The market backdrop
Investors are resetting expectations for returns amidst continuing pressures in the economic environment as the world continues to experience global political uncertainty, sluggish economic growth and trade tensions between economic powerhouses. Interest rates are now expected to remain lower for longer than first anticipated.
In this context, investors are turning to asset classes better able to deliver attractive returns. In particular, they’re seeking out investments that exhibit defensive characteristics. There has also been significant growth in global assets under management, underpinned by the growth in the middle class of developing nations.
Market reactions and considerations
As a result, investors are continuing to direct cash flows to non-residential real estate.
There is some difficulty in this approach. Globally, investors are under-allocated – unable to place all targeted allocations to real estate – and seeking to increase these targeted allocations. However, the scarcity of this asset class means the investable universe is somewhat fixed and, unlike other asset classes such as bonds, there is no unlimited supply to meet investor demand.
For example, there are only 18 premium office buildings in Sydney, Australia and six in Melbourne, Australia. A global investor interested in the best assets in the largest markets of the Australian office sector will find the potential of that market restricted.
This imbalance in supply and demand is driving commercial real estate asset values across the globe. While record high pricing has tempted us to call the peak of the market over the last three years, the attractiveness of the sector amidst such uncertainty and volatility means we expect the cycle to continue to extend.
Historically, real estate investment has been dominated by investment in the office and retail sectors, however as part of this search for supply we are witnessing a shift towards logistics as well as growth in demand for non-traditional sectors.
The logistics sector has benefited from a number of factors, including the growth in e-commerce, improvements to the supply chain, the increased use of robotics, and savings in transportation costs by being located close to the customer. Property is typically a smaller part of the cost structure of an online retailer, and the benefits of proximity allow substantial capacity for these businesses to pay more for well-located accommodation.
Whilst the outperformance of logistics is attractive, it is a sector that is difficult to scale up – there is only a certain amount of suitable property located in close proximity to large residential centres. Given these constraints, the next port of call for investors are non-traditional sectors that look set to be beneficiaries of global mega-trends.
Examples of this abound. The exponentially increasing global demand for data will require a vast expansion of capacity and in many cases different model of communications infrastructure, such as the proliferation of edge data centres that looks set to accompany the move to autonomous mobility. An increasingly urbanised population and declining levels of housing affordability is fuelling demand for alternatives, such as high-quality manufactured housing. A rapidly ageing population and a shrinking taxpayer base is shifting the onus for aged care provision onto the private sector.
This diversification of cash flows into real estate has led to the compression of yield spread between the more traditional sectors and these newer investable sectors.
Further investment in these sectors will broaden this diversification and more effectively disperse risk across real estate, with different factors driving performance in each sector. Under this new model of real estate investment, management expertise becomes increasingly important as opportunities open up that are outside of the traditional sectors and, in many cases, further up the risk curve.
With capitalisation rates at record lows, driving income and managing risk have become key to growth. Performance is increasingly specific to the asset concerned, opportunities are more difficult to identify to the casual investor, and the management of environmental, social and governance (ESG) considerations are paramount to achieving sustainable value.
Real estate is a sector exposed to considerable regulatory influence, entailing both upside and downside risk. The consideration of ESG factors, especially in the current political climate, is unavoidable, and should be ingrained in the active management of the asset, at every point of the buy-hold-develop-sell cycle.
As the world grapples with uncertain prospects across a number of other asset classes, the outlook for non-residential real estate remains distinctly positive, with sound property market fundamentals still at play, and investors continuing to be attracted to the defensive characteristics of this asset class.
Subscribe below to Market Watch to receive my latest articles.Claire Talbot, Fund Manager
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