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#Real Estate — 03.05.2017

Real Estate: What Type of Assets Should Investors Buy Today and Where?

Pol Robert Tansens

We recognise that based on current valuation levels, it will be virtually impossible to create value with prime (trophy) commercial real estate assets in many parts of the world. But does this mean that we should skip prime investments altogether in the long run?

It could well be that pricing for prime real estate – generating steady income – will prove solid (stable) at the end of the day. Big institutional investors, such as pension funds and insurance companies, are diversifying their investments (including real estate as an alternative investment to more traditional asset classes such as bonds and stocks). In addition, commercial real estate markets in Europe do not appear overbuilt. There’s not a vast availability of building space and prime products are difficult to find.

In reality, investors in prime commercial real estate could consider these investments as “investment grade” bonds (albeit including a cyclical aspect). They should hold on to their investments for a long period, accepting the net rental income as their sole return on investment. In other words, the quality of the tenant is paramount (as well as location, location, location!). Furthermore, rents carried by scarce prime assets could grow at a faster pace than underlying values (the opposite of what we have seen in previous years, London offices being the exception).

Obviously, we believe many investors will continue to consider a wide range of “alternative” property types as well, in the primary and secondary property markets. Investors are heterogeneous, and this fundamental fact permeates all aspects of investments (for example geography, use of debt financing, type of product). Hence, investors have been increasingly examining “value-added” investments in primary and secondary locations (whether in Europe, Asia or North America), and alternative higher-yielding investment options including student accommodation, elderly homes, hotels and industrial assets. Total returns should be double-digit. We expect demand for logistics and “alternative” assets to remain very robust because of the higher net rental income they command while anticipating the positive effects of growing e-commerce.

“Passive” investors who do not want to be directly or deeply involved in the management of underlying assets could use the specialised expertise of asset managers to obtain an incremental return to compensate for the higher risk incurred. They could buy units of closed-ended property funds that invest directly in primary assets, and/or purchase units from closed-ended funds which, in turn buy stakes in other investment funds.

The point here is that the risk and return performance is not entirely determined by the fundamental characteristics of the underlying physical assets or by the environment these assets/units are traded (off-market deals offered at a discount etc.). These investors should have a dual investor objective (income and growth) and take into account a number of factors, such as risk, liquidity and investment horizon.

A final word on the listed real estate markets (Real Estate Investment Trusts or REITs). As REITs trade in the stock market, REIT share values may – temporarily – reflect the functioning of the stock market rather than the direct real estate market. That became evident in the days just after the Brexit vote. Unquestionably, rising nominal interest rates pose challenges for REITs as well, making their relatively high dividend yields less attractive when compared to lower-risk, fixed-income securities. UK REITs should be vulnerable in the coming months, with falling capital values on the horizon. Luckily, UK REITs have significantly lower debt levels today than during the financial crisis of 2008. All things considered, we believe REITs should be added to any real estate wealth portfolio, even though listed property companies may be subject to an overreaction and excess volatility, at least in the short run.

Read our Real Estate Strategy Report executive summary on our Voice of Wealth app available on the App Store and Google Play