Comment: Return of the dreaded ‘denominator effect’

The significant wall of money that is currently supporting real estate may have just seen the first few signs of some cracks emerging. Here, Kiran Patel, CIO at Savills Investment Management, says the concern could be that more might be on the horizon.

‘In 2013, the average institutional target allocation to real estate was 8.9%. By 2021, this had increased to 10.7%. While in absolute terms this increase may seem small, it implies a significant increase in capital.

For example, a 10bps rise in allocation between 2020 and 2021 is equivalent to an increase in capital of $80 bn - $120 bn (€78 bn - €117 bn). The 180bp increase in real estate allocation between 2013 and 2021, following the same logic, indicates that a cumulative $1.6 tln of capital has been raised for real estate investment in the last decade or so.

This equates to a compound annual growth rate of 28% – a highly impressive ‘wall of capital’.

However, a number of the supportive tailwinds for real estate capital flows could fade, and cracks could be appearing in this ‘wall of money’ currently supporting real estate.

Negative yielding debt fallen to less than $3 tln. For instance, the amount of negative yielding (nominal) debt has fallen from $18 tln in 2020 to less than $3 tln off the back of rising inflation expectations and interest rate hikes by many central banks. Indeed, we expect negative bonds to be a thing of the past quite soon, providing investors an alternative choice of investments.

Concerns have also emerged about the outlook for equity growth stocks, particularly social media and tech stocks. Rising inflation has hurt consumers’ real spending power, provoking a major equity market tumble in these sub-sectors. The MSCI World Technology Index has fallen by more than 20% since the start of 2022 and the media and entertainment index by close to 30%.

In contrast, and thanks to some elements of an inflation hedging as a real asset, the listed real estate sector has fallen by 13% - broadly in-line with the wider market. Direct property markets have yet to fall, at least in any significant way.

With equity valuations falling and nominal fixed income returns rising, the question raised is whether the ‘wall of capital’ targeting real estate will be maintained – or will capital be re-allocated.

Intuitively this makes sense, as investors trade-off the relative return and risk premia of alternative assets such as real estate. A sustained rise in risk free rates driven by accommodative central bank policy would normally suggest that commercial property valuations need to adjust to maintain the required risk premium for investors to hold real estate in their portfolios.

Spread over 10-year bonds has collapsed
At the prime end of the market, with yields compressing towards 3% or lower for office and logistics assets in some countries, the spread over 10-year bonds has collapsed to the lowest level since the financial crisis.

In addition, all-in debt costs in some European markets are now higher than income returns. The consequence is that debt is no longer accretive for returns for many real estate investors, unless rental growth kicks in a big way. And this is by no means guaranteed, with businesses dealing with challenges brought about by slowing economic growth rates, and the risk of a recession on the horizon.

All else being equal, corporate profits are likely to be squeezed. Increasing business costs of energy, goods, transportation, wages and the like cannot all be passed onto the consumer via a rise in prices to protect profits.

The propensity to pay higher rental income therefore reduces. Bearing this in mind, it is a question worth asking whether the property risk premium over other assets should be higher.

Increased weighting of real estate 
Although the above will be tested over coming months, the decline in equity markets is already increasing the relative weighting of real estate in investor’s portfolios – this is widely known as the denominator effect. This is starting to constrain the ability of some investors to continue allocating to real estate as existing allocations are hitting or exceeding portfolio limits.

In conclusion, the significant ‘wall of money’ that is currently supporting real estate may have just seen the first few signs of some cracks emerging. The concern could be that more might be on the horizon.’


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