Real Estate: diversification is trendy once again!
As volatility – uncertainty – has returned to the financial markets since the beginning of the year, weighing on investors’ sentiment, the low interest rate environment has been boosting property values in recent years. Yet, diversification will be key to secured investment.
Investors could supplement prime investments in gateway cities with new acquisitions located in markets that are further behind in their property cycles, that are less “mature”. Examples are plentiful, certainly in Europe: regional cities in the U.K, France, Germany, the Iberian Peninsula, Central Europe, the Netherlands – the so-called Tier-2 markets – or properties with growth potential within the mature Tier-1 markets. Chances of value creation and rental growth are higher, certainly on deals sourced “off-market”. Obviously, risks are more important as well but should be contained through moderate leverage. A good asset manager is crucial for those investors not willing to implement such a “value-added” strategy on their own. We are enthusiastic about the latter investment strategy, though time is elapsing fast. Discounts on acquisition prices are narrowing, so it might prove more challenging to secure deals with potential in the future.
Low nominal and real interest rates.
Our BNP Paribas Wealth Management economists are predicting that interest rates will linger at low levels for the next 12 months (with the Federal Reserve – Fed – likely to proceed to one interest rate hike of 25 basis points this year instead of the three initially forecast). Moreover, the accommodative monetary policy in Continental Europe and Japan is being pursued. So the lasting low long-term sovereign bond yields (and mortgage rates) will provide a longer-than-expected opportunity for property investors to (re)finance assets. This also explains why we do not expect any imminent spike in gross prime yields. They are likely to oscillate around the current low levels for a longer period, limiting not only the risk of potential capital losses but at the same time the potential for significant capital growth. As a consequence, investors should accept “plateauing” real estate values. Our opinion is also valid for the share prices of Real Estate Investment Trusts (REITs), trading at reasonable dividend yields compared to risk-free rates. In fact, we are now changing our recommendation from Neutral to Positive for Continental European REITs because of the higher-than-expected spread between gross dividend yields and long-term risk-free rates (among other factors such as good annual results for many REITs).
Commercial debt and housing mortgages available.
The post-crisis deleveraging process has been gradually winding down. For example, total debt secured against commercial real estate in the U.K. fell by less than 1% in the first half of last year, which was in sharp contrast with the annual 6-10% decline in previous years (source: De Montfort University). Debt levels may even rise somewhat in the years ahead thanks to new lending. Mortgages are also available in the residential sector, with many buyers having (re)financed properties at more than attractive conditions over the last few months. Moreover, loans that are seriously “under water” - debt at least 25% higher than the estimated value of the houses securing them – continued to fall in the U.S. at the end of 2015, representing 11.5% of all properties with a mortgage (from 28.6% in 2Q12, source: RealtyTrac). Some market authorities are even concerned by credit exuberance, monitoring credit data with high interest; the Bank of England’s Financial Policy Committee wants to avoid “buy-to-let” lending getting out of control in the U.K.
Investors’ profile likely to change, though not necessarily investment volumes.
So in a world of very low interest rates and political uncertainty, private and institutional investors alike have been rushing money into secured real estate (not to mention trophy assets). International investors from the troubled emerging markets have been very active in recent years. Examples are numerous such as the unappeasable Chinese investment appetite. In the U.S., housing sales to foreign buyers climbed from USD 68bn in 2013 to USD 104bn in 2015, of which USD 28.6bn went to Chinese investors alone (source: National Association of Realtors). The Chinese also went on a buying spree in Sydney, Singapore, Hong Kong, Tokyo, Vancouver, London, New York … The key question is whether capital from Chinese, Malaysian, Russian, Middle Eastern and other emerging market investors will continue to flow in through the world’s well-known gateways in the years ahead. In our opinion, a change in the typical buyer nationality is possible. With the U.S. dollar being strong, the international investment market could see far more American buyers in 2016.
Protection against unanticipated inflation.
The actual lack of a “healthy” inflation level in the economically mature markets should normally be bad news for real estate investors, with rents (and values) partially indexed to specific inflation indices in many countries. Fortunately, the “the wall of investment money” has taken over the role of demand inflation to bolster property values over recent years. However, if investors were to buy real estate today, they could still benefit from unanticipated inflation in the years ahead – in contrast to non-indexed bonds for instance – on the condition that the cost of borrowing is capped at the moment of purchase. Japan is an excellent example to demonstrate this. Having long been dismissed as the country of falling housing prices, its property markets are staging a come-back. The weaker yen (thanks to Japan’s accommodative monetary policy aimed at importing inflation through a weaker currency) has raised perspectives for inflation in the years ahead, giving impetus to its real estate markets. As a result, domestic and international investors have been buying houses, apartments, commercial real estate and Japanese REITs over the past 2 years. Housing prices in real terms increased by 9% in the year to 3Q15 (source: Global Property Guide).
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