Where next for global real estate markets?

Global real estate returns have been recovering for the last six years. Have they now passed their peak?

7th April 2016

Continue to the other two articles in this edition of the Global Outlook:

Markets calming but cyclical headwinds strengthening.

We expect the global economy to record another moderate expansion in 2016 but the downside risks have increased. Graham Parry, Group Research Director, explains. Click here to read more.

Global industrial: out of the shed and into the spotlight.

Global industrial and logistics property recorded a great 2015. What are the sector's key themes for 2016 and beyond? Brian Biggs, Research Analyst, Global, shares his insights. Click here to read more.

Total returns remained strong in 2015, but are approaching their peak. 

2015 was another good year for global real estate markets, with total returns estimated around 9.5 %1  p.a., above the average of the last five years (8.9% p.a.) and little changed from 2014. Global real estate returns have been recovering for the last six years and have probably  now passed their peak.

Assessing the market cycle is complicated by the fact that markets have become less synchronised, at least at a country level.  Dispersion in all property returns has started appearing among core markets as some approach their peak while others are at an early or middle point in the cycle.  IPD total returns in the US, Germany, Japan and France were stronger in 2015 while total returns in the UK slowed  sigificantly reinforcing the view that the UK market (driven by London) is closer to the end of its cycle.  

Performance boosted by sustained yield compression, with yields at historic lows. 

One of the other main difficulties in gauging the stage of the cycle is the unusual yield cycle.  We estimate that global property yields tightened by around 30 bps in 2015 and are below their 2007 pre-crisis peak.  As Chart 1 highlights, 80% of the largest prime markets are now at or below their pre-crisis peak.  The Grosvenor global office yield composite, which is a lead indicator of real estate yields more generally, was at 4.2% at the end of 2015. This has historically been a signal for a potential downturn.  However, property risk premiums remain higher than normal, (mainly due to extremely low bond rates) with the global spread at 250 bps, around 100 bps above its long-term average (Chart 2). his suggests that risk premiums are appropriate if interest rates remain depressed for an extended period.

Investment activity continues to be strong.

The continued tightening of yields has been driven by strong investor demand.  Global transaction volumes for commercial real estate deals reached $900 billion2  in 2015, up 10% y-o-y, although still below the 2007 peak of $1 trillion.  Investment volumes surged in the US and Europe, increasing significantly compared to the year before (24% and 23% y-o-y in local currencies, respectively), while activity in Asia slowed (down 11% y-o-y).  Last year saw cross border investment at its highest rate as a share of the total since the Global Financial Crisis, accounting for around 30% of global transaction volumes.  Investors appeared confident to move outside their region as capital values recover and positive rental growth in global cities in the US and Europe continues.

Prime cities continue to attract the majority of investment. 

Despite the dispersion at a national level, one of the interesting trends is the concentration of investment in large, globally connected cities.  These gateway cities continued to outperform in 2015.  New York and London, the top cities in terms of investment volumes globally, together accounted for around 15% of total transaction volumes and an even higher proportion of cross-border investment (around 26% of the total). As a result both markets have seen strong yield compression, with yields now at historic lows. 

The majority of global investment activity was concentrated in 30 cities, which collectively captured around 60% of global investment volumes.  New York, London, Los Angeles, San Francisco and Tokyo have been the top cities in terms of investment volumes in recent years, but some non-gateway cities have begun attracting investor interest. Cities like Dallas and Atlanta in the US ranked in the top ten globally while Madrid made it in the top 30.  Non-gateway cities in the US and Europe have seen yields move in significantly, still there is a healthy spread between prime and secondary pricing across markets that reasonably reflects relative risk (Chart 3).

While we acknowledge that long term fundamentals would favour gateway markets, concentration bias in these markets at historically high pricing (as it can be seen by the historically low yields in Chart 3) is a concern.  At this point in the cycle selective investment in non-gateway markets could offer better value.
 

Total returns for 2016 will be contingent on rent growth. 

Over the past three years, yield shift has accounted for the majority of capital growth but we have now started seeing rental growth playing an increasingly bigger part.  Vacancy rates are trending downwards and with supply still at lower levels than previous peaks3 , moderate rental growth is evident across markets catching up with the strong investment demand seen over the last years.  Our global rent composite shows y-o-y average rental growth of around 5% across prime markets.  Globally the strongest rental growth has been in cities that have a high degree of finance, business services and technology sectors, while cities without strong knowledge-based economies have seen more subdued growth.  We expect this trend to continue over the long-run; the rise of a knowledge-based economy will open a widening gap between cities that have strong innovation-led economies and attract the “creative class” and those that struggle to diversify their economies away from historically strong industrial bases.

From a rental growth perspective, different cities are at different points in the cycle.  Gateway markets like London are advanced in the current cycle, while some cities in Continental Europe, like Madrid, are only now starting to see growth.  Overall we expect there is some more room left in the rent cycle over the next two years, depending on the market.  Rental growth can support pricing for the time being but going forward we do not expect it to be enough to counteract the impact of rising yields; at the current low levels, rent growth would have to be unusually strong to offset even a small increase in yields.

The 2016 outlook is positive but expectations are weaker for the medium term.  

Global real estate has enjoyed a number of strong years, supported by sustained yield compression.  While 2016 should be another positive year for global real estate returns, with available capital for the sector reaching a new record of around $443 billion4, we are approaching the peak for the current cycle.  With little room for yields to move in further, total return expectations for the medium term are weakening despite improving occupier fundamentals.  Many global real estate markets are now looking fully priced and are exposed to any unexpected negative shocks that reduce rental growth expectations and investor demand. Careful assessment of fair value is now more important than ever.

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