Real Estate: Investing Through the Cycle
Real estate assets offer diversification, income and inflation protection for investors who can look beyond the current economic cycle.
Real Estate has traditionally delivered strong long-term returns, allowed investors access to leverage and offered stability in periods of uncertainty in the capital markets. However, the real estate sector is now facing some powerful headwinds as central banks take action against inflation with rate rises at a pace unseen since the 1980s.
There are signs that hot property markets are already cooling as borrowing costs rise. US home sales declined in June for the fifth consecutive month. Predictions of a recession also raise the risks of a correction in the housing market. Although home price appreciation is slowing, we expect it will remain positive in 2023 and accelerate again in 2024.
We believe real estate remains a core component of any successful long-term wealth management strategy. Rental income can offer a natural hedge against inflation, and real assets provide valuable diversification from the volatile public capital markets.
So how can investors approach real estate investments in today’s climate?
Generally, real estate is an option for diversifying an investment portfolio: it is not closely correlated with equities, bonds, or commodities. It allows access to leverage and enables investors to access suitable assets and increase returns. As higher borrowing costs are likely to cool the market in the short term – this can provide a lower entry point for long-term investors.
Residential properties represent a solid proposition for a ‘core’, buy-and-hold investment strategy that will generate a resilient revenue stream over the longer term. The sector has various advantages that have helped it remain resilient to past crises, including the Covid-19 pandemic. In 2020, house prices in most advanced economies rose: the International Monetary Fund (IMF) estimates that house values in 23 of the countries in its 60-member Global House Price Index rose by more than 5% during 2020.
In the residential sector, a well-positioned, high-quality property represents a comparatively low risk as they maintain their value through consistent demand. And while returns tend to be derived from rental income rather than capital appreciation, these higher-quality properties generally do not require significant further capital expenditure once they have been acquired.
We favour residential real estate, particularly in the US, because construction of new homes in the US has not recovered to normal levels since the Great Financial Crisis, resulting in a supply shortfall. Furthermore, the current high inflation environment has resulted in higher labour and material cost, further restricting new supply.
Higher mortgage rates will also result in reduced affordability, pushing more people to rent. This supply –demand imbalance will be positive for the residential sector.
As property is an illiquid asset, buying and ‘flipping’ is a risky strategy – particularly during economic downturns. However, investors pursuing ‘core’ strategy may consider tapping growth opportunities while spreading risks by investing in a public and/or private real estate investment trust (REIT) that offers diversification across geography and sectors.
Inflation is a challenge for commercial property investors as real estate management involves a number of ongoing costs, including maintenance, rates and management fees. It is the quality of the asset that determines the landlord’s ability to pass on these costs to tenants and can make the difference between a profitable investment and one that fails in its purpose.
Sector selection is also important when investing in commercial properties. Demand for certain kinds of commercial property such as logistics is growing strongly, in line with new consumer habits: online shopping volumes increased 46% during the first two years of the pandemic – 20% of all retail shopping. For every US$1 billion in new e-commerce sales, 1 million square feet (92,903 m2) of new logistics space is needed.
This trend will create demand for an additional 160-200 million m2 of logistics space globally in the next five years, driving rental growth in underserved markets. Conversely, demand for retail properties is declining and expected to decline further as ecommerce penetration increases further. The work from home phenomenon has also resulted in office sector prices to decline.
Investors with capital to deploy and a tolerance for more risk can approach real estate investment through a ‘value-added’ strategy. This targets commercial assets that require some additional investment to improve their facilities or to repurpose their function. This will attract newer tenants and increase occupancy rates.
The new tenants will also be more amenable to paying higher rental rates and thus indirectly resulting in higher property values. This approach typically requires an investment of more than five years, but the improvements could potentially contribute more significantly to both income and capital appreciation from the property.
Higher-risk, ‘opportunistic’ strategies are also available for investors in search of higher potential returns. This involves selecting promising assets that require substantial investment through renovations or improvements and sometimes redevelopment, but the potential rewards are correspondingly greater. Time to profitability may be longer too as returns are driven primarily by capital appreciation.
A range of public, private REITs and other private real estate funds can offer exposure to these strategies in the commercial real estate sector.
The global economy is set for a period of some uncertainty and volatility, but recovery is always not far away. Taking a lower-risk ‘core’ or ‘value-added’ approach to real estate investment – and perhaps focusing on the more predictable residential sector through a well-chosen REIT – represents a sensible, balanced way of gaining exposure to the sector at this point in the interest rate cycle.
Disclaimer: BNP Paribas, acting through its Hong Kong branch is not licensed to deal with any real estate property situated in Hong Kong. BNP Paribas, acting through its Singapore branch is not licensed to and does not offer real estate service, and nothing herein should be construed as such.