What a year! Looking back now at the major events of 2016 it is staggering how much happened and how sentiment in the real estate market has swung from one extreme to another. In January last year concerns about the Chinese economy, large declines in equity markets and a $27 oil price led to a focus on the threat of deflation. The 10 year US Treasury yield hit an all-time low in July and negative yielding bonds became common place in the Eurozone. The UK had to deal with the threat and then reality of Brexit which damaged confidence and transaction volumes and led to dramatic REIT share price falls and the closure of open-ended funds. Sterling has also fallen some 15% but with Trump’s election the expectation of higher growth and inflation has seen a surge in the dollar and a rotation from bonds into equities, driving very strong stock market performance.
Whilst transaction volumes in UK real estate in 2016 were down c.30% on 2015, the year will still be in line with long run averages and there is plenty of capital looking to invest. Particularly now that the UK economy has shown resilience to the referendum vote (so far!). The majority of this capital is looking for long income of a minimum of 10 years, where the yield arbitrage over bonds is still healthy and the currency falls make the in-price seem more attractive to overseas buyers than pre-referendum. There are still very few shorter income transactions occurring and the less an investment looks like a bond and carries occupational risk, the more pricing has moved. However with very few forced sellers now that the open-ended funds have reopened there is limited transaction activity for the valuers to use as comparable evidence. REIT shares have been trading at c.20% discounts to NAV, with the stock market pricing in expected falls in values, particularly for the London focused companies.
I still like to examine the reasons for the bullish vs. bearish views on the market: (i) real estate offers an attractive yield relative to bonds and pension funds from around the world are searching for yield and increasing allocations to real estate; particularly now that bond yields are rising and inflation is expected to erode bond values. There has been limited development other than in London and in many markets there is a supply / demand imbalance and leverage is considered less of a risk today than in 2006/7/8. On the other hand; (ii) inflation will lead to an increase in base rates and the real estate yield gap risks being eroded, Brexit will damage London offices where there is the risk of oversupply in 2018-2019 and occupational demand will be weak for some time because of the uncertainty of Brexit. I think that if we take account of both sides of the argument we can position ourselves to exploit the current dynamic.
Brexit volatility and uncertainty in particular is an opportunity (assuming you believe, as we do, that in the medium to long term the UK will be able to forge its own path successfully outside the EU). Now, more than before, we can feed the demand for long income and pay less for shorter income assets with our value-add approach and asset management skill-set. In the meantime we will be looking to avoid the City of London and the majority of the office sector (unless as part of a Mixed Use or Infrastructure-led opportunity) and we remain unconvinced by the retail sector, which is oversupplied and continues to be affected by the growth in internet retailing. Instead, by focussing on demographics and structural/societal changes we can take advantage of some early stage sectors that are systemically undersupplied (eg Build to Rent (BTR), Student Accommodation, Senior Living, Logistics) as part of our “Beds and Sheds” strategy.