Call The Market: Misallocation at the top of the market
Are investors being imprudent by buying prime European real estate at the top of the market?
Behavioural finance has shown us that investors are not always rational, and that greed and fear can be powerful investing emotions. Certainly, when investors are faced with uncertainty, they flock to safety.
Prime commercial property markets in cities like London, Paris, Berlin, Munich, and Hamburg remain perennial favourites. The theory is that assets in these markets will fall less in value than their non-prime peers during a downturn. However, in this cycle, investors need to exercise caution. An awareness of behavioural biases can be useful in avoiding dangerous traps.
A flight to prime property would have been prudent in 2007, when such assets were less overvalued than the rest of the market. But this time, investors seeking refuge in prime may be exposing themselves unwittingly to increased risk. Income forms the bulk of long-term total real estate returns. Capital gains, in contrast, make a smaller – and more volatile – contribution to total returns. Thus, investors who buy ultra-low-yielding assets have greater exposure to future price fluctuations.
Across much of Europe, prime assets currently trade at a significant premium to the rest of the market, and prime yields are lower than they have been at any point since 1990 (figure 1). In contrast, secondary markets have not yet returned to their 2007 values. In effect, investors are paying a significant premium for wealth protection which is increasingly difficult to justify at these prices.
In a recent research note, we argued that French life insurance schemes are the driving force behind low yields in Paris, and that current valuations are unsustainable. We suggested that investors ensure that they are not over-exposed to euro-zone prime property and that they seek better yields in secondary assets.
Our thesis contradicts the received wisdom that prime properties are inherently and always less volatile than their non-prime peers. They are not. Yield is a more important determinant of volatility, because income returns are more stable than price fluctuations.
Cognitive errors nonetheless lure investors into making two key mistakes – assuming that the broad labels ‘prime’ and ‘secondary’ reflect the true risk of properties, and fixating on capital gains at the expense of income. The anchoring and framing biases are to blame.
The first problem is that most investors anchor their performance expectations to capital gains rather than income. In doing so, they ignore the importance of income in providing consistent returns across the cycle and thus expose themselves to additional risk.
Analysis of the MSCI IPD indices shows that total returns in real estate are primarily driven by income returns, which are relatively predictable. Capital gains are a much smaller component of total returns, and they are highly volatile.
For example, the UK market has shown significant price volatility since 1971. The market overheated in the late 1980s, and again between 2003 and 2007. Both periods of outstanding capital gains were followed by significant drawdowns. In contrast, the income component of total returns has been consistently positive since 1971.
An explanation of these exuberant bubbles and painful bursts lies in the field of behavioural finance, which contends that emotions can supplant rational behaviour from time to time. In fact, the highly emotive nature of real estate means that movement in capital-returns is predominantly explained by momentum and investor sentiment. Analysis of the MSCI IPD All Property Annual index finds that over eight tenths of current returns can be explained by previous years’ performance (Brown and Matysiak).
Investors who buy prime property at low starting yields will realise few defensive benefits, because the majority of their total return will have to come from more volatile capital movements rather than income. Buying an asset at a low yield – even if it is a prime asset – means accepting greater of risk, because the heavy exposure to capital movements increases the property’s volatility and its susceptibility to a drawdown.
The second problem lies in the way that the industry frames the real estate asset class along sector, style, and geographic lines. The assumption is that all the properties in a certain category are relatively homogeneous and have similar risk-return characteristics.
But the data show that this widely held assumption is a fallacy. The average market return is impossible to access – it is more a statistical quirk than an achievable investment target. In 2011, the average return on the Frankfurt office market was 2.4% – yet the difference between the best and worst performing properties was a staggering 33 percentage points (figure 2). Buying an office in Frankfurt does not provide the Frankfurt office market return – it provides exposure to an individual asset. To receive the average market return, an investor would need to own a fraction of every constituent. This is impossible in real estate and, as such, active management is essential.
Do not assume that all prime real estate will provide the defensive attributes typical of previous cycles. In reality, many of the most attractive properties – those with higher, sustainable income streams listed at reasonable prices – may lie beyond the prime segment of the market. Investors must not allow themselves to be misled by the industry’s arbitrary labels which mask the unique characteristics of individual properties.
As markets enter the ‘late cycle’ and the pace of yield compression slows, income will form an ever-greater part of the total return. This should allow for greater certainty of performance. Investors would also do well to consider the protection afforded by a slightly higher yield, provided they can get comfortable with the lease length, quality of the tenant, and the ‘re-lettability’ of the asset.
Investors should not interpret this observation – that prime looks overextended relative to the broader market – as an argument to move indiscriminately up the risk curve into secondary assets. It is important that investors focus on good-quality secondary assets. Research can uncover specific assets with a combination of yield pricing and stock-specific fundamentals offering more robust protection than prime assets at current market levels.
Adrian Benedict is investment director for real estate at Fidelity International
Are opportunistic investors calling time on the cycle?
European investment activity rose by 25% year on year in the second quarter. But, while retail funds are competing aggressively for core assets, opportunistic investors appear to be rotating out of low-yielding prime assets. We see this as an attempt to achieve higher returns, rather than marking the peak of the cycle as yet.
Over €74bn was transacted in Q2, making it the strongest quarterly showing on record outside of a fourth quarter. However, the rise in activity can primarily be attributed to Blackstone’s €12.25bn sale of its Logicor platform to CIC, the Chinese sovereign wealth fund. This took first-half investment activity to €130bn, just below the 2007 peak. Although the momentum in the office and retail sectors has slowed, there are good reasons to expect solid year-on-year growth at the all-property level for the rest of the year – not least a resurgence of activity in the UK – which would result in 2017 surpassing the annual total from 2015.
Back in 2006-07, the boom in property investment was driven in the most part by loose lending practices and a flood of capital into the sector, particularly from retail investors, following a number of years when property performed particularly well. This cycle has been different, but the relatively high and stable income returns offered by property in a world of ultra-low interest rates and income yields have again encouraged non-traditional investors to venture into the market.
A little over 10 years ago, investors believed that property rents were going to grow strongly on the back of solid economic growth, implying strong total returns. However, this time it is more about the fact that commercial property appears to offer investors hunting for yield the prospect of achieving higher returns than they could otherwise get from fixed-income assets to meet their target returns. Indeed, there are signs that this environment is again boosting flows into pan-European retail funds. For example, French SCPIs, which are advertised as liquid real estate investment funds and invest on a pan-European basis, notched up record net inflows in 2016 (see figure).
To get this money into the market, funds investing on behalf of retail investors have again been willing to pay lower yields than most other investor types. Indeed, evidence from the Nordics showed that property funds (as well as private buyers) were major net purchasers in H1, while listed property companies were large net sellers.
There are signs that this might be affecting the behaviour of other investors. CBRE reported that opportunistic investors are selling out of prime property where they have met their return targets or are looking to diversify into alternative asset classes. There is also increasing demand for markets that were not on the radar a year or two ago – both in terms of secondary cities and risker countries. Indeed, our analysis suggests that the yield gap between prime and secondary office assets has started to fall.
However, as investment activity in these second-tier locations tends to drop sharply in market downturns, coupled with greater risks to tenant demand, investors will need to ensure that their returns expectations in those markets are sufficiently high to compensate for the additional risk.
Kiran Raichura is European property economist at Capital Economic