MAGAZINE Investors on the defensive as year of uncertainty nears

With real estate markets bracing themselves for potential headwinds in 2019, investors should be adopting defensive strategies to find value, say experts.

Who’s afraid of 2019? Some investors are approaching the New Year with apprehension rather than anticipation. The prospect of the long real estate cycle coming to an end, of interest rates rising and of the European Central Bank (ECB) ceasing its Quantitative Easing programme are all contributing to the gloom.

A slowdown in economic growth in the UK and Continental Europe, including Germany, its traditional engine, is not helping to lift the sense of dread. Add a sprinkling of geopolitical uncertainty, with questions marks over Brexit Britain, France in revolt and Italy and Poland at odds with the EU and it is clear why the mood is far from festive.
Some brush all these concerns aside and see many reasons for optimism. Demand is still strong, real estate is seen as a good investment, foreign capital keeps pouring into Europe from all corners of the globe and the yield gap with bond yields is set to remain attractive.

It is one of those times when the world – or at any rate Europe - is divided between those investors, economists, analysts and experts who see the glass half empty and those who see it half full. The latter firmly believe that the cycle will end gently and not before 2020 or 2021.

‘Real estate markets face potential headwinds in 2019 as Brexit, trade tensions and rising interest rates threaten to weigh on demand,’ says David Skinner, managing director of real estate strategy and fund management at Aviva Investors. ‘Across UK and European real estate markets the prospect of rising interest rates has already had an impact on investor sentiment and will impact capital values next year.’

Hard to find value
Yet property will continue to offer an attractive risk premium over the medium term. The yield on the German 10-year Bund is expected to rise to just 1% by the end of 2021, compared to an average of 4.3% between 2000 and 2007. Therefore, as Skinner points out, ‘while flows into riskier, less-established parts of the real assets universe may start to slow, prime property assets in locations supported  by favourable economic conditions will remain in demand and are less likely to experience significant repricing.’

Investors are likely to adopt a wait-and-see approach as the Bank of England continues to tighten policy and the ECB prepares to phase out its QE programme. ‘Real estate is vulnerable to a higher interest rate environment, and while there is as yet no discernible upward pressure on yield, investors will likely be feeling more apprehensive about the current levels of pricing in the European market,’ say UBS analysts. On the plus side, they point out, rental growth is driving property returns and occupier markets appear to be strong. With prime office yields below 3% in some major cities, ‘it would not take much of a shift to see some impact’.

Defensive positioning
Investors are likely to find it increasingly hard to find good value in this late stage of the real estate cycle, with a backdrop of rising interest rates and expected declines in capital values that will impact total returns. Those with long memories know that market corrections, when they come, tend to be painful. With yields so low, a small correction could have a big impact on capital values.

‘Our analysis that assesses the attractiveness of European real estate markets on a risk-adjusted basis shows there aren’t many sectors and geographies that are attractive,’ says Skinner. ‘Positioning defensively is the most appropriate course of action. Sectors that may offer attractive risk-adjusted returns include supermarkets, student housing and hotels. To enhance income-producing strategies, investors should also look at opportunities to improve or create income growth by actively managing, repositioning and developing assets in strong locations.’

This points to a competitive market, with more investors chasing increasingly scarce and expensive assets in good locations in Europe’s winning cities. ‘The uncertain context and the peak of the cycle are making people focus on quality and security, core markets with good liquidity,’ says Eri Mitsostergiou, European research director at Savills. ‘Everyone wants to buy prime so pricing is very keen, but investors are able to judge which products are worth the high prices. Some assets, such as secondary shopping centres, are being re-priced and that is a good thing.’

Urbanisation continues
Europe’s winning cities are set to become even more of a magnet as the urbanisation trend continues to take hold and mobile young professionals move to places with good jobs and a good vibe. This will support offices and the residential sector in all its forms, especially purpose-built multifamily, co-living and urban micro-living. The interest in residential is likely to spread from established markets like Germany, the Nordics and the Netherlands to nascent markets like France and other European countries.

Another trend that will continue in 2019 is redevelopment, says Lydia Brissy, European research director at Savills: ‘Change of use and repositioning of buildings makes a lot of sense in the current market, it is a way of adding value to the property and then put it back on the market as a prime asset.’ As direct investments become more expensive in some markets, the case for real estate debt and REITs could become more compelling in Europe. ‘Pricing risk is the key risk investors are exposed to when investing in real estate markets,’ says Skinner. ‘If the direct market remains expensive in 2019, REITs are likely to offer a better entry point than direct investments.’

Reasons to be cheerful
The good thing about the long cycle is that everyone has been waiting for it to end and is getting ready. ‘There will be no sudden shocks because people have been preparing themselves for the rise in interest rates and the cycle coming to an end,’ says Mitsostergiou. ‘They are realistic and cautious about where they lend or where they invest, but they look at the fundamentals and  have faith in real estate.’

Barring an exogenous shock, the threat of a major correction in real estate values is limited, thanks to the low leverage in the system and the ongoing dearth of yields from other assets, according to Invesco Real Estate. Real estate’s capacity to deliver strong performance and stable income makes it a compelling alternative in the current low-yield environment. ‘There are risk factors of which investors need to be mindful,’ notes Mike Bessell, European research strategist at Invesco Real Estate. ‘However, participation in real estate from the investor community is one of the highest among the various alternative asset classes, and we expect this to continue to grow in importance in portfolio allocations moving forward.’

Martin Schellein, head of investment management for Europe at Union Investment Real Estate, is among the optimists: ‘Europe is looking attractive, and there is too much money around,’ he says. ‘I don’t think there will be a sharp market correction.’

Question mark over Brexit
Some investors were spooked by the Bank of England’s November report and in particular by the worst-case scenario it envisaged of a disorderly Brexit that could lead to a 33% fall in residential property prices and a 48% collapse in commercial property prices. However, this was not a forecast but a possible scenario that is unlikely to materialise.

Brexit, however messy, will not lead to a downturn comparable to the financial crisis of a decade ago. The situation is very different, with much lower loan to values and cautious bank lending. Most importantly, says Mat Oakley, Savills’ director of commercial research, ‘Brexit is not a global event, so international wealth will not be similarly hit as it was in the GFC. This means that non-domestic investors may choose to capitalise on any fall in sterling or in property prices. This return of equity to the market is likely to stop falls in prices fairly quickly.’ 2018 saw an increase in European investments in the UK, which shows that investors are less worried about Brexit and more concerned about grabbing bargains while they can. 


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