All real estate is local. In recent years, however, this old adage has frequently been overshadowed by loose monetary policies in much of the developed world. Falling return expectations for traditional asset classes have boosted investor interest in alternatives, notably real estate and infrastructure.
Well, monetary policy is already past its inflection point in the U.S. In Europe, too, the beginning of the end of quantitative easing may be getting closer. One upshot of this is that correlations across real-estate markets continue to decline. Going forward, we are likely to see divergences both across and within regions.
Put succinctly, the U.S. real-estate cycle is maturing. Continental Europe looks relatively well positioned, as initial yields remain above the global average. Meanwhile conditions remain mixed in the Asia Pacific region, with trade policies under new U.S. President Trump a key concern. From a sector perspective, logistics continues to benefit from the secular shift towards online retailing.
These broad trends, however, hide as much as they reveal. For example, the scope for internet-driven growth in logistics space naturally depends on how large online sales already are in the market in question. Meanwhile, the impact on traditional retail real estate such as shopping centers varies, with prime locations more than holding their own. Indeed, well-configured retail space in the right locations can actually benefit from more time and money being spent on services that cannot be delivered online, such as dining, health care, fitness and the like.
Looking beyond broad trends
2016 was a strong year for U.S. commercial real estate. For the most part, demand continued to outstrip supply, pushing vacancy rates lower and rents higher. Prices generally ended the year above where they started, delivering total returns to core real estate in line with historical norms.
In more subtle ways, however, the landscape is beginning to shift. While fundamentals remain strong, and risks from new supplies moderate, areas of weakness are emerging, notably in the office sector. With the U.S. close to full employment, the scope for further job creation (requiring new office space) is limited.
Prospects also appear somewhat subdued for U.S. residential and again it pays to look at local conditions. Among the factors to watch are the shifting life-style preferences of households, particularly millennials entering their 30s. As they start looking for a home to raise a family, this could benefit urban nodes outside central business districts, offering amenities similar to city centers and easy commutes.
European real estate too has provided investors with exceptionally high levels of return over the past few years. However, we are now seeing signs that the market as a whole is starting to moderate. While yields may not yet have reached a trough, and further rental growth is certainly likely, countries such as Germany may now be entering a more mature stage of this cycle.
Real estate in core Europe markets still compares well to other asset classes, but further falls in initial yields during the second half of 2016 are adding to the likelihood of lower absolute returns over the next five years. In the short term, we still see the potential for further real-estate yield compression, driven in part by the current large spread over bonds, as well as the expectation of further rent growth. In the longer term, rising real rates would no doubt be an issue. The key remains taking selective bets on emerging micro locations and niche segments with solid growth prospects, while keeping an eye on political risks. An alternative worth considering could be unlisted European infrastructure, where a reasonable premium over government yields looks achievable and active asset management can create further value.
European prime total returns by sector and region
Even within Europe, there is a wide range of expected total returns across different sectors and regions.
Source: RREEF Management LLC, as of 12/2016 Notes: Range shows forecasted top and bottom performing market in each region in % p.a. for 2017-21.
Online leaders vs. online laggards
In assessing the impact of online retailing, attention needs to be paid to how close a country is to maturity.
Source: Eurostat, as of 12/2016 Notes: Horizontal axis shows the proportion of people who have used the internet in the past twelve months; vertical axis shows the proportion of people who have used the internet to make a purchase in the past twelve months.
