Investor Forum: What are realistic returns today?

Real estate is in demand in today’s low-growth environment. But do investors need to lower their return expectations? Rachel Fixsen speaks to six funds 

Canada’s Ivanhoé Cambridge, a subsidiary of Caisse de dépôt et placement du Québec, has not made any changes to its return expectations, according to Meka Brunel, president for Europe.

“Real estate investment requires long-term decisions,” she says. “We do analyse our investments on an all-cash basis and try to make sure that the risk-adjusted returns we are making will benefit our depositors.”

Looking at the prevailing market conditions for real estate and possible future scenarios, Brunel says it is important to bear in mind the nature of property as an asset class. “Of course, global market conditions must be considered when you do invest,” she says. “But we should never forget that real estate is not a liquid asset and this must guide our decision-making process.”

While the heightened competition for core assets has led investors to find new ways of taking on risk to increase returns, Ivanhoé Cambridge resists becoming distracted from the long-term view. “Again, as a long-term investor, and for the benefit of the depositors and the pensions we ultimately help to serve, we should always consider the reality of an all-cash investment and its resilience when times get harder, rather than follow a new trend,” Brunel says.

In August, Ivanhoé Cambridge invested CAD72m (€48m) in the redevelopment of the Mayfair Shopping Mall in Victoria, British Columbia, which over the next two years will increase the gross leasable area from 42,180sqm to 51,470sqm.

During the same month, through a joint venture with Logos, it started expanding into southeast Asian logistics, investing in SGD150m development in Singapore, alongside a local developer. This project is expected to be completed in early 2018.

“Our strategy is clear,” Brunel says. “We are invested in four different asset classes – office, residential, retail and logistics – and we try new areas through funds that give us access to co-investments. 

“We need to be humble and consider that we cannot be good on all sectors and asset classes.”

The returns available from real estate today are considerably lower than they have been. And not just in property, but bonds and all the major equity markets, says Nick Pink, head of fund management for Europe at Barings Real Estate Advisers.

Pink says that if you take “core European property currently yielding 4.5-4.75%” and add long-run rental growth expectations of 2-3% per annum, you end up with “a return of perhaps 6% or 7% per annum unleveraged after costs”. 

He says: “Remember, it’s core property, and in addition to very low levels of new development since the global financial crisis, many other long-term structural drivers are in its favour, like population growth and technology impacts.

“We estimate that compares with a historic return of over 11% per annum for a pan-European core all-property return over the past 20 years,” Pink says. “It can be hard not to look backward when setting future return requirements.” 

He adds: “Some might look at long-run average yield levels as a reliable anchor for value, and others might look to their own market experience to tell them that what is the ‘normal’ yield or capital value per square metre to pay for a given property asset.” But Pink stresses that hurdle returns are not set in a vacuum.

“In broad terms, they reflect expectations for rental growth and interest rates. While property will always be a local business in terms of the growth outlook, interest-rate expectations are a global phenomenon – set in the capital markets in response to central banks’ monetary policies.”

Pink expects low interest rates to remain for the foreseeable future. In general, investors need to accept that returns are lower today rather than increasing risk levels to chase better profits.

“Taking risk like excessive leverage rarely ends well,” he says. “Risks have to be appropriately balanced against return – not taking opportunistic risk to get slightly better than core returns.”

“Over the long term we do not see any particular reason to adjust our real estate return expectations as a result of recent events,” says Rob Wilkinson, chief executive of AEW Europe. 

“For core investments we expect these to deliver between 5% and 7% on an unlevered basis over a five-to-10-year time horizon.”

Wilkinson forecasts returns for unleveraged value-add investments to be in the range of 8-10% over the period. Opportunistic real estate is likely to generate unleveraged returns of 12% – or a leveraged internal rate of return of 16-18%.

“Whilst yields remain at their historical lows for core assets, we expect they will gradually rise over time and total returns will adjust accordingly,” he says. Combined with modest rental growth, this will lead to the level of returns the firm is predicting.

“Over the short term – the next three years – we expect that returns for core strategies will be at the lower end of this range as the potential rise in yields is unlikely to be substantially offset by rental growth,” he says.

Wilkinson says the picture in Europe varies a lot from country to country, with AEW still relatively cautious about the short-term outlook for UK real estate, for example. 

The firm strongly favours a value-oriented approach to real estate in Europe – both for core and non-core strategies. He says: “For core strategies, a value-oriented approach means focusing exclusively on truly core assets that satisfy all the requirements of what constitutes a core asset – location, tenant, building quality, et cetera. Additionally, investors must take a long-term view for core investments in the current environment.”

While still an active core investor, Wilkinson says AEW has increasingly been looking at strategies higher up the risk curve, including value-add and opportunistic. “In 2014, we launched a value-add fund, which focused on investing in value-add offices across Europe.

AEW is actively looking at a number of new real estate sectors, he says, but more as a means of diversification than to boost returns. “Where we are seeking diversification we are increasingly active in the residential, senior housing and debt space,” he says.

“We have changed our future return expectations from real estate – but not based on the current market uncertainty,” says Boris van der Gijp, director of strategy and research at Syntrus Achmea Real Estate & Finance.

There is always uncertainty in politics, anyway, he says. “We have lowered expectations a bit due to the huge competition in real estate investment and also because of the wide spread compared to bonds – all of which is happening because there is so much capital looking for yield. We work for 65 institutional clients and they are more or less accepting a lower return from real estate investments now.

“We were heading for long-term returns of 6.5%, but when I look at the situation now returns over 20 years are closer to 6%, and that change has happened in just the last six months.

“Although we invest all across the world, a lot of our investments are in the Netherlands, where there is now fierce competition for residential property. Last year and earlier this year, the total return for anyone entering the Dutch residential market was around 10%. But with investment yields having come down, you now have to lower your expectations a bit if you are entering the market only now.”

It make sense for investors to take on more risk today, he says, but not necessarily to increase returns. “You have to increase your risk simply to be able to buy,” Van der Gijp says.

“At the moment, we are buying bigger projects. Once we were focusing on 50 units at a time, and now it is 150 or 200 in one deal. And we are also changing the use of some properties, transforming obsolete office buildings to residential, which also involves taking on more risk.”

Where does Syntrus Achmea Real Estate & Finance stand on the question of leverage? “You can take out some leverage to be even more competitive when bidding for investments and, though we are not doing this in the Netherlands at this moment, you do have to do that internationally,” he says.

German insurer Allianz has not altered its real estate return expectations, and is still targeting a range of 4-6%, says Francois Trausch, CEO of Allianz Real Estate.

“While real estate is a sought-after investment class, it is one of several investment classes Allianz is pursuing in the alternative asset space and a 4% return is still achievable in other alternative asset classes like infrastructure or renewables,” he says.

While returns have gone down in some areas of the market, Trausch says there are ways to avoid settling for these less productive assets. “Instead of chasing lower returns, investors should continue to diversify instead, spreading investments in terms of geography, asset class and investment style, as well as considering taking on more risk in selected ways, such as leasing, asset repositioning and value-add plays,” he says.

They should do this in the markets in which they have most experience and capabilities, he says, giving the example of Allianz making office investments in Germany or France.

Today, returns of between 4-6% are realistically achievable on real estate, he says.

Allianz Real Estate is using certain new strategies to boost potential returns in the current environment.

“Indirect investments, such as funds and joint ventures, are ways to complement our direct investment strategy, under which we own properties directly,” he says. 

“Indirect investments and joint ventures enable us to make investments in geographies, asset classes or investment styles that we would normally not venture into as part of a direct strategy.

“Indirect and joint venture investments also enable leverage and therefore levered returns, which is not always possible for direct investments.” These geared investments provide higher returns that complement the majority of the portfolio, which is unleveraged, he says.

Over the long term, returns on real estate investments are likely to slow, predicts Dennis Lopez, global CIO at AXA Investment Managers–Real Assets.

“The phenomenon of lower global growth, interest rates and inflation seems deeply entrenched,” he says.

Does this mean property investors needs to reduce their return requirements for the asset class? “In theory, investors should lower their return requirements, as risk-free rates, a key component of target returns, are at very low levels,” Lopez says. 

“Theory aside, investors may need to lower their return expectations anyway. The large amount of capital flowing into real estate is likely to keep yields for good-quality assets at low levels.”

Rather than taking on more risk to increase returns, Lopez favours defensive action in these conditions. “Overall, it makes sense for investors to tilt their portfolios to defensive real estate investments, considering the level of uncertainty in a number of countries,” he says. 

“However, that should not stop investors from taking on riskier investments if the returns are high enough to compensate.

“The advantage of keeping the bulk of the portfolio in low-risk, core assets is that there is flexibility to take on a handful of riskier investments – development, for example – when the opportunity arises.”

Returns of 6-7% should be achievable under current circumstances, with core real estate, he says, without having to compromise on asset quality or push leverage too high. “For value-add and development activities, low-double-digit returns should be targeted,” Lopez says.

Selective refurbishment and development of offices in key European cities, such as Paris and Berlin, is still a viable option for investors looking to boost their potential returns from property, he says.

“Logistics development could also provide a boost to portfolio returns, and build-to-suit development can mitigate the associated tenant risk.”

Away from the main real estate sectors, Lopez says hotels are a good high-return option for investors, with investment focused on gateway cities such as London, Munich and Amsterdam.