Still an uncertain world
The global economy remains a challenging environment for property investors. While global momentum has improved, it continues to be buffeted by periodic setbacks and disappointments. There have been a number of false starts, including a stalling Eurozone recovery, heightened geopolitical risk and turbulent emerging markets.
The net effect is that the world has not been able to shake off a general feeling of unease. Although the bulk of the available evidence still points to a gradual normalisation in the global economy, the recovery remains contingent on continued extraordinary policy stimulus from central banks and there are continued doubts about what exactly the new normal now is. In the meantime, this prolonged period of abnormally low interest rates has boosted a wide range of asset prices, including real estate, to unprecedented levels.
Further complicating the outlook is the increasing divergence in regional growth prospects. The USA and the UK have pulled away from their beleaguered European and Japanese counterparts. At the same time, uncertainty about the strength of demand in China and other emerging markets is continuing to cloud investor sentiment.
Diversification enhances global real estate returns
From a property perspective, the current mixed fortunes in the global economy are reinforcing the benefits to investors of holding a diversified real estate portfolio, which extends the investment choice to a greater range of potential market opportunities. No single location or property sector outperforms all other markets all of the time.
Total investment returns can be enhanced through a mixed portfolio, which offers the chance to increase exposure to leading markets early in the cycle and then take profit at the top of the cycle before those markets overheat.
As different regions move to different points of the economic cycle it will accelerate the divergence of real estate returns and reinforce the benefits of geographic and sector diversification.
Risk mitigation is particularly important
In addition to offering greater potential returns, the uncorrelated nature of global property market cycles means that diversification can provide a significant reduction in the volatility of portfolio returns, relative to the level of risk in any single market. The chart below shows the correlation between commercial property returns in London and 53 other global cities.
While there is a high correlation (above 0.90) between London and other UK cities, many markets have low or even negative correlation with the London market. Thus, by holding a diversified portfolio of lowly correlated global markets, the investor can avoid taking a compounded hit to returns in all markets all at once.
Diversification benefits are further enhanced when local market returns are adjusted for currency movements. When local currency returns are converted to Sterling (the white circles on the chart opposite) the relative performance of major global cities becomes even more uncorrelated, increasing the stabilisation benefits from a diversified portfolio.
Indeed, the extra cushion provided by currency diversification can be particularly important during large global demand shocks, which tend to hit all real estate markets simultaneously, but which cannot, by definition, hit all exchange rates at the same time. In other words, while local property markets often become more correlated during a global shock, currency-adjusted returns do not.
It takes local knowledge to deliver ‘alpha’ returns
The key difficulty with global property diversification is how to put theory into practice. Despite the clear benefits from global diversification, real estate investors have tended to have a greater home-country bias than investors in other assets classes. This partly reflects the inherent nature of real estate markets. Although property returns are closely tied to the economic cycle, there is often an opportunity in real estate to outperform the market by exploiting greater local knowledge and expertise to generate ‘alpha’: a better risk-adjusted return than the market average. However, there are few global investors who are able to be effective direct investors in a broad range of global property markets. Most are forced to access property opportunities indirectly by finding local experts with aligned interests and values, which is itself a challenge.
The enduring attraction of well-connected cities
The latest data on global real estate investment suggests a renewed appetite amongst real estate investors for global diversification: cross-border investment flows increased again in 2014, but are still not back to pre-crisis levels. However, a major theme since the crisis is that global investors remain particularly selective about which global real estate markets they are willing to invest in.
There has been a particularly strong demand by large global investors with a narrow focus on only top prime assets in the largest leading global gateway cities.
This shift reflects both structural and cyclical factors. Globally integrated and vibrant cities like London, New York and San Francisco have enjoyed more dynamic population and employment growth and are increasingly becoming incubators for a knowledge-based economy. This economic dynamism, in turn, creates greater potential real estate opportunities for local operators to exploit local knowledge to deliver above-market returns. Real estate in these leading global cities is a good investment, particularly for long-term investors.
The property cycle is not dead
Part of the recent bias toward large gateway cities has also been a retreat from risk in a period of enduring global uncertainty, which has kept investors anchored in safe-haven markets. The fact that the global recovery remains patchy has been reflected in continued periodic bouts of investor uncertainty, and a bias toward large, liquid markets. This has pushed yields in a number of key global real estate markets to record lows and created concerns about overheating.
In this environment, the main risk is complacency. While a diversified portfolio of leading global cities will provide strong returns over the long run, investors will need to look more closely at market fundamentals to distinguish which regions and sectors offer the best value, based on where they are in the cycle. With interest rates expected to remain low for at least another year, there is a risk that investors begin to under-price the prospect of an eventual normalisation in growth and interest rates over the medium term. This looks to be a particular concern in some of the larger prime global markets that have benefited the most since the crisis, but which are often the most advanced in terms of the property cycle.
Group Research Director