Despite the economic uncertainty, some prime real estate markets remain attractive, says DTZ's Fair Value Index. Ben Burston and Tony McGough report
In Q2 2011 the global DTZ Fair Value Index score rose to 55 from 50 in Q1, indicating that the investment environment has retained its appeal to investors in spite of an uncertain economic outlook. The rise resulted from an upgrade in Europe from 32 to 41 - with the UK score rising to 50 - and an upgrade to the Asia Pacific score from 65 to 70, with the US broadly unchanged at 73. There were 63 global markets rated as HOT (more than 5% under-priced) at end Q2, 42 rated as COLD (more than 5% over-priced), and 86 rated as WARM.
In Europe and the UK, the rise in the index scores follows two consecutive quarters of declines, and largely reflects the fall in bond yields in core markets over recent months. Yields had risen over the six months to end Q1 2011, but weakening confidence in the economic outlook and an increasing flight to government paper in core markets has resulted in lower yields, with the German and UK five-year bond yields both standing at 1.4%.
As government bond yields compress, prime property is relatively more attractive in comparison to such low fixed-income returns. It offers higher income yields and a broadly stable capital value outlook, which has caused a broad-based increase in the index score.
Of course, yields in peripheral markets have remained elevated, but with the majority of prime European investment locations in the core markets, the net impact of the recent bond yield movements has been positive for the European and UK index scores.
Reflecting the improvement in the relative return of property, several German and UK markets have been upgraded from COLD to WARM this quarter. In the UK, this includes Manchester and Bristol offices, Heathrow industrial and Glasgow retail, while in Germany Berlin offices and Munich retail have been upgraded.
With lower occupier demand, the lack of supply at the prime end of the market is expected to keep rents broadly stable, with growth prospects in some markets.
This lack of supply can be seen in the London markets where a shortage of prime product both in leasing and investment markets is supporting strong rental growth and yield compression. Elsewhere, a lack of supply in the office and retail markets of Milan and Rome is providing price stability in spite of subdued occupier demand.
Asia Pacific continues to compare favourably with the other regions. Investors will benefit from stronger rental growth associated with a more positive economic backdrop than in the US or Europe. As the region's index score of 70 indicates, investors taking a medium/long-term view can access several high-yielding and high-growth markets at a discount relative to pricing elsewhere. This is reflected in the favourable findings for China, India and Australian.
This quarter, upgrades have been concentrated in China and Australia, while some Indian markets have been downgraded. In China, we have upgraded our forecasts for rental growth in Shanghai and Guangzhou retail and lowered our yield forecasts to reflect ongoing strong investor interest in the maturing office markets of Guangzhou and Shenzhen (now rated HOT). In India the occupier market remains strong but high inflation has led the authorities to raise base interest rates, leading to higher bond yields and the downgrade of Hyderabad and Chennai offices from HOT to WARM.
There are, however, several COLD markets where we consider that pricing has moved out of line with underlying fundamentals.
Hong Kong and Taipei are benefiting from a cyclical upswing supported by a strong occupier market as demand recovers following a short, sharp downturn in 2009. This strong growth outlook has encouraged investors into the market, pushing yields down to very low levels. Office yields in Hong Kong and Taipei are now at their lowest points on record at 2.5% and 3.1% respectively. This investor interest has also been supported by the broader global financial environment, with low interest rates in the major western economies leading to a search for higher investment returns elsewhere. Hong Kong and Taipei have been major recipients of such inflows, which tend to raise asset prices.
While we expect strong capital growth over the next year, supported by high rental growth and continued strong investor interest, long-term investors should be wary of a potential unwinding of this asset price growth as the economic fundamentals underpinning inflows change.
While the recent S&P downgrade of the US triggered widespread volatility through global equity markets, actual Treasury yields have reached new lows, with the five-year yield standing at 0.96%. These low rates of return are setting a low required return for prime property. As such the US markets compare favourably in our global ratings, with a US index score of 73 leading the other global regions.
This score comes in spite of a subdued outlook for the US economy and for rental growth. But we consider that the elevated cap rates prevailing in the US market are an attractive buying proposition, even in the absence of strong future capital growth prospects. With cap rates in excess of 6% in many prime markets, income alone is enough to provide investors with adequate returns, especially compared with low fixed-income returns.
Furthermore, in several European markets a lack of new supply is exerting a positive influence on market pricing. Few additions to supply are expected in the near term. This will help stabilise markets with weaker occupier demand and support value growth in stronger markets.
The Q2 Fair Value Index results underscore the appeal of selective prime property. With equity markets displaying extreme volatility and fixed income returns down to historically low levels, property offers comparatively solid income returns. While there are downside risks to the economic outlook, our outlook for capital values continues to be for subdued growth, with supply constraints in many markets expected to mitigate the impact of weaker demand.
Tony McGough is global head of forecasting and strategy research, and Ben Burston is associate director, forecasting and strategy research at DTZ