I have been fortunate over the last few months to visit clients and assets across various countries. I took the opportunity to assess offices in Seoul, residential in Tokyo and shopping centres in Abu Dhabi.
My visits reinforced our observation that regional divergence, alongside variations in strategies and sectors, have become even more important for real estate investing.
Despite today’s economic challenges (an economic slowdown worsened by rising interest rates), it is critical for investors to remain focused on the individual and fundamental drivers that operate within each market.
In particular, we must continue to focus on how economic, demographic, technological and social factors combine to affect markets in unique ways.
Together, these factors do something special – helping real estate assets to start a subtle decoupling from the cycles of economic growth that have traditionally driven performance.
Advancing through the 3-phase cycle
We think real estate valuations will go through these three distinct phases over the short term:
- Phase 1 - Revaluation. Real estate debt costs increase sharply, pushing real estate bond yields higher. This has happened in developed markets, such as the UK, Europe, the US and in parts of Asia too. A notable exception is Japan, a key Asian market, which has stuck with accommodative policy so that yields (and vacancy rates) have been more stable. Appetite for investing in real estate debt often increases at this stage, be it NPLs, whole loan or other outcomes.
- Phase 2 - Recession. The UK and Eurozone are expected to be the first major economies to enter a technical recession by year-end. The US will likely follow in the second quarter of 2023, even though the economy has proven more resilient than anticipated.
Attention shifts away from real estate yields to income risk, particularly as bad debts and insolvencies increase. Traditional real estate sectors have a strong correlation with economic growth (see Chart 1) and weaker assets will suffer.
Chart 1: Real Estate Total Returns vs GDP
Source: abrdn, MSCI and Eikon, November 2022
- Phase 3 - Recovery. Economic activity rebounds amid a recovery in business sentiment and consumer confidence. Compared to the 2007/08 global financial crisis, there’s much lower industry gearing and very low supply within construction pipelines.
This combination will underpin strong income growth prospects for good-quality assets across sectors as the economic cycle moves forward.
The shortage of high-quality real estate in key sectors – residential, high quality and specialist logistics, sustainably-focused offices – is an important driver of yield return.
Beyond economic cycles
But behind the headlines, the fastest growing parts of the real estate universe are often less correlated with economic growth.
Technological change, demographic shifts, the need to reduce carbon emissions and mitigate climate change, as well as changing consumer behaviour, are powerful forces that affect demand for newer types of real estate.
While real estate is correlated to the macroeconomic environment, it is also affected by human behaviour and the changing ways in which we live.
Chart 2: US-listed market capitalisation by sector (Dec 2009 vs Sept 2022) – the growing importance of new sectors
Source: NAREIT, Bloomberg, abrdn, November 2022
Newer ‘de-coupled’ sectors
Here are three newer real estate sectors that are less driven by the boom-bust pattern of economic cycles, offering diversification and growth benefits to a property portfolio.
- Student accommodation. Purpose built student accommodation (PBSA) is a particularly interesting diversifier. Demand for university places typically rises when labour markets weaken.
Student enrolment continued to increase across Europe and the UK during the pandemic. International students already account for a substantial share of the UK’s student population. We also see an increase in English-language courses offered in continental Europe.
This is happening amid a significant shortage of bespoke student housing across Europe. Rising rents for private rentals, and increased competition between universities to provide the best student experience, are creating new bespoke PBSA investment opportunities. - Logistics. In the traditional commercial sectors, we continue to believe in the fundamentals behind the logistics sector, driven by demand from changing business models. The overall vacancy rate across Europe is at a record low of 2.4%. Supply-chain modernisation, e-commerce, near-shoring and just-in-case supply-chain management have quickly absorbed new supply.
A new generation of time-sensitive, on-demand consumers will continue to drive further technological and supply-chain enhancement. We are only now seeing a second wave of investment into areas in Europe, such as cold storage. - Sustainability-focused offices. Office demand will be increasingly determined by building quality and their environmental, social and governance (ESG) credentials.
Prime rents continue to rise across city centres as the type and quality of ‘future fit’ offices account for only a small proportion of total office stock. In Seoul, office-rental growth accelerated to 15% year-on-year in the second quarter this year, as the vacancy rate fell to 3.9%, the lowest since December 2009.
Meanwhile, one of France’s largest property managers has reported a record year for rental growth in central Paris.
Going global
Opportunities to invest in the best assets with the strongest stories will differ from country to country. By taking a global approach, investors can access the best new ideas in the strongest locations.
For example, the UK has a more mature student accommodation market. France offers strong senior living and healthcare operators. Meanwhile, the urban logistics story is at a much earlier stage of development in Australia and across most Asian and continental European markets.
Furthermore, global investing enables the strategic allocation to different economic cycles, different lease indexation structures and, ultimately, markets with higher or lower risk-adjusted return expectations.
Going global also directs allocations to different human behaviours and cultures – changing the dynamic of the underlying cashflow driver.
Final thoughts
While investors will, understandably, be focused on short-term market volatility and opportunities, the longer-term strategic fundamentals of real estate investing remain intact.
It is important to focus on the core drivers of demand in order to capture the best of what real estate has to offer. With that as a starting point, investors can consider the best entry point on a relative-value basis across the equity, debt and listed spectrum.
What’s clear is that, while real estate will always have a correlation to the broader macroenvironment, human behaviour has become more important than ever before.
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