2017 INVESTMENT STRATEGY ANNUAL - LASALLE INVESTMENT MANAGEMENT
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2017 INVESTMENT STRATEGY ANNUAL
Managing Editors
Jacques Gordon Robin Goodchild Richard Kleinman William Maher Mahdi Mokrane
Global Strategist International Managing Director International Regional Director
Director U.S. Research and Director European Research
Global Research and Strategy North American and Strategy
Strategy Research and
Strategy
Elysia Tse
Regional Director
Asia Pacific Research
and Strategy
Contributing Authors
David Baskeyfield Catherine Chen Anne Koeman- Chris Langstaff Leigh Warner
Zuhaib Butt Irèné Fossé Sharapova Daniel Mahoney Manuel Zapata
Simone Caschilli Yasuo Kono Simon Marx
Research Staff
Kevin Ansong Alejandro Diaque Elton Li Sophia Sul Dennis Wong
Mary Burke Kayley Gafur Aya Miyazaki Jared Sullivan Huw Williams
Jade Cheong Jack Hopper Chris Psaras Annabel West
LaSalle Investment Management
Lynn Thurber Mark Gabbay Wade Judge Simon Marrison Jon Zehner
Chairman Regional CEO Regional CIO Regional CEO Co-Head,
Asia Pacific North America Europe Client Capital Group
Jeff Jacobson
Chief Executive Alok Gaur Jason Kern Alan Tripp
Officer Co-Head, Regional CEO Managing Director
Client Capital Group North America United Kingdom
Julian Agnew
Regional CIO David Ironside Stanley Kraska, Jr.
United Kingdom Regional CIO Head of Global
Continental Europe Securities
lasalle.com
ISA 2017
3 15
Chapter 1 Chapter 2
Investment Outlook Portfolio Management
23 24 31
Chapter 3
Regional Investment
Outlook Asia Pacific Europe
38 47
Chapter 4
The Changing Role of
North America Real Estate in a Portfolio
The winds of change will be blowing throughout the world economy in 2017. Headwinds and tailwinds can both be expected, along with market turbulence. After seven years of slow and steady improvement in real estate fundamentals and values in many countries, the pace of change has begun to accelerate. In this year’s Investment Strategy Annual, we distinguish between cyclical, secular, and structural changes in the countries where we are most active. During periods of market turbulence, real estate income streams play an important, stabilizing role in an investment portfolio. Yes, the valuation of income streams can be buffeted by volatility in the capital markets. However, the financial characteristics of rental income will matter much more in 2017. The principal drivers of value will shift from yield compression to income stability and growth. LaSalle’s view is that investors are likely to encounter stretches of elevated capital market volatility in 2017-2018. We do not expect a repeat of the Global Financial Crisis (GFC). Instead, we see pockets of high liquidity juxtaposed with gaps in the supply of capital. Unlike the GFC, when major markets were highly correlated, we see great variety in both real estate fundamentals and capital markets in the different countries where we invest.
CHAPTER 1 Investment Outlook
Chapter 1 Investment Outlook
The Global Outlook for largest economies in the world as a steady contributor to
world growth and rising real estate values.2 Tens of millions
2017 and Beyond of people in emerging markets have been lifted out of
Over the last seven years, macroeconomic conditions poverty over the last seven years and now generate incomes
contributed to unusually strong and stable real estate that are driving consumer spending or fund savings and
performance. However, a series of cyclical, secular, and investment growth around the world.
structural changes are likely, so investors should prepare for
turbulence in the years ahead. Cyclical and secular changes Yet, the starting point for real estate pricing in 2017 is
are a response to broad economic or societal forces; significantly higher than it was in 2010. Cyclical and secular
structural shifts occur when the rules that govern societies trends, accompanied by structural shifts, have all moved
and markets undergo a major transformation. Structural forward in ways that create new challenges and
shifts can be abrupt and are often initiated by political opportunities for investors. Put another way, the last seven
events, new regulations, or a disruptive technology.1 years have fully restored the capital base of real estate to
They are also linked closely to cyclical and secular forces; roughly where it was in 2007; and in global gateway cities, it
frequently, a structural shift is the political or regulatory is now much larger and deeper. The same building stock
response to cycle volatility or to the gradual realization of a that served the 2007 economy cannot sustain the 2017
long-term trend. All three kinds of change have been economy at the same level of productivity. The aging stock
evident in the U.K.’s Brexit referendum, the election of must adapt and needs to be expanded to accommodate 10%
Donald Trump in the U.S., and the centralization of to 12% larger economies in G7 (rich) countries and 30% to
President Xi Jinping’s “core” leadership in China. In short, 40% larger economies in emerging markets. Economic
after a period of relative calm in the capital markets in activity is also now distributed differently across the cities
2010-2016, investors may encounter different risk-return of the world. Relative to 10 or 20 years ago, it is more
conditions over the next five years as structural change concentrated in urban areas and, through trade, more
takes center stage. interconnected to international markets. The 2017 stock of
buildings will need to continue to grow and adapt to all the
The broad economic and financial landscape has changed changes that are coming by 2027.
dramatically since 2010. Economic conditions in developed
countries are now much stronger, balance sheets have been LaSalle’s Investment Strategy Annual is intended to help real
repaired, and real estate fundamentals in many cities have estate investors anticipate these movements, so that they
fully recovered from the Great Recession. China powered can take actions now to address future needs, thereby
through the Global Financial Crisis and has joined the preserving and growing the value of their real estate
Modest Improvements in the World Growth Outlook Expected
GDP Growth Forecasts
7%
6%
5%
GDP Growth
4%
3%
2%
1%
0%
China
Korea
Australia
Mexico
Germany
U.K.
U.S.
France
Canada
Japan
World
South
2016 Forecast 2017 Forecast 2018 Forecast
Source: Bloomberg Survey of Forecasters.
Latest forecasts as of 2016:Q4.
4 ISA 2017
Investment Outlook Chapter 1
10-Year Yields Jump in October and November
Implied 10-Year Rates in 2026: Same or Lower Relative to a Year Ago, Except Australia
Yield Curve Implied 10-Year Rate in 2026 10-Year Government Bonds
Based on Based on 3.2
Yield Curve Yield Curve Change
2.8
Country 12/13/15 12/07/16 (bps)
2.4
Japan 1.87 1.02 -86
10-Year Yields, %
2.0
China 4.53 3.77 -76
France 2.91 2.15 -76 1.6
Germany 2.21 1.48 -73 1.2
U.K. 3.43 2.70 -72 0.8
South Korea 2.31 2.20 -12 0.4
Canada 3.04 3.00 -4 0.0
U.S. 3.61 3.56 -4 -0.4
Dec-13
Mar-14
Jun-14
Sep-14
Dec-14
Mar-15
Jun-15
Sep-15
Dec-15
Mar-16
Jun-16
Sep-16
Mexico 8.37 8.41 +4
Australia 4.19 4.40 +21
U.S. 2.34% Germany 0.35%
U.K. 1.36% Japan 0.03%
Sources: Bloomberg and LaSalle Investment Management.
Data as of December 7, 2016.
portfolios. As in past years, in this edition we reexamine Emerging countries, especially those with a huge trade
the outlook for secular trends in demographics, surplus like China, can afford to continue to stimulate their
technology, and urbanization (DTU). We also introduce a economies and their real estate markets indefinitely.
fourth factor, “E”—the role of the environment through Developed countries, however, could enter the “great
climate change, sustainability initiatives, and the health/ unwind”4 at different times and in diverse ways. Countries
welfare of building users—as an additional long-term trend like Australia, Canada, France, Germany, the Netherlands,
to consider (DTU+E). the United Kingdom, and the United States face a dilemma.
Rising asset prices, including those for commercial real
Lower for How Much Longer? estate, do not continue forever, even when there is healthy,
After three decades, the era of falling interest rates and broad-based growth. So a combination of expansionary
capitalization rate compression is nearly over. It is now time fiscal policies and normalization of monetary policy could
for real estate investors to focus more on income generation become a defining feature of the next seven years for several
as the primary source of return for core real estate. A review of the G7 countries. As the unwinding process begins,
of recent economic history: The Great Moderation (1995- investors should focus on these macro strategies: (1) take
2007) led to an unsustainable expansion of credit and the advantage of the shift from monetary to fiscal stimulus,5
Great Recession (2008-2009). The Great Recession led to (2) find assets where the income stream can keep up with or
the great monetary stimulus experiments of 2009-2016. exceed rising inflation,6 (3) fill gaps in the capital stack
Eventually, these central bank–led stimulus programs through financial structures where upside is traded for a
could lead to a Great Unwinding or normalization of
monetary policy (2018-?), where expansionary fiscal policy 1 Structural change broadly defined: Changes in the institutional, political,
regulatory, or corporate order that governs a decision-making body or a market.
is balanced with inflation-targeting, infrastructure A national example: The relaxation of China’s long-standing “one-child” policy.
investment, and private sector expansion. The other A global example: The rapid adoption of ride-sharing services like Uber, Didi
Chuxing (China), BlaBlaCar (Western Europe), or Grab (Southeast Asia).
unpleasant possibility is “secular stagnation,”3 characterized 2 Much of this growth occurred at the expense of a massive build-up in debt.
by flat or declining productivity, low labor force 3 Coined by Alvin Hansen in 1938 to describe the Great Depression and revived
by Larry Summers in 2010 to describe the slow recovery from the Great
participation rates, and an aging society with declining Recession.
birth rates. Core real estate, held primarily for its income- 4 Coined in 2013 by George Packer in The Unwinding: An Inner History of the
New America to describe the breakdown in American institutions; then used by
generating ability, would likely still be attractive for retirees financial analysts to describe the process of normalizing monetary policy.
under this scenario, but the faster-growing parts of the 5 For example, specific locations and cities that benefit from new roads, transit, or
public recreational facilities.
world economy would suffer and so would the tenants who 6 Within the G7, the U.S. and the U.K. are closest to rising inflation, while Japan
support real estate’s income streams. and countries in the eurozone are furthest.
ISA 2017 5
Chapter 1 Investment Outlook
entirely predictable or obvious, and may not arise for
Through 26 Years of Noise… several years.7 Each country has its own set of
Steady Income Growth circumstances that will lengthen or shorten the triple-low
Leases Are One of the World’s Best Shock Absorbers macro environment. The common thread is that improved
Index of Same-Store NOI Growth economic conditions should accompany any upward
210 movement in base rates. Thus, rising rental income growth
1990s Cycle: 2000s Cycle: expectations should be commensurate with a gradual
190
8 Years 5 Years of increase in the cost of capital. The risk is that these changes
of 53% 20% NOI Growth
NOI Growth could be abrupt and unanticipated, not gradual. Our
Index Levels, 1992=100
170 outlook for these macro conditions and the structural
changes that might affect them are summarized below and
150 in more detail in Chapter 3.
130
Current
Cycle:
Structural Changes in a
5 Years
of 30%
Macro Framework
110 NOI Growth For 2017, investors should focus on an often-overlooked
element of macro change that can shape future
90
performance and guide portfolio decisions. In the past, we
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
2016
1990
have emphasized cyclical and secular trends for investment
guidance. We believe it is time to develop strategies that also
Source: NCREIF.
take structural changes into account. These structural shifts
Data as of 2016:Q3.
will likely create a series of forks in the road (or more
starkly, “T-junctions”) and raise the level of uncertainty in
Current Cycle for West End Offices the capital markets to extraordinary levels in many
Similar to the 1990s Cycle
countries.8 The possibility of encountering structural
Growth in London Outpaces Regional Markets
change must not create “paralysis by analysis” but rather
Index of NOI Growth
clear-eyed acknowledgement that such changes are an
790 inevitable part of international real estate investing.
1980s Cycle: Late Investors who are prepared to take advantage of structural
690 9 Years 1990s Cycle:
of 150% 5 Years shifts can achieve strong performance.
Index Levels, 1980=100
NOI Growth of 45%
590
NOI Growth A wide array of structural shifts—some positive and others
490
potentially destructive to real estate values—is possible in
the next three to five years. For example, the intervention of
Current
390
Cycle: central banks represents a structural shift in response to
8 Years both cyclical and secular forces. Multinational
290 of 26%
NOI Growth interventions across issues as diverse as climate change,
190 disaster relief, refugees, and terrorism can be expected to
grow in number. These actions have often been coordinated
90
and encouraged by supranational organizations like the
1980
1985
1990
1995
2000
2005
2010
2015
Bank for International Settlements, the European Union,
the International Monetary Fund, the World Bank, the
Source: MSCI as of 2015.
World Health Organization, the World Trade Organization,
and the United Nations. At the same time, the rise of
preferred income return, and (4) search for DTU+E nationalism and populist movements can weaken
combinations that are not yet fully priced and that are supranational organizations, leading to abrupt changes that
protected from an active supply pipeline. break down the effectiveness of their spheres of influence.
In 2017, the current “triple-low” macro environment of low Structural changes can have a profound impact on
growth, low inflation, and low interest rates will continue to investment markets, although they can be difficult to
produce a “triple high” of capital flows, prices, and
performance for real estate, as long as this combination of 7 Conditions in the futures market imply that the European Central Bank will not
raise interest rates for another four to five years.
macro forces remains in place. The factors that could
8 See Mohamed El-Erian, The Only Game in Town: Central Banks, Instability,
trigger the demise of the triple-low environment are not and Avoiding the Next Collapse; and Mervyn King, The End of Alchemy: Money,
Banking, and the Future of the Global Economy.
6 ISA 2017
Investment Outlook Chapter 1
WA S H I N G TO N , D C
predict, and frequently produce unintended consequences.
They do tend to be easier to identify (once they occur) since
they can include fundamental changes in how corporations,
governments, and other institutions are organized and
wield their influence. For example, an investor in Hong
Kong real estate in 1998 right after the handover from the
U.K. to China would have earned excellent returns, as
prices plummeted and then gradually came back stronger
than ever before. Structural changes create chaos in the
capital markets, and an opportunistic investor can take
advantage of the gaps that open up as capital takes flight.
Putting It All Together: Macro and Micro
The cyclical-secular-structural macro framework is useful
for understanding the connections between property
2001 L Street, Washington, D.C., United States
markets and broader economic, political, and social trends.
Institutions and organizations that establish regulations in theC world, the job of the investor is to thoroughly evaluate
ONFIDENTIAL OFFERING MEMORANDUM
and guidelines that affect property markets are numerous. the implications of these forces at the property level and how
National, provincial, and local policies all impact real estate these dynamics might impact leases, budgets, and values.
values and supply-demand dynamics.
The interaction of these macro forces (cyclical, secular, and
A successful real estate investor must be able to translate structural) creates opportunities for winners and losers for
how the macro forces could influence the success or failure specific submarkets and properties. For example, the
of any specific investment. In other words, investors face cyclical and secular trends driving a country’s economy or
the dual objectives of striving for success in both their property market could be disrupted by the structural shifts
macro and micro strategies when making investment that occur due to an election result, a new trade policy, a
decisions in specific properties and locations. In real estate, shift in central bank policy, or a geopolitical realignment.
the macro-micro dichotomy is unavoidable. The micro
features of a specific building are rarely able to overcome
Framework of Macro Forces
the strongest macro forces. At the same time, investors who
comprehend the macro trends and their potential trajectory Cyclical Patterns Business cycle, capital market/
cannot afford to ignore the myriad micro characteristics credit cycle, property cycle
that contribute to either strong performance or financial Secular Trends Demographics, technology,
failure. Identifying and budgeting for building-specific urbanization, environmental forces
issues like real estate obsolescence, capital expenditures, Structural Shifts Organizational, regulatory, political
and tenant relations/communications are critical factors for change driven by:
financial success. Put another way, appropriate stock • Financial Institutions
Central banks, International
selection and sector tilts are both important for successful
Monetary Fund/World Bank,
portfolio performance. At various times, either can bank-insurance regulators
dominate performance. Successful investors pay attention • International Trade
to both as they manage portfolios. Trade agreements, WTO, GATT, G20
agreements
The interventions of central banks, regulatory agencies,
• Domestic Policies
and other institutional reform processes have already had a Political parties, ministries,
huge impact on the operation of world property markets. agencies, judiciaries
We anticipate that structural shifts and political events will • Urban Planning
exert even stronger forces in the next three years. Some of Infrastructure, density,
these structural changes will be in reaction to secular trends transportation, education, public
safety
like environmental issues and climate change. Others will
• Corporate Models
reflect geopolitical issues and their consequences: a
Multinational, conglomerate, or
backlash to globalization, antiterrorism, cyber warfare, and narrow focus; approach to
the movement of refugees. With all of these issues at work technology; capitalization,
ownership; corporate culture;
adherence to ESG or SRI principles
ISA 2017 7
Chapter 1 Investment Outlook
As these structural shifts accelerate in frequency, the their facilities as they appeal to younger and high value-add
outcome is “extraordinary uncertainty,” to use a phrase workers. The focus in DTU 1.0 is investing in well-
employed by several different commentators.9 established, walkable urban neighborhoods, such as
Chelsea/SoHo (New York City), Shibuya (Tokyo), the
DTU+E Silicon Roundabout (London) or SoMa (San Francisco). In
LaSalle’s approach to secular trends continues to evolve. DTU 2.0, spatial demographic analysis is used to identify
Over six years ago, we introduced the concept of DTU up-and-coming neighborhoods that are less well
investing as a way to supersede or offset property market recognized as “millennial magnets.” These emerging
cycles. We believe that demographic, technology, and submarkets might be linked to infrastructure
urbanization trends often drive above-average leasing enhancements like Crossrail (London), Noord/Zuidlijn
activity and value increases in dense, walkable submarkets (Amsterdam), or Paris Metro Line 14 (Paris); or they may
that are dominated by millennial workers, many of whom have fewer public transit options, but ride-sharing services
work in fast-growing industries like cloud computing, data like Uber and Didi Chuxing (China) make them accessible
analytics, e-commerce platforms, financial technology, to a growing, well-educated labor force. These innovation
social media, software development, and web design. districts serve many different kinds of co-locating
However, after several years of successful investment in companies, which can often be found in shared accelerator,
these areas, a number of new challenges arise. First, prices incubator, co-working, or live-work spaces rather than in
have risen and yields have fallen in many of the most conventional offices.
sought-after, transit-served urban neighborhoods. This
DTU+E is the next stage in our analysis of these secular
repricing is consistent with the Going Mainstream
trends. Our premise is that pricing and supply response
framework we introduced in the 2016 edition of the
factors need to be considered, along with demographics as
Investment Strategy Annual. Second, a strong supply
millennials start families. Indeed, some of the most
response is underway in many “live-work-play”
well-known DTU-rich, districts may no longer offer the
neighborhoods in the strongest world cities. Moreover,
best value for investors. We also believe it is time to add a
the demographics and preferences of baby boomers and
fourth (environmental) factor into the analysis.
millennials continue to shift.
Environmental factors like climate change, a growing
Many major tech companies like Alibaba, Baidu, Facebook, preference by tenants for sustainable real estate, and
Google, and LinkedIn prefer DTU-rich neighborhoods for
The Residence Buckhead, Atlanta, Georgia, United States
9 Mohamed El-Erian and Mervyn King both use variations of this phrase in their
recent books (footnote 8).
8 ISA 2017Investment Outlook Chapter 1
Where Are We in the Economic Cycle?
Early Recovery Recovery Expansion Mature Cycle Falling Bottoming
China
U.K.
Germany
U.S.
Rate of Change
Canada
(Non-Resource
Spain Driven)
Australia
(Non-Resource
Canada France Driven)
(Resource
Driven) Italy Australia
Japan (Resource
Driven)
1 2 3 4 5 6
Source: LaSalle Investment Management as of 2016:Q4.
Where Are We in the Occupier Market Cycle?
Early Recovery Recovery Expansion Mature Cycle Falling Bottoming
U.K.
Germany
Canada
U.S. (Non-Resource
Rate of Change
Spain
Japan Driven)
China*
Australia
(Non-Resource
Driven) Canada
France Australia
(Resource (Resource
Italy Driven) Driven)
1 2 3 4 5 6
Source: LaSalle Investment Management as of 2016:Q4.
*China is represented by Shanghai.
Where Are We in the Capital Market Cycle?
Early Recovery Recovery Expansion Mature Cycle Falling Bottoming
Japan
Spain China*
Germany
Rate of Change
U.S.
France U.K.
Canada
Italy
Australia (Non-
(Non- Resource China*
Resource Driven)
Driven)
Canada
(Resource Australia
Driven) (Resource
Driven)
1 2 3 4 5 6
Source: LaSalle Investment Management as of 2016:Q4.
*China is represented by Shanghai.
ISA 2017 9Chapter 1 Investment Outlook
increased regulatory pressure on owners and tenants
to reduce the carbon footprint of real estate have all Investment Strategies for 2017
become part of the equation, albeit to varying degrees in Type of Change Style of Impact
different countries. Cyclical Do core-plus and value-add investing
face a tailwind or headwind (i.e.,
Investment Strategies for 2017 leasing/fundamentals)?
How should investors rebalance their portfolios in 2017- Secular Filter for a strategic, long-term
core portfolio.
2018? In Chapter 2, we explain how investors should
Structural Dislocations and opportunities for
identify strategies and even specific assets that take
higher risk-return strategies.
advantage of mispricing and fit together in a portfolio
context. By studying herd behavior, investors can also Source: LaSalle Investment Management.
develop exit strategies that avoid classic late-cycle mistakes
of going too deep into secondary markets or taking on to attract a disproportionate share of economic activity,
uncompensated risks. Core investors should avoid sectors/ including highly mobile human capital. Despite these broad
strategies where returns are not fully commensurate with global patterns, each country and each metropolitan area
net operating income (NOI)/cash flow volatility. Non-core will experience varying degrees of turbulence over the next
investors with build-lease-sell strategies will need to five years.
anticipate where mainstream low cost-of-capital core
investors will want to be in three to five years. Investors Asia Pacific
should also look for capital gaps that will open up due The diverse Asia Pacific region, dominated by the
to overreactions and undershooting associated with economies of China and Japan, enters 2017 with good
structural shifts. momentum. In contrast to the winds of political change in
the West, both of these countries are much less likely to be
Regional Outlook for 2017 buffeted by rapid shifts in political leadership. President Xi
The real estate sector has experienced seven years of strong and Prime Minister Shinzō Abe both govern from strong
performance as a result of favorable macroeconomic and political bases. It is certainly true that structural reform
financial trends. These forces include unprecedented needs to occur at a faster pace in both countries, but neither
growth in liquidity, low interest rates, slow but steady economy is likely to hit major roadblocks in 2017.
economic growth, low inflation, demographic shifts, and
technological innovation. The overarching theme behind Australia, Hong Kong, Singapore, and South Korea have all
this positive performance is the ability of many urban areas grown more dependent on intraregional trade with China
and Japan than with the West. This helped these economies
grow during the Global Financial Crisis and has diversified
their export markets considerably. The property markets
are generally healthy across the region, although pockets of
oversupply can be found in Singapore and the resource-
based markets of Australia. In 2017, we see potential for
developing or leasing across Australia, China, and Japan to
satisfy the growing appetite for core investments from
inside and outside the region.
Europe
The surge in populist politics across Europe could affect
property markets in innumerable ways in 2017.
Nationalistic tendencies can lead to unpredictable
regulatory changes capable of creating T-junctions for real
estate investors. The economies in Continental Europe have
benefited from a weak euro and from economic stability in
Germany, France, the Nordics, and the Netherlands. Poland
and Spain are also exhibiting surprising strength.
Economies and property markets in all these countries
China Garden, Shanghai, China
10 ISA 2017Investment Outlook Chapter 1
Madison Commerce Center, Tampa, Florida, United States
enter 2017 with good momentum. However, the Italian North America
“no” vote on a constitutional reform referendum and The U.S. elections in November have altered social and
upcoming French and German elections will put the EU to political sentiment across many different sectors of the U.S.
new tests that the European Central Bank and European and Canadian capital markets and their underlying “real
Parliament will have to grapple with. economies.” The capital markets are signaling a surge in
We do not see any economic triggers that could cause spending, hiring, and economic activity that may or may
interest rates to move up quickly in the near term. This not materialize. Even before the surprising election results,
means that real estate yield spreads (European major property fundamentals in the U.S. were strong, so even if
markets prime yields to 10-year government bonds) are this uptick in sentiment disappoints, real estate markets
wider in Europe than anywhere else in the world. As long as should be in reasonably strong shape in 2017. The sectors
rent reviews and new leases can maintain or increase of the economy that are likely to benefit most from
current rent levels in 2017, real estate in Europe will be an deregulation, tax cuts, treaty reforms, and onshoring
attractive asset class in an otherwise unsettled include banking, finance, housing, infrastructure, retailing,
macroeconomic environment. and manufacturing. The risks include a rapidly rising U.S.
dollar and a trade war, which could hurt American exports
Real estate in the U.K. has many of the same attributes other in the technology, media, and telecommunications sectors.
European countries, but with the added complication of the
Brexit negotiations still to come. The economic and Overall, the U.S. and Canadian real estate markets enter
property fundamentals going into last June’s referendum 2017 with a healthy supply-demand balance. The
were strong. Any number of issues lie ahead that could presidential administration change will bring uncertainty
reverse this trend if they are not handled adroitly by the EU and volatility to many different aspects of the U.S. economy,
and British treaty negotiators. Most at risk is London’s role with global repercussions highly likely. The rapid uptick in
as the premier European financial center. We do see a long-duration interest rates will be watched closely by all
long-term upside for disentangling the U.K. from a welter real estate investors. The cushion between bond yields and
of EU rules and regulations, but the near-term relocation of real estate yields has largely disappeared, and pricing may
financial firms is a real risk. have to adjust if long-term bonds continue to rise.
ISA 2017 11Chapter 1 Investment Outlook
DTU+E Investing
Anticipating Secular Changes in Demographics, Technology,
Urbanization, and the Environment
LaSalle identified a set of demographics, technology, on the agenda of our major tenants. Environmental
and urbanization (DTU) secular investment trends changes also create new risks and opportunities for
over six years ago. We thought that property property investors. Rising coastal flood risk has also
investments harnessing the power of these steady, introduced new questions concerning property
generation-long changes would outperform. Our insurability and residual valuations in some low-lying
recommendations included targeting “millennial cities. Drought conditions in California prompted the
magnet” neighborhoods, overweighting markets with evaluation of “net zero” water rules that may increase
concentrations of technology tenants, and asset barriers to new construction. In Asia Pacific, the air quality
selection in walkable urban centers. This strategic in cities impacts health/safety as well as competitiveness.
approach has produced outperformance through While city selection is determined by a wide range of
better market and asset selection. Capital markets have factors, quality of life factors will encourage or discourage
also been efficient. Many of the most obvious DTU the migration of the most skilled workers. While gradual
strategies have been repriced, although not to the same environmental changes may not affect near-term
extent across countries. performance, over longer hold periods, real estate
In response, our strategic approach to DTU investing investors who anticipate these changes and act defensively
has continued to evolve to an updated version 3.0 in can increase their probability of outperformance.
two significant ways. First, environmental change joins Second, our DTU+E strategies now draw on spatial
our shortlist of secular drivers, the “+E” in our update: analytics, quantitative, and “big data” approaches to a
DTU+E. Real estate, unlike other financial assets, is much greater extent. We acknowledge that, in some cases,
closely tied to specific places, with great variation in DTU+E-driven investment trends, in part due to their
environments and risks. Sustainability in building success, are now are priced to perfection. To stay one step
operations is a key consideration for market analysts, ahead, our strategies identify micro locations and
with the potential to support faster net operating individual assets with particular characteristics that make
income growth and lower volatility in some markets. In them DTU+E-rich or that are second-order effects of
Europe, our survey results of major office occupiers in DTU+E trends.
Paris guided our refurbishment and development
strategy when we found that sustainability ranks high
DTU+E Trends: How They Impact Real Estate
E-commerce
Baby Boomers’ and Millennials’
changing lifestyles Neighborhood technology
hics Tec clusters
Widening income disparities ap hn
gr Office space per worker
ol
Migration flows
o
og
Dem
Creative office preferences
y
Changing household size
Driverless vehicles, ride-sharing
Human capital levels
“Livability” and pollution
ti o n
Env
Mix of uses and density
Climate change risks
za
i ro
nm Walkability and access to transit
ni
Local regulation and zoning en ba
t Ur Barriers to supply and affordability
Water scarcity and recycling
Infrastructure and emerging
Energy conservation neighborhoods
Source: LaSalle Investment Management.
12 ISA 2017Investment Outlook Chapter 1
In North America, these approaches include targeting
Europe DTU+E Web
apartments in top school districts, mapping granular data
on school district quality, and charting real-time Economic Drivers
construction data to identify locations with barriers to 1.75
Asset Demographic
construction. We also use geographic information Future- Profile
systems (GIS) to rank over 40,000 U.S. grocery-anchored Proofing
0.17
0.83
retail trade areas based on demographics and
competition for screening shopping center investments. 0.84
In Europe, our human capital index quantifies certain
key cities by workers’ skills, knowledge, creativity, and Local 0.93 0.79 Human
innovation (see the graphic entitled Europe DTU+E Web, Dynamics Capital
at right). The results provide support for investment 0.57
strategies targeting leading human-capital-rich cities
Urban
like Paris, London, Munich, and Stockholm. We have Development
also developed a DTU+E web scoring approach to Asset
determine whether a specific asset location is DTU+E- DTU+E Neutral
rich or DTU+E-poor. Our methodology includes using Source: LaSalle Investment Management.
a weighted combination of granular economic and
demographic forecasts, data mining, and on-the-
ground assessments. Rental Apartments in Demand in Urban Areas
Redevelopment of Mixed-Use Districts in Greater Tokyo
In Asia, we have created a quantitative city screening
tool to look for promising logistics hubs in China and a LaSalle Rental Apartment Target Submarket Analysis
DTU+E-based residential scoring model at the
submarket level in Tokyo. Marunouchi, Otemachi
Office/Retail
By nature, the secular changes apparent in the DTU+E Yaesu
Office/Retail
trends impact real estate over long periods. Technological
innovations, however, happen at a faster pace than the
other trends and are often more difficult to forecast.
Indeed, technology is already disrupting long-established
Nihonbashi
patterns in transportation and office space use. Look for Shibuya Retail/Office/
our upcoming white papers on how fintech and Retail/Office Res
blockchain technology, rising e-commerce market share
(and breakneck delivery speeds), and driverless vehicles Shinagawa-
Hamamatsucho
are likely to influence real estate portfolios. Predicting Office/Retail/Res
where technology will be in 10 years is a daunting task, but
through scenario and sensitivity analysis, portfolios can
be designed to have a greater degree of resilience to Ranking of 60 Residential Neighborhoods
unexpected technological change. of Greater Tokyo
1st–10th 11th–20th
21st–40th 41st–60th
Redevelopment Plan
(Completion After July 2015)
Source: LaSalle Investment Management.
Data as of 2016.
ISA 2017 13How should an investor respond to the upcoming changes in 2017? Inaction is not a viable option. Real estate responds to active management. For example, there are leases to be signed, capital budgets to be reviewed, and building upgrades to be considered. Portfolios share the same active management traits as individual properties. They need continual evaluation, course corrections, and rebalancing to keep performance aligned with portfolio risk-return objectives. Investors can employ risk screens, cycle adjustments, and other risk management tools to actively manage their portfolios. The appropriate blend of offense and defense will vary depending on investors’ financial objectives, as well as their risk tolerance, liquidity needs, and time horizons.
CHAPTER 2 Portfolio Management
Chapter 2 Portfolio Management
Achieving a Well-Balanced Portfolio Currently, most value-add funds offer an absolute return
target of 10%-15% and opportunistic funds target 15%-
Successful real estate investing requires a disciplined
20%, in nominal terms. Core funds can also be managed
approach that never loses sight of the portfolio’s objectives.
with an absolute return target, a strategy that is becoming
These objectives should include both a return target and an
more common as more income-oriented investors consider
acceptable risk profile. Today, volatility in the capital
real estate. Absolute return targets can also be expressed as
markets is a constant worry, political risk is heightened,
a “real” return (after adjusting for inflation).1
structural change is more frequent, and the global economy
is struggling to return to growth rates that were normal The principal advantage of absolute return targets is
prior to 2008. Thus, investors need to determine the level of their sharp focus on generating positive, net-of-inflation
risk (known odds) and uncertainty (unknown odds) they returns. The downside is that they are not sensitive to
can tolerate while seeking their target returns. In this the performance of the underlying market. In a healthy
chapter, we provide guidance on the construction of real economic environment, an absolute target can be
estate portfolios with different risk-return profiles. We start readily achieved, but that is more challenging during
with the crucial first step of defining portfolio objectives. periods of economic distress or weak property markets.
Thus, absolute return targets are more meaningful over
Setting Portfolio Objectives for long time periods (five years-plus), where averaging can
Return and Risk smooth out market volatility.
Return objectives for commercial real estate portfolios Relative return targets relate to known benchmarks or other
can take a variety of forms, but can be classified into two market measures. A typical relative return target requires a
broad groups: portfolio to match or outperform its market index by a
specified amount. Today, most developed countries have
1. Absolute returns, and
one or more national indices for their public and core
2. Relative returns.
private real estate markets. There are also multinational/
Absolute return strategies target a specific return that is regional indices, but these are not as established, especially
commensurate with the risks involved. The goal of relative for private markets. The key in setting a relative return
return strategies is to meet or exceed known benchmarks or target is, therefore, the choice of index, particularly in
other market measures. markets with multiple options. Investors should adopt the
index that offers the broadest market coverage consistent
with the portfolio’s strategy.
Risk profiles are much harder to define. Many of the
methods used for more liquid assets cannot be readily
applied to real estate. For example, real estate is a long way
from developing an equivalent to value at risk (VaR) or
Shiller’s cyclically adjusted price-to-earnings ratio
measure2 of corporate earnings and relative value over time.
Specifying a minimum drawdown (VaR) limit (the amount
a portfolio can decline in value) is much harder to monitor
without real-time prices, and specifying a maximum
tracking error is a backward-looking way of monitoring
portfolio risk given the delay in the publication of private
equity real estate indices. Moreover, it is not practical to
track a private real estate index precisely as the specific
holdings within those indices, such as the NCREIF
Property Index (NPI) or an MSCI index, are uninvestable
(because the assets are already owned by other institutions).
The terms used to describe risk in the real estate sector are
not precisely defined, despite the best attempts of the
European Association for Investors in Non-Listed Real
1 The inflation index adopted is usually a national index of consumer price
inflation, but other measures, such as the GDP deflator, could be used too.
2 Robert Shiller, as developed in Campbell, J.Y. and Shiller, R.J. (1988) “Stock
50 Post Office Square, Boston, Massachusetts, United States Prices, Earnings, and Expected Dividends.” Journal of Finance, 43:3, 661-76.
16 ISA 2017Portfolio Management Chapter 2
Risk Screens for Real Estate Investments
Style Criteria Structure Property Types/Markets Assets
Target Return Derived from Fund Terms Property Types Class/Quality
Income* Open or closed-end Mainstream vs. specialty Age, design, future capital
Core: > 60% Promote structure/ needs, flexibility
Other Styles: No Target incentives
Maximum Non-Income Sponsor Experience Markets Tenancy Duration/Credit
Producing Assets* Owner-Operator Gateway, primary, Indexation
Core: 40% Sponsor co-investment
Maximum Development Leverage Maximum LTV* Submarket Environmental
Exposure* Core: 25% Opportunity: >60% highways amenities: retail,
leisure, open space
Location: walkable
DTU+E-rich/-poor
Opportunity Styles Scale of Fund Oversupply Risk Potential for
Distressed assets Size, number of investors High/Low barriers to entry Renovation & repositioning
Develop-lease-sell Number of assets
*Source: INREV Fund Style Classification.
Note: Risks that pertain more to value-add and higher risk are shown in italic font.
Estate Vehicles (INREV) and other industry bodies to A key objective of holding a portfolio of assets is to diversify
improve transparency.3 In particular, the standard style away the specific or idiosyncratic risk associated with an
names like core, core-plus, value-add, and opportunity are individual property. Thus, every portfolio plan should have
highly subjective and loosely defined. The Risk Screens for a targeted minimum number of assets dependent on the
Real Estate Investments chart, above, shows the main risk overall risk profile and size of market. This can be achieved
screens for investing in private real estate, with the INREV through direct investing or through investments in co-
definitions in the left-hand column. mingled funds. A low-risk/core portfolio should ideally
have at least 20 assets, although this number needs to reflect
Managing Risk-Return Opportunities the diversity of tenants in the portfolio (single-let
Real estate portfolio strategies often include a blend of properties increase the desirable number of assets).
risk-return opportunities, not just properties with nearly Value-add funds can have as few as 10 properties, so many
identical risk profiles. It is reasonable to assemble a investors typically invest in several of these funds to achieve
portfolio that comprises assets from across the risk portfolio diversification.
spectrum. The overall target return can be achieved by a
Role of Asset Selection
blend of assets, some with a lower risk-return profile than
the portfolio target, while others could be higher than the The objective of all investors is to own assets where the risks
target. The risk level of the entire portfolio should align are correctly priced. Theoretically, investors should buy
with an acceptable risk-return range, while individual assets where expected returns compensate for expected risk
assets should be tailored to specific market conditions. In and sell those that do not. However, many real estate risks
other words, investors and their portfolio managers will are hard to measure, vary by asset, and are difficult to
need to balance risk and return at two levels—the forecast over a 5-10-year holding period. An example of
individual asset and the portfolio. changing perceptions of risk can be seen in retail properties,
which are generally viewed as more risky than a decade ago
due to the rapid growth in online shopping. The Internet
has effectively increased the supply of retail “floor space,”
3 See, for example, INREV (2012) Fund Style Classification, Amsterdam
inrev.org/library/publications/223-inrev-fund-style-classification.
ISA 2017 17Chapter 2 Portfolio Management
Na Prikope, Prague, Czech Republic
putting downward pressure on rents. However, not all of the analyze the future by recognizing those uncertainties and
retail sector has been adversely affected to the same degree, reflecting them through a range of scenarios rather than
and some shopping centers are much better positioned to relying on a single forecast. There are three types of cycles
deliver expected returns than others. For individual assets, that affect real estate performance: capital market cycles,
the perceived risk can be mispriced, creating opportunities business cycles, and property market cycles.
that investors should seek for their offense positions. Often, these cycles interact; for example, the economic
Real estate is a highly diverse investment class. It is typically downturn of 2007-2009 began in the capital markets with
segmented by geography and property type for attribution the credit crunch that accelerated the business cycle and
analysis, but these classifications rarely capture all the then impacted real estate operations and values. In the
idiosyncratic features of an asset. For example, mixed-use 1980s, a number of real estate markets experienced major
properties blend together the attributes of several property increases in supply (i.e., a property market cycle), aided by
types, and niche sectors (student housing, senior housing, buoyant capital markets, that together contributed to an
or self-storage) often behave very differently from the extreme business cycle that added to the early 1990s
generic categories where they are sometimes classified. downturn. More recently, as market data have improved,
Moreover, asset quality varies greatly within each market along with lenders’ and regulators’ understanding of the
and property type. It includes the physical configuration, sector, cases of significant oversupply have become less
such as a building’s age, maintenance, and compliance with common. The Key Risks Associated with the Main Real
the latest environmental standards. Overall, asset quality Estate Market Cycles chart, on the facing page, depicts how
should be reflected in the speed and rental level with which risks vary over the course of the three cycles.
a property relets, as well as its ability to resist obsolescence.4 A downturn in the capital markets affects real estate market
Asset quality is also linked to liquidity characteristics—a liquidity, as debt financing typically becomes harder to
high-quality property in a major market will find a buyer, obtain. Owners who hold high-quality assets are in the best
even in a severe downturn. position to manage liquidity, except in the event of a severe
Risk-Return Styles and Responses to Cycles restrictive credit environment, such as the Global Financial
Crisis (GFC). Among the U.K. open-ended funds struck by
The investment world is challenging to forecast because
a wave of redemptions following the June 23, 2016, Brexit
there are always a number of potential cyclical and
referendum vote, the funds that recovered and resumed
structural shifts that may not be foreseen. We prefer to
normal trading the quickest were those with prime London
4 Real estate investors frequently underestimate the effects of obsolescence,
particularly for offices.
18 ISA 2017Portfolio Management Chapter 2
Key Risks Associated with the Main Real Estate Market Cycles
Risks Can Emerge at Different Stages
Early Recovery Expansion Mature Cycle Falling Bottoming
Recovery
Economic
Weak job growth of demand Rent arrears Tenant default
Cycle
Property
Delayed rental growth Oversupply Lack of demand
Market Cycle
Capital
Lack of debt availability Price bubbles Exit risk Refinancing
Market Cycle
Source: LaSalle Investment Management 2016:Q4.
assets that investors were keen to purchase at a discount. Forecasting cyclical turning points is always challenging.
Highly leveraged investors can become severely challenged Property market cycles are closely tied to the business cycle,
when the capital market cycle turns. Managing through although local economies can out- or underperform the
loan covenant breaches requires skills that are unlikely to be national economy. Currently, property markets in Houston,
second nature for investors who have not experienced a Calgary, and Aberdeen have softened due to the recent fall
credit crunch. in oil prices, while national capitals tend to outperform
A downturn in the business cycle impacts properties with during economic downturns due to the relative stability of
vacancies and speculative developments the most; leasing government spending. Capital market cycles have
then becomes more difficult as firms retrench and delay or historically had surprisingly consistent rhythms in the
halt expansion. This typically affects the office and developed markets with durations of 15-20 years; business
industrial sectors. The retail sector can be affected too, cycles typically last 8-10 years.5 However, cycles in Asia
although consumers initially react more slowly to an show much more variation and are especially rapid in
economic downturn. The rental residential sector is more Hong Kong and Singapore.
resilient to downturns, as households delay purchasing a
home and will cut back on other discretionary spending
before deciding to cut back on their rent.
Downturns in the property market cycle have differing
effects by property type. Office markets are the most prone
to property market cycle fluctuations. Office building
construction, especially in central business districts, is
complex and typically takes several years. It is also quite
easy for too much office space to be constructed if there has
been a period of strong occupier demand that causes rents
to rise. Developers rush to take advantage, and the true
scale of extra demand is unknown until the new space is
delivered two or more years later.
5 See Goodchild, R.N. (2015), Property Cycles: Reflections by Dr. Robin
Goodchild, LaSalle Investment Management, Chicago. Found at:
lasalle.com/documents/Property-Cycles-Reflections-by-Dr-Robin-Goodchild-
February-20151.pdf. The Glades, Shopping Center, Bromley, United Kingdom
ISA 2017 19Chapter 2 Portfolio Management
Defensive Strategies Risk-tolerant investors should also evaluate more niche
Investors looking for consistent returns should focus on property types, including sectors with prospects for
income generation and asset quality. Income returns should becoming mainstream, bringing down yields in the process.
be evaluated based on average lease duration and reliability. This may apply to self-storage in the U.S., student housing
Short-duration property typically has unstable payments in Continental Europe, and multifamily residential in the
and carries risks associated with releasing space in the near U.K. A further strategy is to target transforming locations.
term. Income reliability relates to the strength of the Widespread growth in the technology sector has led to the
underlying tenant paying rent, as well as the overall emergence of a number of new office submarkets, many of
diversity of the rent roll. which benefit from above-average rent growth.
High-quality assets should also be a focus for risk-averse Increasing leverage is another offensive strategy, especially
investors. High-quality properties are generally the easiest while the cost of debt is so low relative to income returns.
to lease in an economic downturn and are more likely to Avoiding onerous loan covenants is crucial in case asset
retain (or recover) their value. However, some of these values decline, providing more time for values to recover.
properties are too large for inclusion in many portfolios, For low leveraged deals, investors should seek to maximize
entailing significant single asset risk, or are not available in the loan-to-value ratio at which the lender is entitled to call
the private market. Investors can access those properties by for more capital, even if the concession is traded for an
buying real estate investment trust (REIT) shares in entities increase in interest cost. Following the GFC, some core
that own large individual assets. For example, the largest and funds experienced capital calls from their bankers due to
best retail assets are owned by publicly traded companies loan covenant defaults, even though the values of the assets
such as Simon Property Group, Unibail-Rodamco, and still exceeded the loan balances by a wide margin.
Westfield Corporation. As long as the investment is held for Offense-minded investors with domestic-only portfolios
over four years, the performance should be more correlated should evaluate interesting opportunities to add
with the private market than with stocks.6 international real estate to their mixes. We have discussed
the pluses and minuses of investing in global markets in
Offensive Strategies previous issues of the Investment Strategy Annual. The loss
Investors who are more risk-tolerant can employ a more of tax-exempt status at home and increased volatility due to
aggressive or offensive strategy. Investors seeking higher currency fluctuation needs to be offset by the
returns can take advantage of cyclical downturns and diversification benefits available through a global
structural changes that lead to a liquidity squeeze. These investment universe with a wide range of risk-return
value-add and opportunistic situations often elevate levels profiles. Investors seeking to add international real estate to
of financial and operational risk. Focusing development a domestic-oriented portfolio need to carefully define their
activity on deep markets with the best growth prospects can investment objectives and the role of global real estate
mitigate some risk, although that lower risk is often before evaluating offshore opportunities.7 For most
reflected in lower returns. investors, international real estate can be very efficiently
accessed through investments in real estate securities as a
starting point.
Special Situations and
Market Anomalies
The heterogeneous nature of real estate markets ensures that
there are almost always attractive opportunities somewhere,
both domestically and globally. A volatile macro
environment adds to the likelihood that good deals will
become available. However, for investors to readily access
such deals, they normally need to be active and known in a
particular market before a shock strikes. Investors who
invest internationally can sometimes have a more balanced
6 See Hoesli, M. and Oikarinen, E. (2013). Are REITs Real Estate? Evidence from
International Sector Level Data. Journal of International Money and Finance,
31(7), 1823-1850.
7 See LaSalle’s Five-Step Process for Creating an International Portfolio in
Pioneer Tower, Portland, Oregon, United States Chapter 2 of the 2014 Investment Strategy Annual.
20 ISA 2017Portfolio Management Chapter 2
Futura Park, Wroclaw, Poland
view of risks during a crisis than domestic players, who are Maintaining a Well-Balanced Portfolio
either too close to the stress to be objective or cannot access
Real estate investors always need to keep investment
capital to exploit the opportunity themselves.
strategy, targeted returns, and risk in clear view when
Investing in a contrarian manner requires significant building or managing a real estate portfolio. A successful
market knowledge and conviction to execute successfully. portfolio strategy is one that focuses the attention of the
One significant challenge is timing. When a structural shift investor, maintains discipline, and screens out the broader
occurs, it is unclear how long the turbulence will last or how churn of deals that are outside of the explicit risk-return
far-reaching it will be. Discounted deals may appear early in targets. A one-size-fits-all approach rarely works for
a first-wave response to a downturn as property values start investing in real estate; a thoughtful and customized
to decline. Further stress may generate a second-wave approach works best. Finally, portfolio strategies need to be
response some time later, when property values have fallen updated periodically to adapt to constantly changing
significantly further. During the GFC, liquidity dried up market conditions and pricing. The tools and frameworks
quickly in 2008 and the best deals (from the buyer’s for analyzing real estate will continue to evolve in order to
perspective) were struck in 2009, although there were few keep up with the proliferation of real estate products and
sellers. Investors need to be both agile in reacting quickly to the opening of new markets. Despite all of these changes,
opportunities, and proactive in targeting owners with portfolio strategy and risk management help guide the
quality assets who need cash. Some of the most promising direction of an investment program in an increasingly
“special situation” deals are those that are not widely offered complex world.
to all investors but that rely on relationships and mutual
interdependence to succeed.
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