The global economic outlook has shifted dramatically over the last few months. Along with the surge in inflation and swift rise in rates has come financial market volatility.
Over the first half of 2022 a typical US balanced multi-asset portfolio (60% stocks: 40% bonds) delivered its worst total return result since the 1970s, falling in value by 12%-15%.1
Overall, investment returns are likely to be lower in the cycle ahead and this has re-focused investors on the diversification and income security of real estate.
Real estate in the current market
Real estate has not been immune to macro challenges and has come under increasing pressure as inflation rises and interest rates rapidly follow.
Gross domestic product (GDP) is a key driver of demand for real estate and the expectation for growth to weaken at the same time as the cost of capital increases has seen a decline in the deployment of capital.
Real estate returns through the next cycle are likely to become more disparate by sector and quality of asset. This creates real opportunity for counter-cyclical and targeted strategies for experienced real estate investors poised to take advantage of assets under-valued or mispriced.
The real estate universe
The real estate landscape is vast and heterogeneous, with investors able to gain exposure through listed and unlisted vehicles, debt/equity hybrid instruments, open and closed-end managed funds, and in more recent times, real estate credit.
Ranging from more traditional commercial office, retail and industrial assets, real estate encompasses automated logistics and warehouse facilities, hotels and pubs, student housing, apartments, build-to-rent, data storage centres, childcare centres and medical and allied health/life sciences facilities.
Why invest in real estate? The great diversifier
Real estate has historically had a low correlation with equities and bonds. This means the addition of real estate to a multi-asset portfolio can lower overall volatility and support a higher rate of return per unit of risk.
Its status as the great diversifier remains just one of its key roles in balanced investment portfolios. Historical performance results show real estate can deliver strong total returns, security of income and a hedge against inflation.
The long-term relative performance of real estate has been strong.
In Australia commercial real estate delivered a 10-year average annual total return to the end of June 2022 of 9.5%.2 Although slowing into 2022, this compares to 9.3% for Australian equities and 2.6% for 10-year government bonds over the same period.3 The total return from private real estate is achieved at a much lower level of volatility compared to equities.4
When supported by strong economic and population growth drivers, the long-term outlook for real estate is robust.
Income driving total return
Real estate delivers a relatively secure cashflow. A significant proportion of total return – around 70% – accrues from rental income and this reduces volatility as income is more stable than other asset classes, predictable and in Australia, frequently adjusted to inflation.
In addition, consistent and predictable contractual income returns mean real estate is not as sensitive as other asset classes to sudden, unexpected or one-off economic or geo-political shocks.
Inflation hedge | 2022 the true test
Real estate attracts investors throughout the economic cycle and especially during periods of inflation as it is widely considered an inflation hedge.
Pricing power for real estate is frequently in the hands of the asset owner. With rents reviewed periodically, inflationary increases can be passed through to tenants, depending on lease tenure and structure.
In conjunction with the ability for income to be cushioned from inflation, real estate can also maintain the purchasing power of capital through the appreciation of value as construction costs rise.
Quantitatively driven consensus on the impact of inflation on real estate performance is limited.5 Results across time periods, sectors and geographies vary, although a consistent co-dependent variable is GDP growth.6
Central bank policy error, over-correction of rate rises and damaging distortionary impacts of heightened inflationary expectation on the efficient allocation of capital are common in the transition periods from low to high inflation.
It remains to be seen where the Australian inflation story is heading. Conviction remains, however, in the ability for prime real estate managed by experienced and capable operators to deliver on income and maintain capital value through the cycle ahead.
Prevailing risks: inflation, rates and growth
Counteracting the narrative of the benefit of an inflationary environment for real estate is the persistent uncertainty around GDP growth, one of the largest drivers of real estate performance.
Australian Treasury forecasts for GDP growth have recently been revised down to 3% for 2022/23 and 2% for 2023/24.7 Although the outlook for Australia is much stronger than other parts of the globe it remains heavily dependent on inflation targets being met by mid-2024, the resolution of post-COVID supply chain issues, what happens in China’s domestic economy and the geo-political conflict and energy crisis in Europe.
In addition to the lower growth expectations, the flattening/inversion of the yield curve has altered the risk profile for real estate investment.
Real estate has traditionally traded at a premium to the risk-free rate, generally accepted as long-term (10-year) sovereign bonds. The investment yield (calculated as the net operating income by the current market value of the asset) represents the compensation for investors in order to take on the risk associated with real estate investing compared to the security of government bonds.
The sharp rise in the cash rate over 2022 and narrowing of the yield spread between real estate and bond yields reminds investors of the growth-sensitive nature of the capital component of real estate investing.
A final risk factor remains the structural challenges for landlords where patterns of consumption and demand are in flux following the disruption of COVID-19.
The rise of specialised and opportunistic investing
Risk/reward profiles are under review for all asset classes as the cost of capital rises.
Over the first half of 2022 a balanced multi-asset portfolio delivered its worst total return result in 50 years.8 Equity markets have bounced back in recent months, yet the increased volatility and uncertainty has tempered growth expectations. Overall, investment returns are likely to be lower in the cycle ahead and this has re-focused investors on the diversification and income security of real estate.
With a rapidly changing macro environment it is important to remember the underlying drivers of real estate return and the risk factors in play.
New and emerging sectors are potentially set to benefit from changing patterns of consumption while more traditional real estate assets experience significant structural shifts.
Prime assets offering the latest in amenities and sustainability features are keenly contested when they come to market. Investor interest has kept a tight lid on investment yields, although this may diminish the ability for owners and managers to deliver alpha.
A preference for high-quality assets offering spatial flexibility, strong amenity, technology and sustainability credentials has emerged post-COVID.
Real estate returns through the next cycle are likely to become more disparate by sector and quality of asset. This creates real opportunity for counter-cyclical and targeted strategies for experienced real estate investors.
As the spread between real estate yields and the risk-free rate narrows into 2023, some less astute owners will come under pressure from the rising cost of capital. Opportunistic and value-add managers are poised to take advantage of assets under-valued or mispriced, where the potential to deliver outsized returns still exists.
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The spectrum of real estate assets
Within the broad array of private and public market options and the complex web of asset types sits an array of investment strategies.
Core investments are relatively low-risk investments in established, deep and transparent markets. Core assets are high quality with minimal vacancies.
Core plus has a similar profile to core, but with the potential for enhanced returns arising from upcoming lease expiries, re-positioning or other relatively minor asset upgrades.
Value-add investments have a higher risk profile with a longer holding period to execute major refurbishment and repositioning.
Opportunistic investing relies on counter-cyclical astute asset selection requiring substantial additive managerial expertise due either to high vacancies and/or the need for repurposing due to dislocation in the broader market.9
1. Thoughts on the Market, Morgan Stanley, Allocation - Stock & Bond Correlation Shifts, 17 August 2022 www.morganstanley.com
2. The Property Council of Australia/MSCI Australia All Property Digest (AUD) All Assets, MSCI, the index tracks performance of 1,401 property investments with a total capital value of AUD 210.5 billion as at June 2022, www.msci.com
3. Equities return quoted is the ASX All Ordinaries Accumulation Index, Government bonds is the AusBond Composite 0+ Index, www.bloomberg.com
4. The correlation coefficient for All Property/MSCI Australian Equities Index is 0.12. Source: Risk Module - Quarter ending June 2022, The PCA/MSCI Australia All Property Digest, www.msci.com
5. Private Markets Real Estate Fundamentals, Pitchbook, www.pitchbook.com
6. As above
7. Ministerial Statement on the Economy, The Treasurer, The Hon Dr Jim Chalmers MP, 28 July 2022, www.ministers.treasury.gov.au
8. Thoughts on the Market, Morgan Stanley, Allocation - Stock & Bond Correlation Shifts, 17 August 2022. www.morganstanley.com
9. Private Markets Real Estate Fundamentals, Pitchbook, www.pitchbook.com
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