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Global real estate outlook for 2015

Michael Keogh, Associate Director of Research & Strategy, provides a global real estate outlook for 2015.

Introduction
2014 looks set to deliver the strongest year of commercial real estate performance and investment activity since 2006, with sharp improvements in capital growth helping to propel stellar returns in what remains a low-growth, low-inflationary global economic backdrop. The speed and extent of the recovery has surprised many, yet ultra-low bond yields, selective economic recoveries, lower bank-related stress and improving lending terms have all combined to underpin robust domestic and cross-border investment transactions. Pricing across some of the core, more liquid real estate markets, which are recording economic growth and are supported by good property fundamentals, have seen pricing touch previous highs. More opportunistic investors have acquired quality assets in markets previously overlooked, such is the desire for higher return; but buoyant activity and keen pricing remains well ahead of any broad improvement in leasing activity - which largely reflects certain major macro-economic and geo-political headwinds.

So what can we expect in 2015?
Last year was meant to be relatively quiet from a geo-political standpoint, providing economies with the necessary support to deliver on a return to growth. Although this was not the case, it is precisely these fears that still engulf equity and bond markets, whether it's government debt, inconsistent growth, or dis-inflation, that maintains commercial real estate as an attractive relative asset class for 2015. The prospect of divergent Central Bank policy stances will be a key determinant in capital flows, transactional volumes and pricing in the coming year. UK and US policymakers are likely to move well ahead of both the ECB and Japan, with employment and growth more resilient. However, such is the fragility of global growth and the weakness of inflation that any rate move will be glacial-like, well-documented, and most likely pushed into 2016. This will not necessarily mean an associated softening in real estate pricing, as with the prospect of future interest rate rises, rental growth (selective) should also materialise from a stronger economic environment, supporting heathy, albeit more income-driven, market returns.

Property has developed as an increasingly held stock in a multi-asset investor’s portfolio for three fundamental and rather traditional reasons: the high income component of return, the relative risk-adjusted return, and diversification benefits. With greater volatility associated with both equities and bonds, and those asset classes already at market highs, it comes as no surprise that a recent Preqin Investor Interview survey stated that 93% of respondents wanted to increase (41%) or maintain (52%) their allocation to global real estate in the longer term. This provides further comfort around present pricing, and the resilience of performance projected in 2015.  

Europe: ECB measures to persist as growth wavers, aiding commercial real estate attractiveness
Whilst it is true that present economic indicators make for pretty grim reading, ECB action and the prospect that governments can use cheaper finance operations to step up structural reforms, should provide some relief in 2015. In a global hunt for yield, certain macro-issues have not deterred some investment managers keen to deploy capital early in the cycle to capture performance. According to annual figures to September 2014 from RCA, Europe has recorded positive net real estate investment from all the other continents. Looking forward, this trend will be tested unless Europe can return to growth, and enable occupier markets to recover sufficiently to justify the intensity and direction of recent capital flows, and the associated price adjustment. But equally, global real estate allocations need to be understood in a wider context with an understanding of market conditions at the capital’s origin. Accounting for some degree of currency exposure, what is deemed expensive in one market (Europe) can look attractive to another (Asia), while assisting in a growing need for diversification. As changes in regulation enable more players to enter real estate, and the volatility and price of equities and bonds continues to spook investors, greater allocations to commercial property have the potential to keep real estate pricing keen in the near term, even if growth disappoints. With risk free rates dwindling in the Eurozone, and likely to remain low for an extended period, plus growth and inflation forecasts well below target, what historically would seem like very sharp pricing for assets in Germany, UK and France, could therefore persist (or even harden marginally) in 2015, buoying returns.

Asia: Strong demand, limited stock
In many ways, the Asia-Pacific story mirrors real estate divergence across Europe, albeit with a stronger economic framework. Consensus expects expansion with Asia-Pacific of 4.8% in 2014 and 2015, although weakness in both Japan and China have the potential to undermine market confidence, and keep monetary and fiscal policy supportive. In terms of investment volumes, activity remains robust, with resilient domestic and growing cross-border investors likely to push pricing keener into 2015. As such, and with a scarcity of product, investors are likely to turn attention to potential alternative markets, as long as investor principles are not compromised. This will mean interest in the more liquid, transparent centres of emerging Asia-Pacific, or maturing commercial real estate markets across established economies. However, given the limited yield spread now evident across the major centres throughout established Asia-Pacific markets, it is unlikely that investment volumes in 2015 will maintain recent momentum.

US: Yield to rental cycle from 2015
Consensus has economic growth of 2.2% in 2014, rising to 3% in 2015. With inflation subdued, we remain of the view that rate rises will be both very gradual and well flagged, giving markets time to prepare. This should be sufficient to deliver a return of over 10% in 2014, a fifth year of double-digit total returns, whilst the the PREA Consensus Forecast Survey, as of Q4 2014, implied a total return in 2015 close to 9%. This year’s return, however, will be more driven by rental appreciation rather than notable further inward yield movement, particularly in gateway markets. As confidence improves, investors will continue to be attracted to pricing in non-gateway cities or good secondary assets, but given the weight of capital that has already diminished some of the relative pricing appeal of those markets, outperformance will only occur where true occupier strength exists. The robustness of the US economy, coupled with the swift repair in its banking system, has meant the US real estate recovery is ahead of its European counterpart. Pricing may be equally as keen in the major markets, itself a product of excess liquidity and low treasury yields; but broader market conditions look far healthier. Unsurprisingly though, it will not be uniform. Those cities aligned to the boom in energy or technology have recently, and look set to continue to, outperform in the near term, but are also susceptible to external macro events.

Obstacles that could derail performance
Hopefully the worries about 2015 are, in part, a recognition of prevailing problems rather than new difficulties. Much debate relates to a lack of growth in Europe, with markets being sustained by an expectation of ECB action to stimulate expansion. A realisation that there is limited QE appetite, given German opposition, or ability for action, plus questionable intent to reduce deficits or enact structural reforms, could cause certain country debt spreads to widen again. And given the already record low yields across Europe and precarious state of the region's banks, a return to healthy growth could prove too challenging. As such, deflation or dis-inflation could spook bond markets, pushing sovereign yields out in the more highly leveraged economies. This, without an erosion of properties’ associated risk premium, could make further price increases harder to justify or cause yields to edge out. Against a back drop of low growth and pressure to reform, one cannot ignore potential political risk, with several European countries entering an election year in 2015, namely the UK, Spain, Greece and Finland. There have also been recent political upheavals in Sweden and Japan. Although Prime Minister Shinzo Abe of Japan may have won the Liberal Democrats four more years to implement his programme, his ability to finally reinstall inflation and growth will be heavily scruntised. But lingering political uncertainty, leading to economic and financial market inactivity, will undermine real estate performance, from both an investment and occupier perspective. Finally, whilst low commodity prices are proven to support global expansion and will be a relief to consumers and businesses alike, it could if persistent, reduce the investment capabilities of Sovereign Wealth Funds and High Net Worth Individuals. This would be most telling to the more globally exposed real estate markets such as London or Paris. However, such is the level of alternative equity, and the attractive long-term outlook for these markets, that the potential pricing threat would likely be manageable. 

Conclusion: 2015 looks set to be '2014 light'
The swift re-pricing of major markets globally, as investors have sought comfort in liquidity and where growth has been restored, has been the theme of 2013 and 2014. Whilst acknowledging the economic headwinds, it is most likely that persistent financial market fragilities will support solid real estate performance into 2015, with the potential of some further positive yield movement. But investors should begin to realign themselves to what will be a more rental driven cycle. It is likely to be very selective and asset specific, and not that robust, but combined with asset management, should deliver more than income-like market returns which are broadly projected outside of gateway markets. These will still be very attractive on a relative comparable asset class, and sufficient for some institutions given such a low inflationary environment. Plus, with new players and greater allocations seemingly being deployed to commercial real estate, investors will have to be more global in their allocations and nimble in accessing markets to achieve outperformance in 2015. Further afield, our real estate projections are more moderate, incorporating some glacial normalisation in borrowing rates. It will be very difficult to highlight best value picks but as a house, our Tomorrow’s World and megatrends initiatives aim to focus on those sectors and markets that are poised to perform robustly in an evolving, albeit ever volatile world.

Disclaimer
This article is intended solely for the use of professionals and is not for general public distribution. Any assumptions made or opinions expressed are as of the dates specified or if none at the document date and may change as subsequent conditions vary. In particular, the document has been prepared by reference to current tax and legal considerations that may alter in the future. The document may contain "forward-looking" information or estimates that are not purely historical in nature. Such information may include, among other things, illustrative projections and forecasts. There is no guarantee that any projections or forecasts made will come to pass. International investing involves risks, including risks related to foreign currency, limited liquidity particularly where the underlying asset comprises real estate, less government regulation in some jurisdictions, and the possibility of substantial volatility due to adverse political, economic or other developments. Past performance is no guarantee of future performance. The value of investments and the income from them may go down as well as up and are not guaranteed. Rates of exchange may cause the value of investments to go up or down. Any favourable tax treatment is subject to government legislation and as such may not be maintained. The valuation of property is generally a matter of valuer’s opinion rather than fact. The amount raised when a property is sold may be less than the valuation. Nothing in this document is intended or should be construed as advice. The document is not a recommendation to sell or purchase any investment. It does not form part of any contract for the sale or purchase of any investment. TIAA Henderson Real Estate (TH Real Estate) is a name under which Henderson Real Estate Asset Management Limited provides investment products and services. Issued by Henderson Real Estate Asset Management Limited (reg. no. 2137726), (incorporated and registered in England and Wales with registered office at 201 Bishopsgate, London EC2M 3BN) which is authorised and regulated by the Financial Conduct Authority to provide investment products and services. Telephone calls may be recorded and monitored.
  

Michael Keogh

Mike Keogh

Director of Research

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