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#Market Strategy — 21.05.2018

Real Estate: Is It a Good Time to Invest in Property Now?

Pol Robert TANSENS & Prashant BHAYANI

There is some wariness by investors after the appreciation of property prices globally and the rising interest rate environment in the US. Our objective is to summarize the key debates among property investors and also address where the potential best opportunity set might be currently.

It is important, in this regard, to take into account the heterogeneous nature of property globally and our view of the economic cycle in the coming years.

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Is the US housing market going to crash like in 2008?

The epicenter of the last housing crash, the sub-prime market, only accounts for about 5% of the current US mortgage market compared to 20% back in 2015. In addition, the average credit score of a mortgage borrower in the US during 2016 is amongst the highest since 2001, mainly due to more stringent regulations and tighter lending standards.

Overall, home ownership is lower now than in the last cycle. (Source: CoreLogic’s Housing Credit Index)

While selected individual housing markets have had rapid price appreciation, presently, the overall house prices adjusted for inflation are at approximately 2004 levels (Source: Bloomberg, June 2017). Of course, a correction in the housing market can occur in the next cycle, though a 2008 style crash remains unlikely at this point.

What is the impact of rising rates on property returns?

Conventional wisdom is that lower financing rates boost real estate returns. After witnessing one of the greatest bull markets in the history of fixed income, how could higher rates impact property returns in the future?

We believe that interest rates are just one component that drives property returns.  In fact, in times of rising rates, property still has positive returns in most interest rate cycles, contrary to conventional thinking.

Chart 1

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Why? This is logical as rising rates reflect an improving economy, boosting employment and business formation, and generating property returns.  Rents would start rising too, and higher recurrent income would be reflected in values after a realistic time lag.

Given that nominal interest rates are projected to rise at a measured pace, this should allow the real-estate market to calmly adjust without triggering any serious “disruptions”. This has been what is happening across the US real-estate market in recent months.

Moreover, real interest rates could also stay more or less stable, and real interest rates have a seemingly higher significance for property investments.

What about the interest rate cycle outside the US?

The world is in different economic cycles with the US in a mid to late cycle, and Europe and Asia earlier in the cycle. Therefore, in terms of central banks, they are still in the midst of the interest rate cycle in the US, while Europe and Japan have yet to even begin.

Furthermore, in terms of the last interest rate cycle in the US, the Fed Funds rate increased from 1% to 5.25%. Given the lower level of trend growth in the US due to technological innovation and lower population growth, we would expect interest rates to peak at a much lower level between 2.5% to 3.0%.

Therefore, while interest rates are just one factor to drive returns, their amplitude should be significantly lower than the prior cycle. Currently, markets seem to be already pricing in nearly 3 hikes over the next year.

Hence, the concept of carry and search for yield with aging demographics and increased savings could be a positive driver for real estate. Investors will look for the carry and inflation protection to complement their fixed income holdings given the general low yield environment.

What about current core US commercial real estate? Steady unleveraged total returns generated by core real estate at this point

Commercial US real estate continued to deliver strong unleveraged total returns in spite of higher nominal interest rates between 1 January 2017 and 31 March 2018. The total return for 2017 - carried by a mix of offices, retail, industrial, hotels and apartments - was just below 7%, somewhat above our expectations.

The average loan-to-value ratio was 42%, and the average interest rate paid was a fraction below 4%. For the first quarter of 2018, total return for core commercial property in the US - before leverage - was 1.7%, a fraction below the 1.8% in 4Q17 (source: The National Council of Real Estate Investment Fiduciaries NCREIF, 25 April 2018). Evidently, returns on equity were higher after reasonable leverage.

Focus on the rise of non-traditional sectors. We believe it is not about a “core” strategy but about a “value-added” investment strategy at this point of the cycle

“Value-added” investment opportunities (or more aggressive opportunistic acquisitions) are not reflected by core indices and today, we believe a value-added investment approach should be favored over core properties.

Apart from some specific investments (in logistics/storage and alternative sectors such as student housing for instance), we expect property capitalization rates to stabilize at pretty low levels, similar to almost anywhere else in the world.

Hence, even though property yields could still fall in the industrial/logistics sector due to the benefits reaped from e-commerce, property yields could stay flatter in other sectors, limiting capital appreciation returns.

Therefore, asset managers need to target assets that do not necessarily have an “investment-grade” status at the time of acquisition. The rationale behind this is to reposition and revalue the property - or a portfolio of properties - in due course before selling (exiting) afterwards.

The process of “adding value” could be supplemented with somewhat higher (though still acceptable) leverage compared to “core” properties. Indeed, it is expected that unleveraged returns generated by value-added properties will still exceed the interest rate on debt financing, even if interest rates rise further.

Benefits of Diversification into value-added/opportunistic properties

We are of the opinion that any diversification of value-added property investments is a wise idea, not only within the US - which is so vast that a “single” real-estate market simply does not exist - but even outside the US. Property markets tend to be less correlated - thus more diversified - in “normal” times (when there is no major financial crisis).

For example, the Dallas property market can by no means be compared with New York’s, and the housing markets of the West and the East Coast are subjected to different return drivers. Therefore, capital appreciation is different from one region to another, and even recurring income such as net rental streams should be diversified to reduce risk.

As such, a value-added/opportunistic investment strategy should be implemented irrespective of property cycles and market conditions in general.

Returns also favor a longer investment period.  Don’t focus just on the opportunities in the next few years. A downturn can create opportunities for cash-rich investors/managers who can rapidly act and seize opportunities. In addition, not all assets should be bought at the same time, allowing acquisitions to be spread over a reasonable period of time (at least a few years).

This will allow better pricing and enhance return perspectives once property cycles start recovering. Manifestly, real estate managers with a superb track record - of at least 10-15 years encapsulating different property cycles and market conditions - should be selected by investors who are unable or unwilling to implement a value-added investment strategy by themselves.

Obviously, the growth investment objective implies a relatively long investment horizon (often up to 10 years), with no immediate need to use the invested cash.

Our current view is for the global and US economic expansion to extend into 2019 with a relatively low chance of recession.

Furthermore, as the different regional cycles mature, it will create additional opportunities for investors who have longer-term investment horizon, able to take more risk and those who can be patient in deploying their capital.

In addition, there is historical evidence (Chart 1) to show that the current macro environment of rising interest rates does not necessarily have a negative impact on property returns.

Finally, property investors should consider value-add/opportunistic strategies that can still extract value at this point in the cycle.