What does the prospect of tapering of QE and a potential rise in interest rates mean for real estate? Rachel Fixsen talks to six investors and advisers
Tapering already accounted for in current RE allocations
Allocations seen shifting between sectors
Whether and how institutional investors do reposition property allocations in reaction to tightening credit conditions depends on the reason for that tightening, according to Roderik Mulder, chief financial and risk officer at Composition Capital.
“We are not seeing repositioning of allocations occurring at this time among institutional investors,” he says. “Tapering has been taken account of in much analysis and the current allocations set with that already in mind,” he says, adding that, since interest rate increases will come from growth expectations, real estate remains a positive choice.
Whether rate rises do affect real estate allocations is depends on the cause. “This will be a case of whether the interest rate increase is caused by a loss of confidence in public finances or due to increasing growth expectations,” Mulder says.
If it is the latter reason, then that higher yield could be compensated for by higher rents and lower vacancies and real estate allocations could even increase as the inflation hedge argument kicks in. “Allocations could shift between sectors, though, as logistics and retail as consumer-driven sectors, may take some allocation away from offices,” he says.
“If higher interest rates are coupled with higher inflation, trading markets like Hong Kong and Singapore could fare worse than those that are commodity driven, and those that are driven by growing population such as Australia and Malaysia,” Mulder says.
Although interest rate rises may come in the end, Composition Capital believes bond yields could fall in the very near term, given the current delay of tapering in the US and the upcoming fiscal battle on the debt ceiling.
“However, we believe tapering will come and the debt ceiling issue will be resolved, which should then open the door to gradually higher interest rates, probably starting at the beginning of 2014,” Mulder says.
“In Europe the risk of mounting euro-zone tensions could hurt confidence in the euro-zone’s public finances again and increase bond yields,” he says.
In Japan effective growth would have to show a sustainable pattern before interest rates rose, and even then the increase would be slight.
Fidelity Worldwide Investment
Increased appetite for risk will benefit real estate
Rise in bond yields unlikely to hit secondary market significantly
The international property markets are likely to benefit from the current financial and economic outlook, which includes the prospect of higher interest rates but also that of stronger economic growth, according to Matthew Richardson, director of research for real estate at Fidelity Worldwide Investment.
Bond yields are likely to rise over the next 12 months for several reasons, he says. Not only are government bond yields relatively unattractive at the moment, but investors now have more options as economic growth returns. On top of this, market participants are motivated to exit bonds because no one wants to be left standing as capital values fall. Added to this is the winding down of QE,.
“Basically, government bond yields were driven down by the weight of cash looking for a safe haven,” he says.
But now, with economic growth expected in many regions – if not already in evidence – real estate will be one of the asset types to witness demand.
“With many economies – excluding the euro-zone – now emerging from recession, there is increased appetite for risk and investors are increasingly prepared to hold equities and alternative assets such as property,” Richardson says.
In theory, bond rate rises should put pressure on prime CBD assets values, which are very hot at the moment. “However, I don’t think this will happen in reality because UK prime real estate values are driven by overseas investors and their investment strategy isn’t predicated on the UK risk-free rate yield gap,” he says.
A rise in bond yields is unlikely to have a big impact on secondary real estate, Richardson predicts, because the current yield spread is at an all-time high, and this will cushion any upward pressure on yields.
But in any case, rising bond yields should be welcomed, Richardson argues, as it augurs a return to normality, showing that the intended stimulus effect of QE is not necessary anymore.
“This is only going to happen if economic growth accelerates,” he says. “Higher economic growth is good for property as the performance of commercial property is closely correlated to GDP growth.”
Pension fund currently increasing property allocation
If positive economy behind rate rises, real estate will gain
“Even if interest rates do rise in the next couple of years, real estate still seems an attractive asset class in an investment portfolio,” says Martin Tufvesson, deputy managing director of AMF Fastigheter.
The real estate arm of Swedish pension fund AMF is increasing its allocation to real estate. Today, property is in an underweight to normal position – or perhaps slightly overweight, if viewed in comparison to the fund’s very long-term asset balance, Tufvesson says.
“We believe interest rates will remain stable over the next 12 months,” he says. “But consensus reports suggest that over the longer term they will move gradually higher.”
Sweden is still suffering from a low level of economic activity and high unemployment, but at the same time spending power is on the way up and household consumption is expected to grow, he says.
“Since we are doing some re-positioning from other asset classes towards properties, limited changes in interest levels will not have any major impact on our allocation.”
AMF has around €4.8bn in real estate, which represents 12% of the pension fund’s total investment assets. AMF’s current allocation target for real estate is 10-15%.
“Higher interest rates might lead to slightly higher cap rates. But if the reason behind an increase in interest rates is a more positive economic outlook then the real estate values will benefit from a downward risk adjustment and a stronger rental market,” Tufvesson says.
The Swedish pension fund’s real estate investments comprise a directly-owned property portfolio as well as half of the Rikshem property company, which is a joint venture with Swiss buffer fund AP4.
The directly-owned portfolio is highly concentrated, limited to certain properties and hubs, all within Stockholm CBD and some specific areas within greater Stockholm, Tufvesson explains. It includes offices, retail properties and shopping centres,Rikshem, on the other hand, has a portfolio of residential properties in various growth regions of Sweden.
Interest rate rise seen happening as gradual, cyclical process
Some investors may cut RE allocations in favour of short or medium-term bonds
“Rates are not as influential on property prices as are rental prices and vacancy rates,” says Volker Wiederrich, CIO at consultancy Swisslake Capital. For this reason, he says, real estate will still be in a good position compared with other asset classes when interest rates rise.
The Swiss property investment advisory firm does not expect interest rates to increase significantly over the next couple of years. And the increase will probably take place as a gradual and cyclical process.
“We have already seen the first step since the financial community started debating the beginning of the FED’s tapering,” he says. “In the case of increasing rates, investors will probably reassess their allocation to real estate and might potentially reduce allocations in favour of short and medium-term bonds, as well as floating rate notes.”
Wiederrich says global economies are not strong enough to support property NOI growth capable of offsetting an interest rate increase. “It will take quite some time until we see the economy becoming more robust,” he says.
“Monetary policy makers are well aware that a significant short-term increase will at least hurt the economy. The question is, how long can they afford to wait for the economy getting more solid?”
As a consequence, international money is still chasing security, Wiederrich observes, and says properties in the best locations in major cities seem to provide this kind of safety.
China will continue to be Asia’s growth driver with a broad range of real estate opportunities in terms of sectors and strategies, he says.
“Opportunistic investors are showing increased interest in Southern Europe where values have remained at relatively low levels since the outbreak of the crisis,” he says.
On a global scale, Wiederrich sees the continuing debt restructuring process providing investors with attractive deals.
He says the industry will have to develop new ways of providing property finance in future, and cites emerging real estate debt funds as the first step in this process of change.
Principal Global Investors
London-focused RE stocks positioned to gain from upturn
Room for risk premium to narrow before property values fall
Rises in bond yields are a sign that the economy is recovering, and this dynamic is driving real estate strategy for Principal Global Investors, according to Simon Hedger, global portfolio manager for property securities.
“We’re running a global property securities fund, so we have to remain fully invested in real estate – we can’t run away and hide,” he says. “We have to look at it on the basis of what’s changing, and the likelihood is there’s more opportunity for growth.”
Looking at the UK, Hedger says rents are rising quite strongly on office buildings and stocks such as Great Portland, Derwent London and Shaftesbury are well placed to capture the upside as the economy recovers.
“We like office space, but are also looking at stocks owning buildings dotted around, rather than just those in the centre of London,” he says. Areas such as Vauxhall and some districts immediately north of the centre focused on small-to-medium-sized businesses have been picking up, he says.
Interest rates may be on the rise, but they are simply coming off an unsustainable low level, he stresses.
“The reason they’re going up is due to growth in the economy, and as that strengthens it will lead to employment growth, which means that businesses need more space,” he says.
Financial markets had already built in a risk premium that included an allowance for interest rate rises. “So there is room for that risk premium to contract and, therefore, some level of absorption of higher rates before they affect the valuations,” he says.
In terms of the global picture, Principal Global Investors now has a slight bias in favour of Asia, especially China, compared with the FTSE EPRA/NAREIT developed index. “We feel the fears surrounding China are now overdone, presenting a pricing opportunity,” he says.
Around 50% of the index is represented by US securities, 35% in Asia and 15% Europe, he says. “In the next six to 12 months it’s all about where the global economy is now and what the prospects are for growth, but recognising what is already reflected in the pricing of stocks” he says.
Standard Life Investments
Income-seeking RE investors may look to corporate bonds instead
Property will be increasingly sought for capital growth
Despite monetary policy developments in Europe and the US, strong reasons for investing in real estate will remain, according to Andrew Milligan, head of global strategy at Standard Life Investments.
“In the euro-zone and the UK, we would not expect interest rates to rise, as the Bank of England and the European Central Bank have made clear there will be no interest rate tightening in foreseeable future,” he says.
In the US, on the other hand, once the crisis in Washington is over, economic growth prospects are expected to be such that credit may be tightened, he says. “We would expect US bond yields to be higher rather than lower in 12 months’ time, and that would affect European bond yields.”
Investors targeting real estate for its income stream may choose other investments instead as yields rise, such as corporate bonds, which have a liquidity advantage over property, Milligan says.
However, those seeking capital growth will be encouraged by the reasons behind a possible US monetary tightening. “The reason the Fed is even thinking about tapering is that the US recovery is going to become self-sustaining and monetary policy needs to be brought back to a more stable situation,” he says.
But Standard Life Investments will not be changing its property allocations. “We moved to a heavy or overweight position in property last year because we were expecting the economic upturn to become more entrenched and we make our decisions on property on a three-year view,” says Milligan.
In the UK, growth is forecast to pick up in 2014-15, he notes. “People may still buy property for yield, but they will increasingly buy for growth, which will be more favourable.”
In this new scenario, certain real estate sectors may become more appealing to investors. If growth broadens out, logistics and retail may become more popular with buyers, for example, Milligan says, while offices with a running yield may attract less interest.
“The particular aspects of the lease will be looked at more carefully, because we are entering a new scene with more competition for other assets that can give income,” he says.