January 14, 2020
Diverging Markets Demand Discerning Investors
January 14, 2020
Diverging Markets Demand Discerning Investors
January 14, 2020
Morgan Stanley Real Estate Investing “MSREI” believes that the current confluence of macroeconomic, capital market and property market dynamics will continue to produce a robust flow of investment opportunities for private real estate investors in 2020. In contrast to the last three to five years, where investors were generally able to ride broad-based market performance to generate above average returns (largely through cap rate compression), the dispersion between countries, markets, sectors and asset types will likely widen requiring investors to deploy capital more thoughtfully.
Global growth re-acceleration expected due to easing trade tensions and easier monetary policy
On the macro front, trade tensions and monetary policy are easing concurrently for the first time in almost two years, which we believe is expected to lift global growth from 1Q20 on. However, the recovery will be uneven and driven more by emerging markets as the U.S. and other developed markets are late-cycle. Risks, including re-escalation of trade tensions, heightened conflicts in the Middle East, U.S. election year uncertainty and the Brexit transition will continue to create market volatility and pockets of illiquidity. Against this macro backdrop, global property and capital markets remain relatively strong, although bifurcation in performance will be increasingly evident, with pockets of strength visible in specific assets and sub-market locations that meet the needs of occupiers, in particular in the affordable residential sector, well-located industrial assets and highly amenitized office assets in transit-oriented locations.
Real estate returns will be more driven by growth in cash flows
Real estate has benefited from the economic recovery cycle and low interest rate environment in most parts of the developed world, supporting attractive returns driven in large part by cap rate compression over the past several years. As a result, current valuation levels in most sectors and markets are elevated and future returns should be expected to moderate. Within each sector, returns will likely be more dispersed by market and the opportunity to deploy capital broadly against in-demand macro themes such as industrial and residential will be more challenged given the amount of competition. This will require successful investors to understand the idiosyncrasies of individual markets by leveraging local market expertise and access off-market opportunities by calling on deep partner relationships. Additionally, with returns less reliant on cap rate compression and more dependent on growth in cash flows, this will require even more active asset management strategies to reposition assets and create value.
Low interest rates should continue to support attractive cap rate spreads
Given global interest rates are expected to remain low for an extended period, capital flows should continue to be robust across all major global markets, exerting upward pressure on pricing particularly for higher quality assets in prime markets. Cap rates are likely to remain relatively stable and spreads over long-term government bond rates are expected to remain above historical average levels across most regions and sectors, perpetuating the attractive investing environment that exists today.
Display 1: Major Economies have begun to Decouple1
Display 2: Easing Helps to Support a Recovery in Global Growth2
Display 3: Cap Rate Spreads Remain Wider than Historical Averages in Most Markets
In the U.S., the benefit of lower interest rates will continue to support the economy, however growth is expected to slow from 2019 levels and stabilize around trend. The Fed will likely remain on an extended hold through mid-2021,3 allowing inflationary pressures to build from an ever-tightening labor market amid few signs of overheating. The economy remains on solid footing with no recession in the near term forecast, helped by less external drag and sustained easy monetary policy.
In Europe, the modest global recovery and policy easing will likely result in slightly improved but still below-trend growth. Negative interest rates are likely to persist as the ECB maintains its easing bias, while moderate fiscal stimulus may provide additional support to the cycle. Following the Conservative Party’s election victory in the U.K., MSREI expects an easing of Brexit tensions, with growth accelerating to above trend as Brexit uncertainty reduces and through fiscal easing.
In Asia, MSREI continues to believe in the long-term growth prospects for the region, particularly in markets such as China and India fueled by increased urbanization, middle class formation and service sector growth. China’s growth is expected to stabilize at around 6%, with trade tensions tilting risks to the downside. In Japan, growth will remain sluggish in the near term due to the consumption tax hike, but the medium-term outlook remains constructive, supported by fiscal policy and productivity growth. In Australia, growth is expected to remain subdued in the near term due to persistent household deleveraging and then re-accelerate from additional stimulus measures, including further interest rate cuts. Population growth in Australia’s major cities of ~1.5% per annum over the next decade4 remains well above other developed countries which should continue to support real estate demand across all sectors. In South Korea, the pause in U.S.-China trade tension and a mini global recovery should help growth accelerate modestly over the next two years. Lastly, growth in India is expected to improve in 2020 due to continued accommodative monetary policy and increasingly supportive fiscal policy.
Across all regions, property market fundamentals remain relatively in balance. The industrial sector continues to exhibit the strongest performance globally, spurred by outsized tenant demand driven by ecommerce and supply chain reconfiguration, although supply is increasing in several markets, most notably in the U.S. Residential sector fundamentals continue to be supported by supply shortages predominately at affordable price points, although some regulatory risk is evident in markets where affordability is stretched. Office sector fundamentals continue to be closely tied to market specific demand and supply dynamics. Lastly, retail sector fundamentals continue to be the most challenged, with ecommerce, oversupply in some markets, tenant bankruptcies and the rise of discounters creating headwinds for growth. These challenges could present opportunities to reposition retail assets that are in the midst of being re-priced.
Within this macro and real estate environment, investment strategies need to be aligned to each sector and differentiated by geographic region and country. Opportunities should be sought after in sectors and markets with secular tailwinds that will support outsized growth in excess of macro/cycle fundamentals (e.g., industrial, residential and healthcare) and the focus should be on sub markets supported by above average demographics underpinned by strong technology drivers.
Separately, there may be more opportunities to pursue investments in re-priced markets (e.g., luxury residential, retail and select office markets). Finally, where debt and equity markets are fragmented or dislocated, there may be opportunities to selectively target distressed debt situations, (e.g., India, China) and potential public/private market value arbitrage opportunities.
Display 4: Global Market Cycle5
GLOBAL REAL ESTATE MARKET OPPORTUNITY
MSREI believes that the unique mix of recovery, volatility, and potential distress and the dispersion evident across real estate markets and sectors will present an attractive window to make real estate investments. In this investing environment, MSREI believes local market knowledge, presence and relationships, combined with the ability to actively manage assets to drive Net operating income6 growth will be critical to deliver above market returns.
Outsized pockets of growth should appear as decoupling of developed and emerging markets continues
Global growth is expected to recover to 3.2% in 2020 and 3.5% in 2021 up from an estimated 3% in 2019.7 The growth re-acceleration can be characterized as a mini-cycle recovery (similar to the modest rebounds seen in 2013 and 2016) in the context of a late cycle expansion. With the global monetary easing cycle under way since 1Q19 and trade tensions now de-escalating, global growth is likely to trough in 4Q19, followed by a recovery from 1Q20 onwards. The expected recovery will be uneven and vary across different economies based on their relative exposure to trade and manufacturing, the magnitude and effectiveness of policy easing and a reversal of some of the idiosyncratic factors which had also weighed on growth in 2019. As a result, MSREI expects further decoupling between and within developed and emerging markets, creating opportunities to target outsized pockets of growth as well as potential market dislocations.
Display 5: Another Mini-Cycle Recovery in the Context of a Late-Cycle Expansion8
Emerging market growth is expected to increase from 3.9% in 2019 to 4.4% in 2020 and 4.7% in 20219
In China, an easing of trade tensions will lift corporate sentiment and continued policy support should help prevent a hard landing. In emerging markets outside China, macro stability has given central banks the space to adopt accomodative monetary policy, which helps to support a recovery in growth. In India, the improvement in the health of the financial sector will help to reduce risk-aversion and, coupled with continued policy reforms, drive an improvement in domestic demand. Similarly, in Brazil, lower rates will help to boost consumer demand and the passage of pension reform will help support corporate sector sentiment. Current tensions with Iran and potential oil price impacts could create headwinds for emerging markets growth.
Display 6: A More Meaningful Acceleration in EM Growth10
Developed market growth is expected to continue to moderate from 1.7% in 2019 to 1.3% in 2020 and 1.5% in 202111
In the U.S., growth is expected to stabilize around trend in 2020, as lower rates help to offset fading fiscal support. In the euro area, growth is expected to pick up gradually over the course of 2020 as external headwinds subside and the impact of policy stimulus kicks in. In the UK, we expect Brexit tensions to ease after the election outcome which could support a rebound in growth. In Japan, growth is expected to remain relatively sluggish with the consumption tax hike weighing on activity in the near term, although continued fiscal support should contribute to more moderate growth in the medium term.
Display 7: Long Term Structural Trends
The re-acceleration of global growth is likely to be driven initially by the consumer sector
While the consumer in aggregate is in relatively good shape, with healthy household balance sheets, still-low unemployment in most markets and moderate wage growth, a pick-up in sentiment from easing trade tensions and the lagged effects of lower interest rates should spur further spending. As consumption growth improves, business investment is likely to follow leading to increased levels of capex spending.
Low interest rates over the near to medium term will continue to support growth
Over the course of 2019, interest rates around the world dropped precipitously. In the U.S., the ten year government bond rate has dropped from 3.2% in late 2018 to 1.8% today (as at January 10, 2020).12 Similarly in Germany, the German bund dropped from +0.4% to -0.2% over the same time period. MSREI believes interest rates will remain low for an extended period of time due to structural forces associated with aging demographics and higher global savings rates in addition to cyclical drivers, i.e., the desire to use monetary policy easing to stimulate the global economy. Twenty central banks eased their monetary policy in 2019 and a further thirteen central banks are expected to ease further in 2020 bringing the global weighted average policy rates to a seven-year low by March 2020. The 2020 rate cuts that we expect are concentrated in the EM space, with the central banks in India, Brazil and Russia cutting rates once more to take nominal policy rates in these countries to either a historical or post-crisis low. In developed markets, the Federal Reserve (Fed), European Central Bank (ECB), and Bank of Japan (BoJ) are expected to stay on hold throughout 2020 while MSREI expects one rate hike by the BoE in 4Q20.
Despite a generally favorable environment risks remain skewed to the downside
Trade tensions remain the biggest downside risk to the recovery. Despite the phase-one trade deal that was announced in mid-December between the U.S. and China, both parties remain far apart on key elements of a broader agreement, which will create ongoing uncertainty and may cap the upside for private sector confidence. On top of trade tensions, uncertainty around the U.S. elections in late 2020 and geopolitical risks elsewhere in the world, including heightened tensions in the Middle East, ongoing protests in Hong Kong and the Brexit transition plan and associated trade agreements, could keep a lid on corporate confidence and overall growth.
We expect that commercial real estate will continue to perform well in this moderate growth, low interest rate macroeconomic environment
Cap rate spreads have increased and are now above historic averages in most countries and sectors and real estate fundamentals, helped by relatively low levels of new supply, currently remain favorable contributing to moderate forecasted rent growth across most markets. Institutions are continuing to allocate more capital to real estate given its attractiveness relative to other asset classes, which is likely to lead to continued strong capital flows, which have totaled $1.7 trillion for the last 12 months through the third quarter of 2019.13 Overall, given high pricing levels, returns are expected to decelerate as cap rates stabilize and rental growth becomes the major driver. In this environment, MSREI believes that it will be increasingly important to focus on intense asset management to improve properties in order to meet changing occupier needs and optimize growth in cash flows.
Display 8: Online Sales Penetration Increasing
Logistics Rent Growth Above Historical Av.
REAL ESTATE FUNDAMENTALS AND INVESTMENT OPPORTUNITIES
Disruptive trends should benefit logistics and residential sectors and challenge office and retail sectors
Long-term trends including technology and data usage, population growth and urbanization, mobility and travel, and sustainability and climate resiliency, will continue to disrupt commercial real estate usage and locational preferences. MSREI believes that rent growth will be strongest in the industrial and residential sectors driven by ecommerce and housing shortages. Office sector rental growth will be closely tied to market specific supply and demand characteristics. The retail sector will continue to face challenges associated with ecommerce and changing retail business models. Additionally, in today’s environment, a significant amount of real estate stock does not match tenant/occupier needs in terms of amenities, functional specifications and Environmental, Social, and Governance standards, requiring repositioning and asset management strategies to drive value. While these top-down long-term trends will inform investment strategies, local market knowledge and relationships will be even more important to identify opportunities given the expected divergence in performance by location and sub-asset type within each sector.
ecommerce will be the differentiator
Across the globe, the industrial sector has seen more yield compression than other sectors over the last three years (73bps vs 32bps for office and 12bps for retail) driven by outsized investor demand (industrial liquidity over the same period is 57% higher than historical average).14 Along with the significant improvement in capital markets, rent growth has been very strong, particularly in the U.S., but more recently in Asian and European markets. Underpinning the strength in tenant demand and fundamentals has been the growth of ecommerce and associated supply chain reconfiguration to support compressed customer delivery times. Assuming growth in ecommerce sales continues to outpace broad-based retail sales, it is likely that the ecommerce leasing share will continue to increase. This should favor markets that have relatively stronger expected retail sales growth, higher increases in ecommerce penetration and assets that can reach a large population base in the shortest possible time. Within markets, assets in locations where labor availability is high and existing infrastructure is robust will likely attract the most occupier interest, generate the strongest rent growth and outperform the broader market.
Demand for affordable housing should create development and repositioning opportunities in major residential markets
MSREI believes that overall housing shortages will persist across major markets contributing to affordability challenges. House price growth continues to exceed rent and wage growth leading to lower home ownership rates in many parts of the world and stronger demand for renting. While political risks and“tenant-friendly” populist movements may constrain rent growth in the more affordable segment in certain cities (e.g., Berlin, New York), opportunities still remain to drive occupancy and mark rents to market. In the U.S., the multifamily sector has seen record levels of demand that has pushed vacancy rates down to 5.9%, near this cycle’s lows.15 In Germany, for-rent residential fundamentals remain robust (nationwide rent growth of 1.4% per annum over the last three years, higher in major cities like Munich 9% and Frankfurt 5%) given the steady demand from the country’s structurally low homeownership rate and high relative rent affordability. In the UK, accelerating urbanization should support strong demand growth for the private rented sector (PRS). Given the overall strength of investor demand for product in the residential sector, yields have compressed significantly (e.g., down 120bps in Germany and 30bps in the U.S. over the last three years).16 Given the mismatch between housing demand (more affordable) and available supply (luxury) is likely to continue, MSREI expects to see opportunities to reposition or create more affordable product in major residential markets around the world, while at the same time evaluating potential distress in the luxury residential segment of gateway cities including New York and London.
Tech-centric office markets likely to outperform
In the office sector, fundamentals vary across gateway cities but remain broadly balanced, with steady job growth and lower supply offset by secular efficiency trends such as densification, coworking and rising capital expenditures. Despite recent weakness in some technology valuations, venture capital fundraising and research and development spending from “Big Tech” firms’ remains healthy, supporting tech-centric office market demand across major global cities, including San Francisco, Seattle, Boston, London, Stockholm, Berlin, Singapore, Shanghai and Sydney. Vacancy rates within these cities have reached record lows and rent growth has been above five percent per annum over the past several years17. However, supply levels have begun to increase, particularly in Europe, which is likely to moderate future rent growth.
Office tenants’ preference for higher quality, amenitized space in walkable locations with robust transportation infrastructure has led to clear outperformance for assets that meet those specifications. We expect that differences in sub-market and asset performance will be even greater over the next few years requiring that investors leverage micro market knowledge and an indepth understanding of occupier needs to identify specific locations and assets to capture this expected outperformance.
While ecommerce trends and housing shortages represent supportive tailwinds for the industrial and residential sectors, densification of office space will likely continue to be a headwind to office absorption, albeit it at a decelerating pace. Additionally, markets with significant coworking exposure (e.g., WeWork) may see a marginal slowdown in rental growth driven by a reduction in new take up, and in all likelihood, a more significant negative impact on cap rates, particularly for properties with significant coworking tenancies. MSREI believes this will potentially create repositioning opportunities for specific assets that may undergo re-pricing.
Source: PMA, JLL, CoStar, MSREI Strategy, as of December 2019
Strong headwinds will continue to favor higher quality properties
In the retail sector, despite steady growth in consumer spending, MSREI believes that fundamentals will be challenged due to growth in e-commerce, shifts in retailer business models, the rise of discounters and future store closures. The sector will likely continue to bifurcate with the better quality centers outperforming less well-located Class B/C centers. For example, NOI growth for high productivity malls has averaged 3% over the past five years, double the NOI growth of lower productivity malls and this trend is expected to continue and be most pronounced in countries with high levels of retail space per capita, such as the U.S. and UK18 MSREI believes there may be opportunities to acquire better quality centers or high street locations where NOI has bottomed and occupancy costs are sustainable. These centers may be mispriced due to an overall lack of investor interest in the sector.
Structural trends predominately associated with technology and demographic changes will continue to disrupt each real estate sector. In addition to ecommerce, housing shortages and coworking trends already referenced as impacting the industrial, residential, office and retail sectors, MSREI believes that aging demographics will be a secular tailwind for healthcare (predominately medical office and life science). Within the hotel sector, moderating tourism flows and higher levels of supply (from traditional sources, Airbnb and shortterm apartment rentals), are likely to create near-term headwinds for fundamentals. As a result, MSREI may selectively evaluate opportunities in these sectors, leveraging development and operating partnerships, where feasible.
Display 11: Market RevPAF19 Bifurcation
Significant Bifurcation Evident Globally
MSREI believes that the expected recovery in economic growth in combination with lower interest rates will continue to offer attractive investment opportunities in global real estate markets in the short to medium term. Low interest rates should support healthy cap rate spreads and robust capital flows. Additionally moderate levels of supply in most markets and sectors combined with pockets of outsized tenant demand should create conditions for NOI growth in certain sub-markets and sectors. Appreciation will result from superior NOI growth versus yield compression which has contributed to strong broad-based market performance over the past five years. Within this investing environment, MSREI believes local market knowledge, presence, and relationships combined with the ability to actively manage assets to drive NOI growth, particularly in the industrial and residential sectors, will differentiate managers in their pursuit of above market returns.