Real estate, as an asset class, is evolving from a succinct set of commercial sectors with a strong link to economic growth into something more complex.

Real estate investors have been accustomed to economic growth leading to more physical capacity needed to support a rise in demand for goods and services. The reverse was mostly true during recessions.

But as the economy becomes increasingly digital and we can shop, work and entertain ourselves from the comfort of our homes, will this relationship break down?

We think not. But the relationship is changing, and new opportunities are emerging.

Past performance no guide to the future

The correlation between the UK’s gross domestic product (GDP) growth and UK ‘All Property’ total returns since the 1980s is 0.47, demonstrating a clear positive relationship. A higher number indicates a stronger correlation.

This is the strongest correlation with economic growth out of all the major asset classes (see Chart 1), even though there have been many peaks and troughs.

Source: MSCI, Refinitiv, MSCI, abrdn September 2023

Taking rolling ten-year periods, the correlation between UK property total returns and GDP was at its strongest in the 1980s and 1990s — at an average of 0.7 – before gradually drifting lower to average 0.3 in the decade to 2022.

Recent economic shocks, coordinated recoveries and the effects of ultra-loose monetary policy temporarily boosted the correlation. But, after adjusting for these exceptional events, the relationship does seem to be softening.

So, why is this happening?

We have identified four main reasons:

• International capital flows. There has been significant growth in these flows – diversifying the pressures in capital markets. Cross-border capital now accounts for some half of all property transactions in many countries. Different pools of investors with different motivations have been influencing capital-value trends and distorting domestic-market pressures.
• Asset class maturation. Put simply real estate has become institutional – increasingly compared to investments in fixed-income assets. Therefore, relative pricing of assets has begun to influence property valuations, at times even more so than underlying economic conditions. The use of borrowed money and the cost of debt have further diluted the explicit link to economic growth.
• ‘Property’ means something different. ‘All Property’ isn’t what it used to be. In addition to offices, retail, industrial and multi-family properties, this sector now includes more ‘operational’ assets, such as student accommodation, data centres, healthcare facilities, cinemas, marinas and even cemeteries and golf-driving ranges. The INREV ODCE index – which covers diversified European property funds – has a 17% weighting to so-called ‘living’ sectors (as of June 2023), a share that has grown from less than 1% in 2018. These sectors benefit from changing structural demand and are less tied to short-term economic developments.
• Sustainability. For an asset class that’s responsible for some 40% of global greenhouse-gas emissions, environmental, social and governance (ESG) credentials are now playing a substantial role in asset- and sector-performance differentiation.

Polarisation is emerging within sectors. Some offices may become ‘stranded’ assets. Other energy-efficient properties should be easier to lease, offer investors greater liquidity and carry much lower capital-expenditure requirements to meet Net-Zero decarbonisation targets. This could be the most significant driver of real-estate performance over the coming decade. 

Will the relationship completely fade away?

We don’t think so. When the chips are down we tend to need less space, financing is tougher, and investors retrench. There’s no getting away from that.

Some sectors will sustain a stronger link to the economy than others. The so-called ‘pro-cyclical’ sectors – such as offices, retail, light industrials, logistics and leisure – are likely to hurt more during an economic downturn and recover faster when the economy gathers pace.

Meanwhile, sectors such as residential, student accommodation, senior living, urban logistics, healthcare, and data centres are likely to show greater resilience due to other long-term drivers of demand. Take senior living and healthcare, for example. France’s over-65 population is expected to grow by some 5 million by 2050, which is the equivalent of half the population of the Paris metropolitan area, yet the provision rate of bespoke publicly- or privately-financed later-life accommodation is less than 4%. The same story is true in many other countries.

Is real estate the perfect inflation hedge?

The short answer is no. The long answer is, well, partially. The crux of the debate can be found in the interpretation of a ‘hedge’, or protection. On the one hand, real estate total returns demonstrate a low annual correlation with inflation (even when lagged) and therefore would not constitute a perfect hedge, according to some definitions.

However, by a second, and arguably more relevant, definition the asset class has delivered above-inflation ‘real’ – inflation adjusted – total returns over the long term, supported by resilient cash flows and capital appreciation.

Comparing inflation-adjusted real estate returns against inflation-adjusted government bond returns paints a clearer picture. Since 1988, real UK government bond returns have delivered -0.1% per annum, while real UK real estate returns have delivered roughly 6.3% over the same period.

That would appear to be a healthy relative return, even if you factor in the risk premium required to invest in illiquid real-estate assets. You can see this happening in other countries where we have sufficiently reliable data.

How will real estate perform over the shorter term?

We are moving at pace through what we consider to be a distinct three-phase real-estate cycle. These phases are:

1. Re-valuation. An ongoing re-adjustment of real-estate yields in the higher interest-rate environment. We believe this is some 75% complete given expectations for rates to peak this year.
2. Recession. A period of performance dispersion based on asset quality and the strength of economic linkages by sector. Our preferred sectors are logistics, residential (including private-rented residential, student accommodation, micro-living and senior living) and some select components of the core office and retail sectors.
3. Rental Growth. Elevated cashflow generation and income growth, resulting from a decade of insufficient development and low levels of new supply coming through in the next five years.

Final thoughts

We believe that investors are still not factoring in the effect that climate change, energy efficiency and regulation will have on real estate performance in the coming years.

While these factors will also share a relationship with economic growth, we believe that asset quality and building efficiency will be key drivers of performance and this should be an area of significant focus.