How do pinch points relate to real estate markets, and how can investors use them to their advantage? Geoffrey Armstrong explains
Local vacancy levels are crucial in measuring the supply and demand for real estate. Although the precise level varies by city, each locality will have its own vacancy-level tipping point. If the vacancy level is above this point, tenants hold the stronger position; if it falls below, rents rise and the balance of power shifts to the landlord.
Tokyo’s tipping point, for example, is typically viewed to be 5%, which implies an even lower vacancy level in modern grade-A space. Indeed, central Tokyo’s office vacancy rate has now fallen below this figure (4.8% in July). This should be good news for the local office market, provided business conditions there continue to be robust.
London, meanwhile, seems to have a wider range of tipping points, but the principle still applies. The graph (right) shows the link between London vacancy levels and rental growth. The trend for low vacancy periods linked to rising rents is evident. We find that in most markets there is a lag between vacancy rates changing direction from rising to falling, before rents start to rise.
In continental Europe, pinch points can be found in slightly different places. In Germany, for example, a shortage of housing in certain cities is creating pinch points in residential property. As Germans move away from a number of cities in eastern Germany, demographic trends appear to be favourable in cities like Hamburg, Hanover, Frankfurt and Berlin. In these cities, demand is far outstripping supply.
A declining population is not enough to offset this effect, particularly when set against a strong, tightly regulated rental market. Up until recently, rental rates have risen very slowly in Germany and, while this might sound like a mixed bag for German landlords, in reality this has made building/rebuilding quality housing stock an unattractive option. It is not cost effective to build new stock to a compelling standard, creating a significant pinch point around new housing supply, with a lack of supply set against high demand in key locations.
Furthermore, the German government’s approach will not change soon, partly due to the constraints borne by local government – Berlin, for example, rarely has enough cash to cover its commitments. Another key motivation for German authorities is to keep rents low. This has some benefits for existing landlords (market stability, but low rental growth), but is less positive in terms of providing sufficient new affordable accommodation to meet increasing tenant demand. This has been the situation for some years, benefiting residential property investors as rents rise without an increase in supply.
Time (and lack of it) forms another crucial pinch point for real estate. In most markets, it typically takes several years to acquire a site, obtain planning permission, and commence and carry out construction. As a result, it could take three to four years to bring a new asset to the market.
This time lag allows a significant divergence between supply and demand to develop. Potential government policy restrictions (such as zoning or green belts) further contribute to the emergence of an inefficient market.
With a lull in activity caused by the financial crisis, we are only now getting to the stage in most markets were companies are comfortable undertaking speculative constructions, and even then generally only in the most prime locations. This has a created a slower than expected supply pipeline in most markets, which could lengthen the current property cycle.
In the retail property sector, time is especially crucial in developed economies, where acquiring the space needed to begin to build can take significantly longer than in developing counterparts. Westfield London, for example, spent the best part of a decade getting off the ground in acquisition time alone – a process which would likely have taken a fraction of the time in a more fast-paced market like China.
Similarly, in office space, acquisitions can eat away at a build’s timeline. With any developer likely requiring more than one existing site to create a prime space, sellers of existing stock can find themselves in a strong bargaining position and hold out for higher prices. Architectural time and costs here are high too; there are no identikits in these markets, as buildings must be tailored to the market.
Logistics property is a little different, however. In this property segment, time is not the issue; logistics bases can be very quick and simple to build. Given the go-ahead by authorities, and with a tenant ready and waiting, a new logistics property could be built and brought to market within mere months. However, the key resource here is location – a property designed for a logistical purpose must be, as its label suggests, built in a good strategic location, close to requisite transport infrastructure.
In this market, then, there is clearly significant scope for first-mover advantage. Those companies that move (or have moved) quickly to acquire sites when transport networks expand command significant power within the logistics market. However, this specific sector is somewhat more exposed to the vagaries of the business cycle, meaning that investors must exercise caution as investing in this kind of property can involve a little more risk.
Put simply, property pinch points are inevitable on the road ahead, across the wide spectrum of real estate. But while investors can find a huge variety of opportunities within real estate markets, the savvier could also look beyond the property sector into connected areas. For example, the pinch point trends we are witnessing in global real estate can also be followed into construction and transport bottlenecks as part of a diverse global opportunity.
Geoffrey Armstrong is a deputy fund manager at Sarasin & Partners