Investors have been drawn to real assets in general and to real estate in particular due to the comparative stability and attractiveness of their income returns and the prospects for growth.
A recent heightening of capital market, political and geopolitical risk levels has resulted in a less certain outlook for investment assets broadly, including real assets. This may reinforce the attractiveness of real assets’ income potential, which is largely based on long-term contractual cash flows.
Three themes to watch in 2017
Presently, three themes dominate investors’ concerns about real assets for 2017: current prices, future performance and predictability in the light of political developments.
- Prices. In many markets, the real estate yields/cap-rate spread over local long-term government bond yields are close to the long-term average spread. In Europe and parts of Asia Pacific, spreads as of mid-November were more than one standard deviation above the long-term average. This gives some comfort that, relative to other asset classes at least, real estate prices are not out of line. It also suggests that in a macro environment of modest inflation and low interest rates, there is little reason to anticipate an imminent or sharp upward movement in real estate yields/cap rates. Indeed in much of the world, yields/cap rates seem at least as likely to remain stable or even to fall further first, which could result in upward pressure on prices.
- Performance. In many ways, the outlook for future performance depends on the potential for growth in real estate net operating income. The outlook for market fundamentals gives some reassurance. Commercial real estate fundamentals remain robust in the U.S. and are strengthening in Australia, much of Continental Europe and a number of other countries. Demand has softened slightly in some developed markets recently, but supply remains broadly in line with demand and rents continue to trend upward. This should provide support to real estate returns, in our view.
- Predictability. The future is inherently uncertain. This simple point has been brought home by the rising tide of populism that has swept across the world and poses a challenge to the established world economic and political order. Consequently, levels of political and geopolitical risk are elevated. The surprising result of the U.S. presidential election has created an uncertainty about key aspects of U.S. economic policy and international relations that will only become clear over the next few years. The surprising result of the U.K.’s referendum on membership in the EU has created an uncertainty at the heart of the world’s largest economic group that is expected to last several years. In Asia Pacific, uncertainty lingers over the next stage for Abenomics in Japan or China’s political transition in 2017. This level of uncertainty has implications for real estate markets and for investment strategy.
Where we see opportunity
What does this mean for real estate opportunities in 2017? First and foremost, it is important to emphasize that despite the elevated levels of uncertainty, we at Invesco Real Estate do not expect to change our general approach to investing in the United States, the United Kingdom or elsewhere:
- Real estate markets. Our focus continues to be on real estate fundamentals, identifying sectors, markets and/or assets that we believe should deliver sustainable outperformance. We will monitor carefully the impact of any changes in economic policies on patterns of real estate demand to determine where current opportunities may become less attractive and where new opportunities may arise.
- Listed real estate stocks. Our focus will remain on well-capitalized companies with high-quality assets with the best potential to deliver sustainable outperformance over the long term. We will watch changes in valuations and outlooks closely and make any adjustments to our portfolios accordingly.
At this relatively advanced stage in the economic and real estate cycle, we had already taken steps to position our real estate portfolios in preparedness for potentially more difficult times, should they emerge. The heightened economic policy uncertainty as a result of the U.S. election or Brexit merely reinforces this approach, so any changes are likely only to be at the margin to take advantage of changes in the nature of the new opportunities arising.
Policy questions linger in the U.S.
What might be some of the changes to market fundamentals? In the U.S. for example, although we believe the overall impact to real estate cash flows will be muted, based on President-elect Donald Trump’s pre-election policy stances, we think the following property sectors and markets are most likely to experience specific post-election adjustments in market fundamentals:
- Retail might benefit if proposed tax cuts spur consumer spending
- Health care, particularly hospitals, might experience a negative impact from a reform of the Affordable Care Act (also known as “Obamacare”)
- Industrial, especially coastal markets, may be negatively impacted if trade agreements are rewritten, causing a decline in imports and slowdown in port activity
As investors in real assets, we find President-elect Trump’s proposals to increase investment in a broad spectrum of infrastructure assets to be one of the most interesting topics to arise during the campaign. It is one of the few areas of policy in which there appeared to be a broad consensus, which might make it easier to put into action. How this increased investment is implemented may create opportunities both for investors in infrastructure and master limited partnerships (MLPs) directly, but also indirectly for real estate investors as some buildings/locations may become more competitive as they become more accessible. We plan to monitor these changes very closely.
Keeping an eye on the capital markets
What can we expect from capital markets? Capital markets can be volatile and subject to rapid shifts in sentiment. Specific sentiment impacts from interest rate expectations and policy decisions may include:
- Uncertainty around a Trump administration’s specific policy choices and objectives may create short-term volatility as investor sentiment changes. This might trigger a short-term flight to the perceived safety of gold, the U.S. dollar and hard assets
- A change in Federal Reserve leadership and/or the direction of interest-rate policy could have a direct and meaningful impact on cash flow discount rates and the value of real assets. For example, U.S.-listed real estate investment trusts (REITs) currently traded at an estimated 8% discount to asset value as of November 2016.1 Extreme price reactions to interest rate uncertainty may represent a buying opportunity
Invesco Real Estate will stay current on the President-elect’s policy initiatives, the British and European Union negotiations over Brexit, and any other major political developments that may emerge around the world. We will assess both broad market and real estate fundamental impacts as they become more visible. To reiterate, real asset investing is a long-term asset class based on relatively stable income derived from relatively long-term contractual cash flows. Our focus continues to be on market fundamentals: Identifying companies, sectors, markets, and assets that we believe have the potential to deliver long-term performance.
Learn more about how direct and listed real estate can meet the needs of institutional investors at InvescoRealEstate.ca.
Learn more about REITs in Canada here: what is a REIT