GLOBAL REAL ESTATE
Relative value opportunities in a market priced to perfection
Where are global investors likely to find attractive real estate opportunities? It’s a fair question, with economies in mid to late cycle, interest rates rising and properties generally priced to perfection. Global core real estate returns have averaged just over 10.5% since late 2010, following global financial crisis lows (EXHIBIT 1). Valuations have been a significant driver of those returns, however, leaving much of the real estate market fairly priced.
A great global run for real estate has led to a relatively fully priced market
EXHIBIT 1: OPEN-END FUND RETURNS, GLOBAL ROLLING 12 MONTHS
Source: IPD, J.P. Morgan Asset Management; data as of June 30, 2018.
Finding value requires looking beyond the averages. Regional markets are at varied stages of the economic cycle and monetary policy normalization. These differences, and a host of distinct dynamics across and within regions, styles and sectors, create pockets of opportunity that can help investors diversify and enhance real estate portfolio income and return.
Here are some areas our regional real estate specialists view as among the most promising over the next 12 to 18 months.
U.S.: DON’T UNDERESTIMATE CORE
Century Plaza Towers and 2000 Avenue of the Stars,
Los Angeles, California
Since early 2016, income from leases of existing U.S. core assets has been growing at a faster annual rate (4% to 5%) than core property values (2% to 3%).1 We anticipate that rising construction costs will help support increasing rental incomes. When construction costs go up, new properties have to charge higher rents to be viable; that allows existing core properties to raise rents with less risk of losing tenants. Rising construction costs will also limit new space available for lease—another positive for rent growth. So we see further upside in core rents and valuations, provided the economy and demand continue to hold up.
EUROPE: BUY VALUE-ADDED AND SELL INTO CORE
While investors have been drawn to the U.S. value-added sector in search of higher returns, they have been hesitant to move beyond core in Europe. This is not surprising, given the instability engendered by a host of geopolitical uncertainties—the ongoing Brexit negotiations, the outlook for the eurozone, the Scottish referendum, Italian elections and the end of the Merkel era, to name a few. “Europe” is not a homogeneous place. The result, based on what our on-the-ground investment teams have been seeing, is a pricing spread between value-added and core assets that has remained well above average.
This very risk aversion has created an arbitrage opportunity for knowledgeable, discerning investors to seek out undervalued and undercapitalized properties (e.g., languishing office space in top-tier European cities), carefully price the risk and implement a strategy to revitalize and lease up the building with quality tenants. Once the property is fully occupied and stabilized, the goal is to sell it into the core market, where demand is high and valuations attractive.
Of course, it’s also important to have a finger on the pulse of the market and recognize when the spread begins to tighten and the opportunity starts to fade. We’ll keep you posted.
ASIA-PACIFIC: A DIVERSIFIED MARKET IN MID CYCLE
53 Albert Street, Brisbane, Australia*
Asia-Pacific real estate has matured from a largely value-added and opportunistic market to one with greatly expanded and increasingly transparent core opportunities. Japan, Australia, Korea, Singapore, Hong Kong, New Zealand and China account for roughly 90% of the overall Asia-Pacific real estate market and offer ample opportunities in the major gateway cities for building a solid, well-diversified core foundation. What’s more, the growth outlook is relatively strong; Asia-Pacific appears firmly in mid cycle in economic growth and monetary policy normalization.
Multi-family properties for lease in Tokyo and Osaka are among the many high quality core opportunities we are seeing. Net in-migration, increasing household formation and a strong preference for smaller rental apartments are driving core real estate opportunities in these cities, despite Japan’s overall aging population. An influx of youthful Japanese workers, in search of higher paying, better quality jobs and a dynamic urban environment, has helped maintain occupancy rates of over 95%2 and household formation rates of 1.6% and 1.4% for Tokyo and Osaka, respectively.3 This is supporting stable, attractive core levered internal rates of return (IRRs) of around 8% for multi-family leased space, with roughly 80% of returns from current income.4
REITs: ADDRESSING VOLATILITY
Volatility has returned to the equity markets—the REIT market included. With its varied investor base—encompassing ETFs, hedge funds and momentum players—REIT equity is far more volatile than the value of its underlying real estate. In this late-cycle, high volatility environment, investors may want to consider a combination of these two approaches to enhance real estate portfolio performance:
- Dampen volatility by investing throughout the REIT capital stack. A REIT, like any other business, has both equity and debt (typically including secured mortgage loans, unsecured bonds and preferred convertible debt). Buying the debt offsets the leverage embedded in REIT equity and can meaningfully reduce a REIT portfolio’s volatility.
- Use the liquidity and volatility of the REIT market to potentially enhance returns. An experienced, skilled investor, particularly one with a benchmark-agnostic approach, can be nimble, buying and selling those REITs they believe are under- or overvalued to potentially generate attractive total returns.
Even in a market that is largely priced to perfection, knowledgeable, experienced global investors with a broad toolbox can find a robust set of attractive real estate opportunities.
1 National Council of Real Estate Investment Fiduciaries (NCREIF) Fund Index Open-end Diversified Core Equity (NFI-ODCE); data as of September 30, 2018.
2 The Association for Real Estate Securitization; data as of November 2018.
3 Occupancy rates as of 2017. Cities of Tokyo and Osaka government websites; data as of June 2018.
4 J.P. Morgan Asset Management; estimates as of November 2018.
*Photo courtesy of nettletontribe architects
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