Analysis: Are we due a real estate downturn?
Past experience suggests yes. But investors find themselves in unusual times
How long can the current market cycle last? This has been a much discussed question within the real estate industry for several years. But as the anniversary of the demise of Lehman Brothers passes, the question hangs over the market.
Real estate markets today pose a conundrum. By historical standards, a correction is overdue, and predictions that ‘this time will different’ are usually the result of naïve, wishful thinking. But investors would struggle to find reasons to be pessimistic about the next 18 months when looking at the market.
A consensus has emerged that predicts an extended market cycle where values remain relatively flat, in part explained by years of quantitative easing and low interest rates, which have encouraged vast volumes of capital to divert into private, income-producing markets like real estate and infrastructure. The sheer weight of capital flowing into real estate has been one of the biggest factors in its recent performance and pricing.
Consensus forecasts for the US and UK suggest real estate investors are expecting a plateau in the coming years. The most recent Pension Real Estate Association (PREA) consensus forecast for the US, projects a return of 6.2% for 2018, followed by 5% in 2019, 4.4% in 2020 and an annual average of 5.2% between 2018 and 2022. The equivalent figures for capital appreciation (that is, returns generated by rising prices) illustrate the flat outlook: 1.5%, 0.3%, -0.5% and 0.3%.
The UK’s Investment Property Forum (IPF) consensus forecast is more negative but similarly flat. Total returns and capital appreciation are forecast as follows: 5.8% and 1%, respectively, for 2018; 3.2% and -1.6% for 2019; 4.2% and -0.7% for 2021; 4.8% and -0% annually between 2018 and 2022.
A recent commentary on the UK market by Capital Economics sums up the paradox. Its title asks: A boom but not bust? “Current forecasts for commercial property prices to plateau rather than peak would represent a significant break from the boom/bust cycles of the past,” it says. “Yet while some parts of the market look vulnerable to a negative shock, it is hard to make a case that the economic or the interest rate outlook pose a serious short-term threat to property values.”
If investors do not deploy capital allocated to real estate markets, the question then is what else to do with it. This predicament explains why investors continue to invest, albeit more conservatively. But at the same time there is the concern of getting caught out.
“We’re all worried about it,” says Eric Adler, CEO of PGIM Real Estate. “So what do you do? Because on the one hand we all don’t want to be blind to potential for a downturn, but on the other hand it is very hard to act drastically in the face of an underlying market that does feel different to last time.
“That’s the conundrum. We are all worried that this has been going on a long time, and we’re conscious that cap rates have been as low as they ever have been for macro reasons that surpass real estate… but there is nothing that points to a calling of the market.”
Andy Rofe, managing director for Europe at Invesco Real Estate, says the global financial crisis has meant that we have “effectively missed out a cycle”. He says: “This cycle is going to last a lot longer than 10 years… what you’re seeing is a prolonged market cycle because of the low-interest-rate, low-growth environment, which has been a direct outcome of the [crisis].”
He adds: “When you look at it on a global context, people have been saying we were reaching the top of the market in the US for the last three years. Generally, Europe is two to three years behind the US, and there hasn’t been a noticeable slowdown in the US market to date.”
A change to this outlook would require a significant “external trigger”. The most obvious contender, of course, is Brexit. “That may well cause some market dislocation, as it did two years ago, when we had the referendum vote, but that was in hindsight very short lived, and I would expect the same to happen, irrespective of what the outcome is,” Rofe says.
“In terms of the real estate markets, whichever way it goes, there will be some impacts, but I’m not sure there’s going to be a huge impact. It will more be sentiment-driven, which is very different from 10 years ago when we had a massive overhang of debt which was fundamentally affecting the dynamics of the market. And I’m not sure you can really put Brexit into the same bracket.”
Adler says investors have become focused on Brexit, as we get closer to its departure date of 29 March 2019. “We haven’t really seen a direct impact – or an easy-to-identify impact on the real estate markets,” he says. “But in the discussions we have with our client base, which is international, it is higher and higher on the agenda. So I think the next six months will be very interesting on that front… we are getting close to the end game, and it’s still not clear how it plays out. That’s got people nervous, but not really acting on it yet.”
Geopolitics has become more present in the public consciousness in recent years. And while there can be a danger that investors apply too much importance to it, Adler says it can make sense to be more aware of it when markets are late in the cycle.
“The one thing I would say is that, as we get later in the cycle, investors get more anxious,” he says. “It’s normal. They are just wondering when the shoe will drop, and so the risk I see is it is more of an event risk. It is some kind of specific event at a time of maximum lack of investor confidence. That could be enough to spark something.
“If you look at downturns, they are normally sparked by some event when investors are nervous. And then afterwards we can do a post-mortem and understand the structural reasons for the downturn.” For Adler, this means “making sure we prepare for a downturn even if it’s not obvious to point to why we would have a dramatic one”.
Investors are therefore looking at “asset classes that tend to be more downside protected”, such as residential, industrial or self-storage. “Simplistically, that is anything that puts a roof over people’s heads, and anything that you can store things in,” Adler says. “Cap rates can expand, but those industrial rents feel solid. So you see more and more money piling into those spaces.”
The other area is investors ensuring they are diversified by vintage – that is when investments were originally made – so if the market turns, their entire real estate portfolio is not uniformly affected. This involves making disposals and taking profits. “You are more regularly looking at your portfolio and wondering what could be a good time to harvest,” Adler says. “So, again, you are not too long if something turns.”