg: While it has taken a long time for the first REIT in India to list after passage of REIT legislation, we are encouraged and hopeful to see more REITs in India and other new REIT markets globally. The Embassy Office Parks IPO signals credibility for more sources of capital to enter the market, which has positive long-term growth drivers.
Creedon: We are very encouraged by these markets. Beyond India, we believe several emerging markets will see the launch of REIT structures in the next few years, including markets such as the Philippines. China will be a huge opportunity that we are keeping our eyes on. Talk of REITs just started in Indonesia. We expect South Korea to have a REIT compatible with international standards in a year or so.
What are you seeing in terms of investors favoring global assets that are reporting on and performing well based on environmental, social, and governance (ESG) metrics?
Creedon: This is a huge area of focus for our clients and for us. We don’t believe an ESG focus comes at the cost of returns and, in fact, believe it’s now the opposite. Companies globally have increased their focus on ESG factors and disclosure around ESG metrics. Interestingly, we also think it’s becoming easier to comply with ESG goals with the advancement of various technologies, which in many cases have helped the lease-up of new buildings and lowered cap rates.
Rexroad: ESG efforts have long been important to investors in Australia and Europe. They are increasingly important to U.S. investors, particularity in U.S. public pension plans. They are on the rise in Japan, but I rarely see ESG referenced throughout the rest of Asia.
Historically, people have looked at ESG as a screening technique to decide whether an asset or a company was “good” or “bad.” Now, we look at how to quantify the risk that a company’s ESG policies represent (environmental statistics, social policies, and corporate governance practices).
Krieg: We have certainly seen an uptick from our investors in the level of inquiries around how ESG factors affect investment decisions, particularly from European investors. Generally speaking, real estate companies score well on most traditional ESG metrics when being compared to the broader corporate universe, and that’s a positive for the asset class as a whole.
Bigman: Investors have been focusing on corporate governance for a very long time. And now, most real estate companies that we invest in have a sustainability officer. We’re in the early stages of having companies differentiate themselves in terms of how they apply their standards.
As you look ahead to 2020, what do you expect will be top of mind for global real estate investors?
Crowe: Top of mind is whether or not we’re in a recession. What does the slowdown in this cycle look like? It’s more likely to be a corporate-led slowdown, as the consumer will be in pretty good shape.Bigman: We are most focused on this unprecedented disparity in valuations among and between the sectors, in each of the major regions of the world. Can these disparities get any larger? Or how much will these disparities tighten? Some sectors are trading at 30% and 40% premiums to NAVs and other sectors are trading at 25% and 35% discounts to NAVs.
Rexroad: I think the economic and political environment is absolutely the top question. Which country you are focused on is probably determined by where you sit. The U.S. has the broadest reach, so there’s hyper focus on our economic number. Trade wars are a large concern, followed by the U.S. presidential election, and Brexit.
Creedon: We think (global) investors will continue to debate the future of physical retail space, the effect of coworking and flexible leases on the office space, and the seemingly never-ending demand in the logistics arena. The cycle has proved extremely difficult to call, and so that will continue to be a debate. We and others are looking for the next areas of disruption and thinking through how technology can help some real estate become more productive.
Krieg: On a macro level, the ongoing trade conflict—not only between the U.S. and China, but tensions between the U.S. and other trading partners. The upcoming presidential election in the U.S. is also a key macro event that investors will obviously be watching as well.
Particularly top of mind will be the direction and magnitude of any change in interest rates. The [real estate] asset class has benefitted from more moderate levels of rates, and we foresee rates staying subdued in the near term. In terms of fundamentals, we think new construction supply is at reasonable levels, with demand keeping pace across most property types.
What do you see as some of the most compelling markets in Europe and Asia?
Bigman: The most compelling opportunities are those where the share prices trade at a substantial discount to their private market values. In Europe, this includes the large cap stocks in the U.K. that own office and retail assets, known as the U.K. majors, whose shares are trading at extreme discounts, as well as the owners of high-quality malls on the Continent. In Asia, the Hong Kong property companies that are owners of commercial assets are trading at the some of the widest discounts between private real estate value and share prices that we see on a global basis.
Rexroad: In Asia, I think that the Japanese market will continue to be supported because they are viewed as a safe haven and an income generator. In Hong Kong and Singapore, the interest rates are tightly tied to the U.S. and benefit from the U.S. rate reduction. However, political protests in Hong Kong continue. In Europe, it really varies not just country to country but also property type to property type. For example, continental office is strong and we love German residential; yet, in the last six months, those companies have sold off, particularly those tied to Berlin because of rent control issues.
Krieg: We remain cautious on the Hong Kong market based on trade tensions. We do, however, see some attractive value opportunities within some office and retail landlords with strong balance sheets and severely discounted valuations.