Real-estate cycles do not simply die of old age. This is worth keeping in mind, 10 years into the current U.S.-led recovery. Since 2009, price and rent growth has varied widely across sectors, countries and cities. Moreover, many core real-estate investments are held for longer than a single cycle. But even if you just think about the causal relationships between real-estate values and economic growth, the picture appears to be much more nuanced than vague memories of the great financial crisis might suggest.
The last downturn was unusual in several ways. For one thing, it was global. For another, real estate and the bursting of the U.S. housing bubble were clearly a central trigger. The relationship between real-estate prices and general business activity is rarely as clear-cut, even within any one national market. Like all investments, the value of real-estate assets in principle depends on two things. The first one is how much income (mostly rents) is expected to grow in real terms. The second is the inflation-adjusted or "real" interest rate investors use to discount those income streams. Economic growth, thanks to, for example, gains in productivity or employment, clearly tends to support income. But other factors matter, too, starting with local supply-and-demand dynamics. Moreover, real rates tend to fall during recessions and rise in times of growth. For real-estate prices, this can create a buffer even in times of economic gloom – as a look back at U.S. real-estate prices since the 1950s shows.
None of this suggests we should ignore the business cycle. But we believe it is only part of the equation. To be sure, the economic outlook in the U.S. and other major economies is more uncertain than it was a year ago. In our view, it remains too early to batten down the hatches. Trimming risk in anticipation of a future correction and proper global diversification, however, are increasingly essential. For example, real-estate performance across much of the Asia-Pacific region remains healthy on the back of strong capital markets and stable occupier fundamentals. Meanwhile, powerful structural forces, from demographics to e-commerce, are impacting real estate in ways that transcend the cycle. Both within the U.S. and globally, our sector and market allocations seek to account for both late-cycle and structural factors.
To illustrate the delicate interplay of structural and cyclical factors, look no further than the market for European logistics. This is a clear winner of the shift towards e-commerce at the expense of traditional retail stores. Rental growth in European logistics remains well above levels typically seen in the past. At the same time, however, the amount of space under construction continues to grow and has more than doubled over the past three years. For now, demand continues to outstrip supply across much of the continent. The average European vacancy rate has fallen to just 4.1% and in many markets continues to tick downwards. And as usual, even this aggregate picture can hide plenty of opportunities and risks, such as the degree to which any particular location might be exposed to global trade tensions.
You can tell similar stories for other segments. Vacancy is down significantly, and most major cities are well positioned to see sustained rental growth. In part, this reflects population growth of cities due to internal migration from more rural areas. Low vacancy is creating opportunities to actively manage office, logistics and residential space. And even segments and countries that have been under pressure can present opportunities. As already mentioned, traditional retailers continue to suffer from changing shopping habits. In the United Kingdom, uncertainty surrounding Brexit has dampened investor interest. As a result, the UK office and shopping-center markets look attractively priced, compared to the rest of Europe. In such areas, we see room for selective contrarian bets – although only with a forensic approach to assessing risks. Target returns should be set according to risk profile, while any move up the risk curve should be backed by solid fundamentals. Reducing exposure to assets and markets that are expected to underperform over the medium term also seems reasonable. So, to sum up, it is true that no cycle lasts forever, but we continue to see attractive opportunities.
A look back at U.S. real-estate prices and major post-war recessions hints at causal relationships far more complicated than is widely appreciated.
Sources: National Bureau of Economic Research (for recessions), Federal Reserve Board (for real-estate prices) as of 09/2018
In many European cities, working-age populations and employment are likely to continue to grow over the next few years. This should support rental growth.
Sources: Oxford Economics, RREEF Management L.L.C. as of 11/2018