Will Sovereign Wealth Funds sell out of real estate in 2016?

Sovereign Wealth Funds have become important investors in the global real estate markets. We believe sustained lower oil prices have the potential to trigger a sell-off in their real estate holdings.

11th February 2016

Sovereign Wealth Funds (SWFs) have been important investors in the global real estate markets in recent years.  This article looks at the potential impact that lower oil prices could have on SWF real estate strategies.  Our analysis suggests that if oil prices remain at current levels, there is a material risk that SWFs may begin selling assets to help ease their domestic fiscal pressures.  In this environment, London office looks to be the global market most at risk from profit-taking. 

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The importance of SWFs is relatively new:  SWFs have become a major investor across a range of global asset classes in recent years, including global real estate.  While SWFs have existed for decades, their influence as a global investor is relatively new and has been largely driven by the sustained rise in energy prices since the early 2000s.  The total value of SWF assets is now estimated at around US$7.4 trillion; of this, energy-based SWFs are estimated at around US$4.1 trillion (56.4% of total).  As Chart 1 shows, the rise in SWF assets has closely tracked the sustained rise in the current account surpluses of oil exporters over the past ten years. 

SWF have become active real estate buyers:  As the asset base of SWFs has increased their acquisition of global real estate has also risen, particularly over the last five years.  The move into direct property has been led by Middle Eastern and other energy-funded SWFs (Chart 2).  Over the last five years total global net direct real estate acquisitions by SWFs totalled US$89 billion (gross acquisitions of US$122 billion and disposals of around US$33 billion).*  This represents around 3% of total commercial property real estate transactions (excluding land) through this period, reaching a record high of 6% last year.**
 

SWF activity is highly concentrated in a handful of cities:  In terms of their geographic real estate allocation, SWFs have been narrowly focused on a small selection of top-tier global cities: 80% of total SWF investment has been in just twelve leading global cities, with 53% of their total real estate investment in just three cities; London, New York and Paris (Chart 3).  In London, SWFs have purchased a total of US$37 billion in commercial real estate assets since 2007.  By sector, they have been predominantly invested in offices, which account for around half of their total direct real estate acquisitions through this period.

But the wheel may be starting to turn:  The combination of sustained lower oil prices and a diminished outlook for commercial property returns has the potential to shift SWF’s investment appetite for property.  Although SWFs are typically characterised as “long-only” investors, little is actually known about how they will respond to any sustained change in market conditions.  While most have long-term capital preservation objectives, many commodity-based SWFs were also set up explicitly to shield their domestic economy from large and sustained fluctuations in commodity prices.***  

Lower oil prices create significant challenges for SWFs:  The sustained drop in oil prices over the past year means that OPEC is now running its first current account deficit in almost 20 years.  This is creating a multitude of pressures for oil-exporting countries, where both financial and political stability hinge on the oil price remaining high enough to fund the government budget.  The IMF estimates that the “fiscal breakeven” oil price (i.e. the price of oil the government needs to avoid a deficit), is on average around US$83 a barrel for OPEC members.  With oil prices now around US$35 a barrel, the combined fiscal deficit across all OPEC countries is estimated to rise to around US$300 billion in 2016, or an average of 7% of GDP.  As a result of these fiscal pressures, Saudi Arabia has already been forced to issue its first sovereign bond since 2007 to help fund its deficit.

A number of SWFs may be forced to sell assets:  With oil revenues falling, new capital inflows into SWFs have dried up and pressure is now building for SWF to start to sell down assets to assist their governments to meet their state funding needs.  Norway has already announced its plans to withdraw around US$430 million from its state oil fund in 2016. It is conceivable that if the oil prices remain low, more SWFs may be forced to return cash to national governments through asset sales, including commercial real estate.   


 

London is particularly vulnerable:  If SWFs were to sell, then London office is likely to be high on the list of potential disposal assets.  SWFs have acquired an estimated US$27 billion in Central London offices since 2007, spread across more than 70 deals.**** The City has been the main focus of this investment, with US$10.9 billion (this equates to 11% of total deals in the City through this period).  But they also have large exposures to Canary Wharf and the West End.  Current pricing means that now is a particularly good time to take profit in the London office market.  With London office yields moving below 4%, London capital values are now at a record high relative to the price of oil.  Chart 4 has started to receive attention; it highlights that in Q4 2015, the value of 1 sq ft of prime West End office was equivalent to 110 barrels of oil.*****

For now, there are no immediate signs that SWFs are changing course on real estate.  Indeed, 2015 was another record year for property investment by SWFs, with an estimated US$39 billion in direct net new global real estate acquisitions.  With that said, SWFs do appear to have started targeting a wider selection of global cities, particularly across the US.  But with oil prices expected to remain relatively low for the remainder of the decade, SWFs are likely to come under more pressure to repatriate funds to help offset domestic funding pressures.

Markets like London, where SWFs have an over-weight allocation and where pricing is now approaching record levels, remain particularly vulnerable to profit taking.  While there are no signs that they are heading to the door yet, a sell-off by SWFs could be an important trigger for the next downturn in the London market. 

* Over the last decade total global net direct real estate acquisitions by SWFs totalled US$141 billion (gross acquisitions of US$193 billion and disposals of around US$51 billion). 
** In addition to direct real estate (which accounts for around 50% of total SWF real estate assets), SWFs also have exposure to real estate through real estate debt and indirect investments in unlisted property funds and REITs. 
*** A number of potential objectives of SWFs have been suggested. These include: (i) to diversify assets; (ii) to get a better return on reserves; (iii) to provide for pensions in the future; (iv) to provide for future generations when natural resources run out; (v) price stabilisation schemes; (vi) to promote industrialisation; and (vii) to promote strategic and political objectives.
**** During the past eight years, SWFs have been net buyers of London office stock, with only twelve assets sold. The average holding period for SWFs is around six years from acquisition.
***** The chart originally appeared in Jefferies UK Equity Research report 25 January 2016.

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