Real estate, like the equity markets, was highly correlated in the aftermath of the credit crisis. Today, countries around the globe are in different phases of their economic, monetary and political cycles. This has impacted property markets and will continue to do so to varying degrees. In turn, correlations in the property markets are declining and the benefits of global diversification are rising. At the same time, low interest rates have increased demand for higher-yielding investments, including both real estate and infrastructure.
Investor demand has lifted capital values for property, particularly in markets like the U.S., and returns over the last several years have been well in excess of their longer-term average. With the market more mature today, total returns are reverting to more normal levels which are expected to remain competitive to both the equity and bond markets. Indeed, total returns to unlevered core U.S. real-estate assets stabilized to 7% in the second quarter (four-quarter trailing average) from 8% in 2016. Reasons for the slight deceleration include interest-rate volatility after the U.S. elections and a modest slowdown of net-operating-income growth. However, monthly data indicates that prices firmed in the spring. There are pockets of weakness, as oversupply has caused rents to stall in some apartment markets, while store closures have challenged some retail formats.
Overall, however, the outlook for U.S. real estate remains positive with vacancy rates near 15-year lows and property delivering an interesting yield relative to interest rates. We expect that total returns will remain in the 6 to 7% range in 2017 and 2018. In inflation-adjusted terms, rents actually remain about 5% below their 20-year historical average. This suggests that there is further scope for rents to recover. It is quite possible that like the broader economy, real estate will experience a more temperate, but also more protracted recovery than in the past. Indeed, assuming that real rents converge to, and possibly overshoot historical averages over time, it is reasonable to expect that property incomes might outpace inflation for several years. Meanwhile, mortgage lending has remained somewhat constrained, limiting the threat from new supply. However, we expect to see considerable dispersion across the U.S. real-estate universe, creating opportunities to outperform through judicious sector and market selection.
In regional terms, Europe continues to be well positioned. For a change, European voters and policymakers have actually provided reasons to be cheerful rather than fretful, from elections in the Netherlands and France to progress in sorting out the Italian banking system. There remains, of course, the ongoing specter of Brexit, but we would see this as more of a concern for the United Kingdom than the rest of the continent. Indeed, several markets such as Frankfurt, Dublin, and to a lesser extent Paris and Luxembourg, look well positioned as potential beneficiaries of Brexit-related relocations.
Overall, confidence is high, growth is accelerating and political risks have decreased. As such, European real estate remains an interesting investment class. Prime European real estate seems set to record another exceptionally strong year of double-digit returns in 2017. Germany, France, the Beneluxand Iberiaare expected to be some of the strongest-performing markets in Europe in the coming two years, while most UK markets seem set to see rent growth below the European average in the five years until 2021. Office take-up across the major European cities increased in the first half of this year, while logistics may be the top-performing sector over the next five years.
Macroeconomic conditions have also strengthened in the Asia-Pacific region. On the back of solid fundamentals, we expect the Asia-Pacific real-estate markets to deliver healthy annual total returns of about 6 to 8% over the next five years. Within the region, Australia is expected to be among the top-performing markets, as occupier demand in the office sector has started to recover in key markets, while Japan continues to yield the highest excess returns over the risk-free rate.
Real rents on U.S. real estate remain about 5% below their 20-year historic average.
Source: CBRE-EA, RREEF Management L.L.C.; as of 03/2017
* Adjusted for core consumer price inflation; equally weighted across apartment, office, retail and industrial sectors
U.S. commercial-mortgage lending has remained fairly constrained, limiting the threat from new supply. Outstanding debt is close to historic averages.
Source: Federal Reserve; as of 3/31/17