Patrick Moonen. senior multi asset strategist at ING Investment Management (ING IM), comments on the latest developments in global real estate.
The performance of global real estate has been very strong so far this year: global REIT’s are up 19%, driven by both the search for yield and a better economic outlook. Furthermore, Merrill Lynch’s June Investor Survey showed real estate was the most over-owned asset class relative to its own history. However, is real estate still as ‘safe as houses’ as these figures suggest?
After a strong start to the year for real estate, ING Investment Management International (ING IM) has observed significant regional differences in recent months, with the US continuing to outperform the market and Japan catching up after a slow start to the year. While Europe is sitting comfortably between these two markets, the most interesting observation has been the decoupling of UK real estate and its potential consequences.
The primary reason for this is related to the apparent shift the Bank of England (BoE) has made to its monetary policy; it has clearly tried to inject more volatility into rate expectations by issuing – at first sight at least – rather confusing messages. However, it is now widely expected that the BoE will act first on interest rates, although the exact timing of such a move remains uncertain. Given the sensitivity of real estate to rates, this underperformance is no surprise. Therefore, in the short term, rates dominate fundamentals.
In addition to this, the BoE has announced macro-prudential measures in an attempt to stem the rapid rise of UK house prices, which are no longer limited to the confines of London. Indeed, expectations of rising prices are visible across the UK. The Financial Policy Committee’s recommendation that no more than 15% of a lender’s total number of new mortgages should be greater than 4.5 times the borrower’s income, coupled with an affordability test to assess whether a borrower can afford to pay their mortgage if rates rose above 3%, is expected to arrest this sharp incline in prices. However, the jury is still out on the effectiveness of these policies – especially when considering that one of the major drivers of housing prices in the UK is lack of housing stock. A further issue to consider is that London market prices are affected by international investors who will not be affected by the implementation of such legislation.
Within Europe we have a preference for Eurozone real estate over the UK. Not only is the European Central Bank (ECB) still in the easing part of the monetary cycle, but the valuation metrics are also more favourable. Our analysis of yield metrics for both the Eurozone and the UK shows that the Eurozone has recorded a higher dividend yield of 4.1% compared to the UK’s 3.3%. Furthermore, the Eurozone real estate still offers a large premium of +2.3% relative to corporate bond yields, whereas in the UK yield of real estate is actually lower than the yield on corporate bonds, standing at -0.25%.
The explanation for this divergence is the risk of deflation, which could limit rental increases. In order to compensate for this, investors will require a higher immediate yield. This risk is less important in the UK; the implied 10 year inflation expectations are at +2.9% in the UK, compared to +1.4% in France and even less in Germany and Italy. This deflation fear may explain why, in Japan, the yield gap between real estate and bond yields is even larger.
Real estate offers a good income stream and has some optionality on economic growth. However, whilst we are positive on the sector, it must be highlighted that ING IM has downgraded its exposure in global real estate from a medium to a small overweight. The main reason behind this is the strong year-to-date performance coupled with an increased risk of somewhat higher bond yields following the BoE’s comments. In line with this, we have also reduced our exposure in UK real estate, where we are currently neutral.