Real Estate Summary
Real Estate Summary
Real Estate Summary Edition 1, 2018 UBS Asset Management Opportunity amidst converging returns and shrinking risk premia 04 Global overview 14 European summary 08 APAC summary 20 US summary
2 Content 04 Global overview 08 APAC summary Our research team Brandon Best Michael Böniger Melanie Brown Kurt Edwards Nicola Franceschini Kara Foley Zachary Gauge Tiffany Gherlone Paul M. Guest Gunnar Herm
3 14 European summary Fergus Hicks Samantha Hartwell Amy Holmes William Hughes Declan O'Brien Joshua Rome Sean Rymell Laurie Tillinghast Shaowei Toh 20 US summary
5 In the early months of 2018, economic fundamentals are supportive of another solid year of real estate performance. But monetary conditions are tightening and our central preoccupation persists: how will this affect the risk premium for real estate? This year transaction volumes will remain near long-term averages, rental growth will remain healthy, particularly in the prime segment, and as yet we do not expect a meaningful move outwards in yields.
Real Estate Summary Edition 1, 2018 6 Macroeconomic overview Whichever witty metaphor one uses to sum up economic conditions, remember, we mis-used “steady as she goes” last quarter, the fundamentals are supportive of real estate performance.
Positive trends such as above-average consumer spending and business investment growth in Europe; fiscal stimulus in the US; or an upswing in global trade are all worth noting. This can be seen in the estimates of 4Q 2017 GDP growth and the higher frequency data from 1Q 2017 and is reflected in the OECD’s leading indicators (see chart 1). But also take note of the lingering fragilities, such as anaemic consumer spending in Japan, growing credit risks amongst emerging markets, and slow wage growth in the developed economies. Regardless, with global GDP forecast to expand more rapidly than in 2017 and at its fastest pace since 2011, our confidence in the underlying demand for quality real estate is warranted.
Chart 1: OECD trend-adjusted composite leading indicators (index, long-term trend = 100) Source: OECD; December 2017 There is an interesting quandary in that most forecasters and indeed the economic press are optimistic that global growth is accelerating, while others, notably UBS’ Investment Bank1, have pointed out some underlying weaknesses. Their analysis shows just how much of the acceleration is down to a narrow recovery in commodity exports and on investment in the US energy sector. It argues for more of the same in 2018 (that “steady” adjective again!), rather than acceleration. This is not a threat to our forecast for real estate investment performance in 2018 which is more or less in line with the long term average of an unlevered 6-8% drawn almost entirely from income return.
1 UBS Investment Bank, Global Economic Perspectives – The 2-minute Global Macro Drill, 23 January 2018 This relies on supply remaining under control and this, of course, varies by market, but where supply growth has been strongest we have either seen or expect to see an adjustment in rents, e.g. Singapore or London office, or have seen very strong levels of demand growth that have compensated, e.g. in US multi-family or in global logistics. As yet, there has been no generalized pickup in construction activity. It remains notably shallow in Europe, compared to the pace of economic growth. We explored these questions in some detail in our 2018 Top Ten Questions publication2.
Capital markets In light of still-favorable fundamentals, the shift towards a higher interest rate monetary environment remains our central pre-occupation. This has been part of our baseline forecast for several years and it is worth noting that US commercial real estate has adapted well to both higher interest rates and the adjustment to the Fed’s balance sheet. Thus far, there has been no sharp re-pricing of alternative assets and though inflows to real estate, whether equity or debt, have slowed from 2015-16’s record levels, they remain in line with or only slightly below their long-term average.
Chart 2: Property pricing: global prime yield / cap rate movement quarter to quarter Sources: CBRE; NCREIF; UBS Asset Management, Real Estate & Private Markets (REPM); 4Q17 This dynamic is reflected in real estate investment activity: volumes in 2017 were only slightly down on the previous year. Nevertheless, the balance has shifted in the detail: activity has slowed in the US but accelerated, albeit slightly, in both Europe and Asia. The cause of this cannot be laid at the door of higher interest rates. The supply cycle is also more advanced in the US, with rental growth slowing albeit to still above-inflation levels.
At the global aggregate level, 4Q 2017 saw a second consecutive year-to-year fall, with only 3Q 2017 2 UBS Real Estate & Private Markets, Top Ten Real Estate Questions for 2018, December 2017 90 95 100 105 110 115 120 Jan- 2006 Jan- 2007 Jan- 2008 Jan- 2009 Jan- 2010 Jan- 2011 Jan- 2012 Jan- 2013 Jan- 2014 Jan- 2015 Jan- 2016 Jan- 2017 Canada Euro zone Japan Switzerland UK USA 0% 20% 40% 60% 80% 100% Expansion Unchanged Compression
Real Estate Summary Edition 1, 2018 7 outperforming 2016’s volume. There is also an evident shift in pricing (see chart 2). Amongst the 340 market-sectors we track, those experiencing yield compression continue to significantly outnumber those seeing yield expansion. By 106 to 20, if one is keeping score. However, price gains are now concentrated in the red-hot logistics sector, in Europe, and in second tier cities and countries. Looking ahead, we expect investors will continue to find it challenging to put money to work. We expect another slight fall in volumes in 2018. Markets will eventually have to adjust to the shrinking risk premium.
In most cases, prime yields today are lower than they were in 2007. As interest rates slowly rise, investors will need to assess what is an appropriate risk premium by market and sector. As noted previously, the US real estate market has adapted well to the tighter monetary environment, with volumes down but pricing largely unaffected. The ECB’s quantitative easing program has been fundamentally different, however, as explored in a study by Oxford Economics3. We believe this will have broader consequences for the pricing of real estate, amongst other illiquid assets, but this will not occur before 2019-20.
The year ahead will show another solid, if diminished, out-turn from our asset class. Strategy viewpoint The main pillars of our investment strategy are unchanged going into 2018. Firstly, the importance of strategic diversification, that is a geographic allocation close to market neutral, as market returns converge in a period of slower capital value growth. Secondly, we will continue to be guided by long-term structural changes in how real estate is used - i.e. seeking out an overweight to sectors or geographies benefitting from long-term changes such as logistics, niche asset classes, or markets with major infrastructural investment plans.
Thirdly, we will approach tactical new investment decisions as a risk management exercise, seeking to minimize exposure to markets where pricing and/or fundamentals appear to be out of kilter with long-term trends. We believe this approach is prudent for a core investor; however, it is important to note that we think the risk of a sudden reversal in market fortunes is low. The traditional cyclical warning signs are not blinking red: leverage is manageable; construction is broadly in line with demand growth; and the spread between prime and lower grade real estate has not shrunk unduly. Although investors will never punish you for taking risk off the table when your return targets have been met, it is not time yet to halt new investments much less take money out of the market.
Real estate remains a relatively attractive asset class in a still-low yielding world.
3 Oxford Economics, ECB tapering: beware of global consequences, 14 December 2017
Real Estate Summary Edition 1, 2018 9 Output still below potential for most of Asia. Tightening labor market conditions will ultimately feed into sustained wage growth. Expected returns set to be lower for new capital buying into today's market Limited core investment options squeezing capital into corners and alternative segments of Asia Pacific real estate.
Real Estate Summary Edition 1, 2018 10 APAC summary Demand & Supply As we look back at the previous editions of this real estate summary, we highlighted, to the extent of belaboring, the macro resilience of Asia going into 2017, riding on the bottoming of the global trade cycle and the expansionary fiscal spending in most of Asia.
In hindsight, we are happy to have been caught out on the upside by the broadest synchronized global growth upsurge since 2010. In fact most market observers were surprised by the cyclical upswing in trade as 2017 progressed, prompting several upgrades in the economic outlook for Asia over the past year. The International Monetary Fund, in its January 2018 world economic outlook update, maintained its growth outlook for Asia in 2018 at 6.5%, on the back of a high base effect and a possible slowdown in the Chinese economy. That said, Asia will still contribute to more than half of total global growth in the next two years, as domestic demand continues to gather momentum.
Chart 3: GDP growth and forecast (Real, annual, %) Source: Oxford Economics (as at January 2018) Note: 2017 data for China and Singapore are actual figures As at December 2017, most Asian economies recorded remarkably stronger PMI readings compared to the same period in 2016, with Japan, Taiwan and India taking the spotlight. Obviously, trade frictions still exist, in particular with the United States, as recent tariffs imposed on the imports of solar panels and washing machines from South Korea and China stoke fears of trade protectionism. Estimated output gaps for the majority of Asia Pacific economies in 2017 suggest sufficient slack across the region, which may indirectly infer that monetary policy should generally remain generally accommodative, especially given that inflation is still trending low.
China is well poised to capitalize on the favorable external environment to further advance its reform goals, in particular, orchestrating the deleveraging of the economy while balancing growth and job creation targets.
Australia's economy continues to transit from resources towards services. Latest available data from the Australian Bureau of Statistics showed that the labor market continued to impress as the total employment level of approximately 12.3 million as at September 2017 was the highest level on record. Despite the jobs boom, unemployment rate has hovered steady at 5.6%, which suggests that there remains significant spare capacity in the economy. With the economy operating below full capacity, limited wage growth remains a concern as that stifles consumer spending which makes up approximately 60% of the Australian economy.
In view of rising household debt and (still) heated housing market, the Reserve Bank of Australia is likely to be patient on its monetary stance and hold its ground on interest rates in the near term. In the meantime, government investment is expected to make a substantial contribution to near term growth, with the states ramping up spending on major infrastructure projects.
Chart 4: Estimated output gap (2017, as percent of potential output) Source: Oxford Economics (as at January 2018) Japan's situation remains somewhat peculiar. Buoyant corporate profits and strong business confidence have bolstered the confidence of Japanese corporates, with new machinery orders in 2017 rising to the highest level in a decade, a clear signal of the beginning of an elusive capex cycle which is expected to further close the output gap in the next two years. The unemployment rate is at a multi-year low, and the jobs-to-applicants ratio rose to 1.59 in December 2017, the highest since January 1974.
Puzzling enough, all these have not translated into noticeable wage inflation. Japan needs to resolve the conundrum of a tight labor market which is not feeding into wage growth, therefore hindering sustained growth in domestic consumption. 0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 Australia China Hong Kong Japan Singapore SE Asia APAC 5Y average 2017F 2018F -2.0 -1.5 -1.0 -0.5 0.0 0.5 1.0 Australia Korea India Japan China Singapore Hong Kong
Real Estate Summary Edition 1, 2018 11 On the other end of the spectrum, trade growth and the investment up-cycles in Singapore and Hong Kong translated into solid GDP growth of 3.1% and 3.7%, respectively, in 2017. Both economies are estimated to have closed the output gaps and the recovery in capital expenditure will pick up pace going forward. While wage growth remains rather anemic now, we believe tightening labor market conditions will ultimately feed into sustained wage growth and boost consumer sentiment.
Central banks in Asia are likely to watch for sustained improvements in labor conditions and monitor ongoing regional interest rate normalization over the next couple of years.
Real income is supported by relatively benign inflationary pressures and regional governments will focus on expansionary fiscal policies. With output remaining slightly below potential for most of Asia, economic activity should support leasing markets and fundamentals in the near term. Industrial As a whole across the region, especially developed Asia, industrial sector employment and space requirements by end- users have not increased in tandem with the strong showing in industrial activities over the past year. This is largely attributed to the structural shift in manufacturing towards high value-added and less labor-intensive activities.
Particularly in Singapore, and along the Yangtze River Delta of China, the demand dynamics of the industrial and factory space segment have shifted towards built-to-suit and well-specified industrial and business park space. In the warehousing segment, there is a growing inclination towards smaller infill space in markets where there is a high and rising proportion of online sales from businesses to consumers, and an increased focus on same-day delivery as a unique competitive edge in the crowded e-commerce segment. It is becoming increasingly apparent that on a bottom-up basis, higher quality industrial space will continue to deliver favorable rent growth and occupancy in Asia.
Although speculative development has surged in some cities in China in the western and central regions, limited new supply of high quality space and obsolescence of existing facilities means there is still an overall shortfall of modern logistics stock per capita in China. Demand from third party logistics (3PL) and e-commerce players is increasing and the marginal increase in rents is more obvious in the higher tier cities where supply is more balanced, and in satellite cities where there is a shortage of modern stock. In Singapore, business parks rents have increased for the third consecutive quarter, and ended the year with an annual 3.3% increase.
Demand has been driven by the technology, biomedical and banking sectors and we expect that this trend will continue into 2018. The key driver of business park outperformance is the limited supply pipeline which will persist into 2020, and this bodes well for the medium term prospects of the segment.
The Hong Kong government is considering the introduction of a second industrial revitalization scheme that, if put into effect, will further reduce the volume of industrial stock. Over at Tokyo, overall rental growth for warehouses in 4Q 2107 was 1.4%, the same as the previous quarter. However, the limited availability of supply in Tokyo Bay is underlying strong rent uplifts, while submarkets such as Ken-o-do continue to struggle with high vacancies. In Sydney, limited potential supply of industrial land due to the expansion of residential boundaries is supporting low vacancy rates. Melbourne has more land in the North and West, and these suburban greenfield industrial areas will see limited long term rental growth.
Retail November was an interesting month for retail sales in Asia last year. We have often bemoaned the softness in consumer sentiment, alluding to lethargic retail sales growth as one reason why physical retail space is suffering. However, the launch of the Apple iPhone X last November almost singlehandedly propelled retail sales growth to two year highs for most Asian markets. Obviously not all retailers can emulate the same, but this tells us that consumers probably can dig into their pockets, and luxury retail and consumer products still have a place in the retail sector.
Retail property performance across Asia Pacific remains mixed.
Demand for prime and CBD retail space has been steady in key cities and markets in Japan and Australia, supported by inbound tourists and demand from international retailers. High street rents in the prime areas of Tokyo remain in growth mode, as limited new supply of prime retail space provides the support for rental uplifts. The situation is similar in Sydney and Melbourne where low vacancy continues to underpin the resilience of prime retail. The emergence of the middle class in Asia, in particular China, has created a new retail driver in the form of tourist spending. Domestic consumption in most of Asia is veering towards non-discretionary spending and food & beverage.
This is where the impact of e-commerce has been more muted in Asia (excluding Australia), because the dense nature of cities insulate the suburban malls from a direct substitution effect from e-commerce. Low vacancy is underpinning the defensive qualities of dominant shopping centers in Australia and suburban malls in Singapore, Hong Kong and China.
Office The majority of office markets continued to see flat to positive prime rental movements in the fourth quarter of 2017 with the strongest growth being registered in Sydney, Melbourne, Hong Kong and Shanghai. Rent growth is expected to remain healthy in the Australian ex-resources markets over the next two years in an environment of steady leasing demand, low vacancy and conversion of Grade B stock into other uses. The Sydney office market is set to remain one of the stronger performing markets on a global basis, particularly for existing owners where rental growth is now supporting valuations.
Occupier markets remain under pressure in Brisbane and Perth although any sustained increase in commodity prices may translate into a faster than expected recovery. In Tokyo, significant supply in the Grade A space will be delivered to the market in the next two years, and the secondary space that is vacated as tenants relocate to newer buildings will exert downward pressure on rents and occupancy. In Hong Kong,
Real Estate Summary Edition 1, 2018 12 low vacancy and strong demand from mainland Chinese financial occupiers for prime space continues to push rents higher in Central, and positive spillover effects were observed in Quarry Bay in the east of Hong Kong Island. Beijing and Shanghai continue to attract significant leasing interest from the financial and technology sectors, particularly from domestic companies. Despite the growth of emerging office submarkets, landlord expectations have remained high and core office rents in Beijing and Shanghai (e.g. Financial Street in Beijing, and Little Lujiazui in Shanghai) held steady in 4Q17, recording flat year-on-year (YoY) growth.
The Singapore office market has seen steady leasing improvements in the last half of 2017, but this is focused on new and prime office space along the Marina Bay. It remains to be seen if the backfill vacant space will see solid take up as business sentiment improves in Singapore Chart 5: APAC CBD prime office rent growth Chart 6: APAC CBD office vacancy rates (% p.a % of existing stock) Source: CBRE, PMA, 4Q 2017 Capital markets Data from Real Capital Analytics (RCA) suggests that transactional activity in income producing property (excluding sales of development sites) in Asia Pacific hit an all-time high in 2017.
In terms of composition, activity was focused on the three largest commercial real estate markets in the region of China, Japan and Australia, although these markets saw flat to negative year on year growth in transaction values. Overall, transactional volumes for income producing commercial assets in China were approximately 6% lower in 2017 compared to 2016. Australia saw a 10% decline year on year, while Japan transaction volumes increased marginally by 3% in the same period. Notwithstanding the above, in terms of markets, Hong Kong charged ahead in the last quarter, ending 2017 as the individual market with the highest transaction volume, at USD 20.9 bn, way ahead of Tokyo at USD 16.5 bn.
Singapore was the third most active investment market in 2017, at USD 14.5bn, a year on year increase of 50%. Unchanged from the last few quarters, given the fully priced environment in Australia (Sydney and Melbourne) and key cities of Japan, existing owners are increasingly reluctant to sell given the costs involved and lack of alternative investments for recycled capital. In the near to medium term, the key constraint for new capital will be finding suitable assets to purchase across the region. And for this reason, we have started to see deal sizes drop in Tokyo and Sydney, while neglected markets such as Hong Kong and Singapore saw massive capital flows into transactions well in excess of USD 500 million.
Expected returns are set to be slightly lower for new capital buying into today's market, particularly given the lack of forced sales and the risks of reinvesting capital to achieve the same expected return, either domestically or globally.
Chart 7: Most active Asia Pacific markets in 2017 (USD billion, excluding land sales) Source: RCA as at 4Q17 (15) (5) 5 15 Perth Brisbane Sydney Melbourne Chongqing Wuhan Tianjin Shanghai Shenyang Beijing Hangzhou Nanjing Shenzhen Guangzhou Hong Kong Tokyo Singapore Seoul 4Q17 4Q16 5 10 15 20 25 30 35 40 45 Sydney Melbourne Brisbane Perth Nanjing Beijing Guangzhou Ningbo Shanghai Qingdao Hangzhou Dalian Shenyang Chengdu Wuhan Tianjin Chongqing Hong Kong Singapore Tokyo Seoul 3Q17 4Q17 -40% -20% 0% 20% 40% 60% 5 10 15 20 25 Hong Kong Tokyo Singapore Shanghai Seoul Sydney Melbourne Volume (USD) YoY % (RHS)
Real Estate Summary Edition 1, 2018 13 Strategy viewpoint At the time of writing, most of Asia is in the midst of celebratory preparations for the lunar Chinese New Year. The Chinese zodiac is based on a twelve year cycle represented annually by an animal, and 2017 was the year of the rooster while 2018 is signified by the dog. 2017 was definitely one of the more encouraging years for Asia Pacific economies in recent times, and while there were flashes of geopolitical tensions, the year of the rooster ended far from calamitous. In the Chinese written language, phrases and expressions containing both the characters for rooster (鸡) and the dog (犬) almost always insinuate mayhem, disorder and upheaval.
Will the dog finally encounter the rooster in 2018 resulting in mass chaos, or will the dog and the rooster narrowly miss each other at the passing of the year? Will 2018 turn out to be propitious or appalling for real estate? Of course, answers to these questions will only be revealed in hindsight Instead of leaving circumstances to luck and chance, we advocate that investors continue to take an evergreen approach towards risk management and active income creation, identifying real estate opportunities underpinned by structural trends, and taking a long term view of prospects within Asia Pacific.
Barking up the wrong tree Much of the rhetoric in the last few years focused on the risks that a sharp slowdown in China will pose to the Asia Pacific region, and how a ticking time bomb in the form of an overleveraged Chinese economy threatens the post-GFC recovery globally. As we have highlighted in earlier editions of this report, China has a deep ammunition box to tackle its existing debt issues, and much of the debt remains domestic, which is unlikely to trigger any sharp pullback in global liquidity in the event of a shock. Also, the recovering global economy provides an excellent backdrop for China to double up on its deleveraging efforts in the next few years.
These risks are in no way underwhelming, but most of us tend to focus too much on China, ignoring the obvious financial risks in other markets of Asia Pacific. Private sector leverage, in particular household leverage, in Australia, South Korea and Hong Kong, for instance, are near term risks more likely to implode than China's imbalances. As the US continues on its rate hike trajectory, Asian economies will most likely have to run in parallel to avoid drastic capital outflows, and that has to be balanced with the debt servicing burdens of households. If monetary policies tighten excessively, that may further dampen domestic demand, and in an extreme scenario, lead to short term wealth and financial shocks that could reverberate through the Asia Pacific region.
These are but some of the risks that real estate investors should be more aware of, instead of being distracted by the 'groundhog day' nature of China's financial risks.
Is the tail wagging the dog? With core yields in most Asia Pacific markets at or below historical lows, investors are increasingly basing their investment decisions on the absolute achievable returns. The chase for yield inadvertently distorts the perceived rationality in risk-adjusted returns and capital starts to move up the risk spectrum. This is particularly evident in the volume of transacted land sites in the last few years, as both cross border and domestic investors piled into development activities in Asia Pacific in the hope of extracting better returns. Since late 2014, investment into land sites by Asia Pacific domestic investors as a percentage of total investment value has climbed from approximately 70% to more than 82%.
Cross border investors have also jumped onto the development bandwagon, to the extent of throwing caution to the wind, as investment into land as a percentage of total investment value rose from approximately 40% in 2014 to more than 60% in 2017. Obviously, construction cycles vary across markets but this concerted shift into development does not mask the fact that the chase for absolute returns is swaying investment decisions towards high(er) risk strategies. The focus on risk management has to take center stage going forward, given that limited core investment options are squeezing capital into tight corners and alternative segments of Asia Pacific real estate.
The dog ate my homework Today, as central banks start to withdraw liquidity and raise interest rates, the period of rapid yield compression is coming to an end in Asia Pacific markets. Income has or will soon become the main driver of returns. Investors should not find excuses for not augmenting occupier performance or not engaging in active management of the undervalued aspects of real estate. The end game is to increase and grow the income component of the property, by increasing rents or increasing rentable space, and thus boosting intrinsic value. In an environment of higher interest rates, investors should turn their attention to Asia Pacific markets where occupier conditions are improving relative to recent averages.
For example, expected returns are set to be much lower for new capital buying into core Sydney or Tokyo office sectors. This also implies that in a supply constrained market such as Sydney or in the Tokyo Grade B space, value creation becomes even more essential. In these markets, active asset management strategies could prove to be very rewarding in the medium term.
Clearly, every dog has its day in the realm of Asia Pacific real estate, where cycles are heterogeneous across markets. There is arguably no clear leader in the pack at any point in time. For instance, markets with strong(er) fundamentals such as Australia or Japan are now fully priced and investors should not let their guard down (no pun intended) in underwriting excessive capital growth, and should place a greater emphasis on asset section. Some markets such as Singapore and Hong Kong are however expected to attract greater investor interest in 2018 on the back of anticipated recovery after a long period of underperformance.
However, these are not the obvious top dogs as capital will need to take a view on the still divergent occupier and capital cycles in these markets.
14 European summary
15 The eurozone economy is expected to grow at the strongest rate for a decade with survey data indicating sentiment is at record highs. Prime rental growth is expected in most A-cities, as well as select B-cities, while yields at or below record lows in the majority of European markets. The UK is holding up better than expected, as overseas investors continue to target London assets and demand remains buoyant. Risks remain skewed to the downside, however, as Brexit continues to loom on the horizon.
Real Estate Summary Edition 1, 2018 16 European Summary Demand 2017 has been a breakthrough year for the European economy, which is enjoying its strongest growth rate for a decade.
It is estimated that the eurozone would have seen GDP expansion of 2.5% in 2017. There has been something of a mismatch between stratospheric surveys and hard data over the course of the year, however manufacturing and retail sales output rebounded in November and December indicating that hard data should close the gap somewhat in 4Q17. All of this has also been gained at a fairly modest uptick in inflation, which was just 1.4% in December, with core inflation remaining at even lower levels. This indicates consumer demand spending is unlikely to be restricted by rising prices in 2018.
This expansion has been driven by strong levels of growth among emerging markets, but also strong performance in Europe's larger economies, most notably Germany and France. Germany is expected to have grown by 2.4% in 2017 as stronger than anticipated growth in exports provided an upside surprise. France has seen growth accelerate in 2017 following the election of the market-friendly Emmanuel Macron, while the UK economy is thought to have turned in stronger performance than anticipated, expanding by around 1.8% p.a despite high levels of Brexit-related uncertainty. Political risk also declined over the course of 2017, providing some much-needed respite to beleaguered governments.
Negotiations over Brexit have progressed to discussions about trade while both sides appear to agree on the need for a transition period. Meanwhile, populist parties did not manage to achieve upsets in elections in the Netherlands, France or Germany, although the right-wing “alternative für Deutschland” have made the process of coalition-forming in Germany more challenging. 2018 will bring a general election in Italy which could provide another challenge, with the populist 5-star movement ahead in the polls and with the prospect of Berlusconi re-entering Italian politics. However, there is overall less concern over the political situation at the beginning of 2018 than there was at the same time last year.
The positive fundamentals saw office leasing activity continue to rise Y-o-Y for the fourth consecutive quarter, with 4Q 2017 letting volumes 13% higher than the same period the previous year (see chart 8). Volumes were strong in the major German cities with Frankfurt, Munich and Hamburg all seeing double digit growth compared with the previous years. Berlin saw take-up rise by just 4%, however the total of 925,000 sqm was significantly above the long term average. The low growth rate is explained more by the stellar performances in recent years than any moderation in demand. Madrid (+32%) and Barcelona (+5%) also saw healthy levels of demand, with the latter seeing an increase despite uncertainty over the Catalonia's political status.
Surprisingly, Central London saw take-up rise by 7%, with the City (+16%) and West End (+31%) experiencing tenant demand despite the negative outlook for Central London offices. While their numbers seem impressive, much of this was driven by banks' consolidation and growth in serviced office providers, which accounted for 15% of the market in 2017.
Unsurprisingly, given the high demand for space, rents have continued to grow with aggregate prime office values across the eurozone increasing by 5.7% in 2017 (Y-o-Y). Relatively low levels of development combined with a recovery in demand is now driving rental growth in multiple European cities. France's improving fortunes are well summarized by the 20% growth in rents in Marseille in 2017. Lyon also saw solid levels of growth, while even Paris saw values edge up by 2.5%. German cities continued to tick over nicely; most saw growth in rental values of 1-2%, with the exception of Berlin and Munich which saw respective annual increases of 9.1% and 4.3%.
Berlin continues to be the strongest performer as it continues its transition to a hub for technology and media companies.
Chart 8: Aggregate European office take-up volumes (including Central London) Source: JLL 4Q17 In the retail sector, consumer confidence remains buoyant with surveys in the UK and Europe significantly above the long run average. On the continent, this has driven improved sales growth as low unemployment and solid wage growth have translated into higher till receipts. In the UK, however, there are signs that consumer demand is beginning to wane as higher inflation and stagnant wage growth is hitting demand. Christmas sales were disappointing for most retailers, indicating consumers are starting to feel the pinch.
This has translated into pan-European prime rental growth of 2.0 % in the retail sector, although there continues to be a divergence between prime and secondary locations. Prime rents in Milan grew by 13%, while Rome saw increases of around 12% (YoY). Barcelona (+4%) and Madrid (+5%) continued to perform well, as Spain continues its recovery. Elsewhere, the year has been mixed in terms of prime rental performance across Europe, indicating that even the top locations are not immune from the pressures facing the 4'000 8'000 12'000 16'000 1'000 2'000 3'000 4'000 5'000 2Q 4Q 2Q 4Q 2Q 4Q 2Q 4Q 2Q 4Q 2014 2015 2016 2017 Take-up Rolling annual
Real Estate Summary Edition 1, 2018 17 sector. In Paris, rents were flat as they were in London, where a business rates revaluation increased affordability pressure on retailers. Surprisingly, prime rents fell back by 5-7% in the major German cities underlining how even prime locations are not immune to the issues facing the sector. Even in some of the better locations, we have seen evidence of retailers looking to renegotiate leases or close stores as the sector continues to be disrupted by e-commerce. Chart 9: Consumer confidence – Outlook next 12 months (Balance – Seasonally Adjusted) Source: Datastream, January 2018 The industrial sector is undergoing a structural transformation at present, driven by the exponential growth of online retail as well as solid fundamentals within traditional industrial sectors.
These factors have increased the user-base of industrial with pure play ecommerce operators looking to acquire space, as well as third-party logistics operators and traditional retailers. As a result, take-up has risen strongly over the past few years and European prime logistics rents rose by an annualized 2.7% in 3Q17.
However, prime rental growth is likely to be suppressed by the footloose nature of many occupiers in the logistics sector. Occupiers are consistently moving away from more established western European markets to cheaper and less highly regulated countries. By way of example, German cities have seen no rental growth over the past year, whereas the Czech Republic has seen industrial rents rise by 12%, as those looking to supply Germany and Austria are progressively looking to lease space in CEE countries. Poland is also a popular destination for occupiers, however high levels of development have precluded any rental increases in the last year.
Operators within traditional industrial sectors have also been acquisitive, as manufacturers in particular look to optimize their networks to maximize efficiency. This process could be accelerated over the medium to long term, as there are indications some European manufacturers may look to 're- shore' some or all of their production functions back to Europe. Wage inflation in emerging markets has eroded the benefits of outsourcing while customer service and the ability to come to market quickly have become more vital. This could lead to higher demand from manufacturers for heavy industrial space within Europe, although this is something we expect to happen over a longer time frame.
Within the distribution sector, demand is especially keen for both larger format (>10,000 sqm) units with modern specifications, as well as smaller format units located close to urban centers. This is known as the 'hub and spoke' model and is typical of e-commerce operators. The network is generally based around large regional hubs with smaller format 'last mile' centers near major centers of consumption, where goods are sent before being allocated for delivery to customers. These 'last mile' centers have seen the highest levels of rental growth as competition for these sites is immense. Also, as we will outline in the next section, development of these sites is problematic in most urban locations due to competition with residential uses.
Supply On the supply side, occupier markets have become increasingly tight as robust levels of demand have not been matched with a supply response in the majority of European cities. The EU-15 vacancy rate continued to decline in 3Q17, (now standing at 7.9%) the lowest level since the financial crisis. Munich has the lowest vacancy rate (3.3%) of all European cities, as the historic center continues to see low levels of development. Many occupiers have begun taking space in the out- of- town hubs surrounding the city due to very low levels of availability within the center. Berlin continues to undergo a structural transformation with high demand from TMT4 occupiers pushing vacancy to record lows.
Despite relatively high building levels (7.2% of total stock), London's vacancy rates remain comfortably below the European average at just 6.2% of units in the City of London and 3.7% in the West End, although these rates are rising. Warsaw by contrast is suffering from high levels of vacancy (12.9%) and continued high levels of office development (12.2% of total stock). Most cities are seeing a divergence between the prime CBD areas (where supply remains very tight) and secondary markets where vacancy rates are higher. In the retail sector, development activity has largely moderated within most sectors due to challenges arising from the growth in online retail.
High street development is largely restricted due to the historic nature of most European city centers. In the retail warehouse segment, the development pipeline for 2017 and 2018 is starting to look fairly high in an historical context although many projects have not yet started on site, which suggests project delays and potentially lower completions than forecast. Across Europe, Sweden is set to see the biggest per capita increase in provision and there are notable national differences in the kind of development taking place. Shopping center development has been restrained recently as issues facing the retail sector have left developers reluctant to start development apart from on low risk projects in prime locations.
Having seen growth rates of 5% p.a. in the 4 Technology, Media & Telecommunications (40) (30) (20) (10) 10 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 UK EU
Real Estate Summary Edition 1, 2018 18 years preceding the credit crunch, European shopping center stock is expected to grow by just 1-2% p.a. over the next five years. As outlined in the previous section, there has been an upswing in demand for industrial real estate and, while pipeline data for industrial assets is somewhat lagging, there are now signs that there has been a pick-up in development in most European countries. PMA estimated every major region in Europe saw completions rise in 2017, though this has not made much difference to availability as the vast majority are design and build schemes.
As a result, vacancy remains low although the industrial sector is very prone to supply shocks due to relatively cheap and rapid construction periods. Urban Poland and CEE are seeing a significant amount of space come online for instance, as high availability and a relaxed planning regime has seen a significant amount of space developed. Urban logistics has a degree of protection from increased development as competition for land in and around cities make industrial schemes challenging to underwrite. As a result, 'last mile' facilities favored by retailers and 3PL (third- party logistics) operators for online fulfillment are in especially short supply at present.
Chart 10: Prime rent index (1Q00 = 100) Source: CBRE: 4Q 2017 Capital markets Preliminary estimates for total investment volumes in 2017 indicate this could have been a record year for European real estate. It is estimated that EUR 85 billion was invested in 4Q 2017, a 5% decrease on the same period last year but strong by historical standards. On a whole year basis, volumes were up 9%, with EUR 285 billion thought to have been transacted. This outperformance was largely driven by investor interest in industrial, with total volumes ending 2017 67% above the previous year. This surge is partly explained by an increase in M&A activity as several multi-billion deals closed for industrial entities over the course of the year.
Offices saw a slight uptick as well, (5% above 2016) while retail volumes fell by the same amount underlining a general cautiousness surrounding the sector. Drilling down a bit deeper into retail, shopping center transactions were very muted over the course of the year with total volumes declining by around 43%. At the other end of the spectrum, there was a 17% increase in transactions for hotels Alternatives remain very popular as investors look to continue to target the sector as well as looking for yield. On closer examination at country level, the UK surprisingly saw volumes increase by 12% as several 'mega-deals' in Central London pushed transactions up for the year.
Chinese and Hong Kong based buyers have accounted for a significant share of London office investment in 2017, attracted by its relative cheapness compared with European cities and its safe haven status. Germany remained in high demand as its solid performance and promising outlook attracted investors. And the Nordics saw significant activity as well (see chart13). In a sign that investors are finally moving up the risk curve, 'Non- core CEE' (including countries like Bulgaria, Croatia and Serbia) volumes increased by 36%, although this is coming off a low base, The increased investment comes as something of a surprise considering yields are at or below record levels in most markets.
Prime yields for offices, retail and industrial have all been at record lows for some time and over the course of 2017 compressed about 20 basis points further on an aggregated basis (see chart 11). This reflects equally stretched valuations in the fixed income sector, as well as a positive outlook for rental growth in the majority of locations. Nonetheless, pricing is certainly getting to a point where it is difficult to see how it could compress further. Prime yields in Paris and Munich are now just 3.0%, while Central London looks relatively good value at 3.75% in the West end and 4% in the city.
All of the main German markets have seen yields compress further this year with Berlin and Hamburg trading at 3.1% and Frankfurt not far behind at 3.2%. Overall, it is the same story across Europe with the majority of prime assets priced higher than they were 12 months ago and not a single center seeing any outward yield shift.
There are big question marks about how sustainable this is. With inflation returning, the ECB announcing the end of quantitative easing and the Federal Reserve tightening in the US, we are expecting a gradual normalization of bond yields over the next few years. With prime real estate yields at or around 3%, there is not far to go before there is almost no premium over bonds whatsoever, which surely amounts to a mispricing considering real assets depreciate and require illiquidity premiums. This would put upward pressure on property yields, which could have a significant impact on capital values.
Investors looking to buy at such yields need to have reasonable assumptions of near-term rental growth to mitigate an expected rise in yields. This has understandably lead to widespread concern about when the music will stop, however as there are no rate rises penciled in until 2019 at the earliest, it is difficult to see a large correction coming in 2018. Going forward though, it is difficult to see how yields could compress any further.
80 100 120 140 160 180 200 220 4Q02 1Q04 2Q05 3Q06 4Q07 1Q09 2Q10 3Q11 4Q12 1Q14 2Q15 3Q16 4Q17 Retail Index Industrial Index Office Index
Real Estate Summary Edition 1, 2018 19 Chart 11: EU-15 Yield Index Chart 12: European investment volumes Source: CBRE 4Q17 Strategy viewpoint Having already benefitted from the growth of e-commerce, the industrial sector may be about to see a second tailwind- this time in the manufacturing sector. Rising wage costs in key developing economies have begun to erode the cost benefits of outsourcing production and have prompted European producers to consider 're-shoring' operations.
CEE locations, particularly Poland and Czech Republic have already benefitted from significant relocations, especially from the automotive sector and are expected to see manufacturing GVA (as a share of GDP) continue to rise significantly over the next 10 years. In the fashion industry as well, many operators have begun to realize that speed to market and customer service are worth paying for; Zara produces 60% of its products in Europe and North Africa, while online retailers ASOS and Boohoo source around 50% of products in their home markets.
There are two catalysts to this process. Firstly, the EU-led TEN- T program5 will invest significant capital to developing and bolstering physical and digital infrastructure within the EU. Secondly, improved technology will provide opportunities for streamlining processes. Driverless cars have the potential to boost drivetimes, while robotics and 3D printing in factories have the potential to reduce labor costs significantly. These gains, if realized, may further reduce the comparative cost benefits of locating in Asia. There are already tentative signs of development in this direction. Ocado and Amazon have already implemented robotic systems in their distribution warehouses, while on the production side, Adidas have just opened a fully automated robotic factory near the German town of Ansbach.
Both Adidas and competitor Nike have announced their intentions to re-shore as much production as 5 A European infrastructure investment program to improve roads and seaports especially possible over the next five years in order to be closer to the end consumer.
From the outset, it's important to emphasize that we are not expecting a wholescale 're-industrialization' of Europe. While some cost benefits of manufacturing in emerging markets are falling, such areas still have advantages in producing less complex, mainstream products. However, there are indications that production is becoming more customer-centric. Just as the online consumer expects rapid fulfilment of online retail orders, they will increasingly have similar expectations of production meaning global supply chains will not be optimal for all operators.
A growth in reshoring will create new challenges for occupiers and landlords, however.
As technology will most likely play a key role, electrical infrastructure will need to improve due to the power intensive nature of the new automated systems. We are already seeing evidence of occupier decisions being influenced by this factor, and this could potentially re-shape how we think about prime and secondary locations. Going forward, a well-located high spec warehouse will not be able to command top rents unless it has a sufficient power supply as well.
Chart 13: Employment change in manufacturing (2000=100) Source: Eurostat, Oxford, 4Q17 3.00 4.00 5.00 6.00 7.00 8.00 9.00 4Q 2005 2Q 2007 4Q 2008 2Q 2010 4Q 2011 2Q 2013 4Q 2014 2Q 2016 4Q 2017 Retail Yield Industrial Yield Office Yield - 20'000 40'000 60'000 80'000 100'000 4Q 2013 2Q 2014 4Q 2014 2Q 2015 4Q 2015 2Q 2016 4Q 2016 2Q 2017 4Q 2017 Benelux Nordics Italy Germany UK Spain France Ireland Other* 70 80 90 100 110 120 130 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 2024 Czech Republic Eurozone
20 US summary
21 For nearly two years, US commercial and multifamily real estate has produced returns driven by income growth and in-line with long-term expectations.
Offsetting forces are in action. A positive outlook for the US economy and labor markets supports values while upward movements in interest rates reduce spreads. Our expectation is that the 2018 performance will be a continuance of the income-lead returns of recent years.
Real Estate Summary Edition 1, 2018 22 US Summary Real estate fundamentals For all of the anticipation and speculation about transitions, 2017 turned out to be a comparatively ordinary year for US commercial real estate. Our expectations for 2018 are similar. Capital market forces slowed in 2016 and 2017, easing fears of overheating but bringing with them, slower appreciation in real estate values. Property-level income growth continues to power forward at more than twice the rate of inflation . Chart 14: Occupancy recoveries (%) Source: CBRE Econometric Advisors and Axiometrics as of December 2017 Occupancy rates are high relative to the past ten years and now are facing a small degree of downward pressure with supply growth matching or exceeding demand in all but the retail segment (see chart 14).
Rent growth is the driving force behind income gains. Economic conditions create some optimism that growth will continue to reflect positive momentum for the US.
Apartments Vacancy rates are increasing slowly in the apartment sector, under pressure from a peak point in new construction. At 5.3% vacancy remains below the 20-year average of 6.1%. Rent growth remains positive at 2.3% in the year ended December 2017, per Axiometrics. US homeownership rose somewhat to 64.2% during the fourth quarter. Higher rates of homeownership could slow apartment demand. However, the current strength in the labor market has been high enough to offset changes in homeownership. Industrial Industrial retains its position as the sector with the highest rent growth and returns.
Growth in net rents is strong but decelerating, increasing by 5.0% during 2017 after a gain of 6.3% 2016. It was the only sector to outperform the NCREIF Property Index average return in 2017.
Availability for total industrial has been fairly flat at 7.4%, which is as low as it has been since 1Q01; however, the warehouse subsector experienced a small, 10 bps increase in availability during the fourth quarter to 7.6%, as supply growth is exceeding its long-term average. Office At 1.7%, office rent growth underperformed inflation during 2017 with nearly flat rents across Downtown locations and 2.9% rent growth in the Suburbs. Yet, the gap between Downtown office vacancy at 10.7% and Suburban vacancy at 14.2% remains wide.
Heading into 2018, deliveries of new office buildings are increasing especially in tech markets; however, we expect development to slow in coming years.
Recent movements in vacancy are minimal but favorable, implying that there is almost enough tenant demand to sign leases for new space. 80 82 84 86 88 90 92 94 96 1Q07 4Q07 3Q08 2Q09 1Q10 4Q10 3Q11 2Q12 1Q13 4Q13 3Q14 2Q15 1Q16 4Q16 4Q17 Apartments Industrial Office-downtown Office-suburbs Retail-neighborhood/community
Real Estate Summary Edition 1, 2018 23 Retail Retail sales in brick and mortar stores increased by 4.1% during 2017, nearly twice the rate of inflation. Consumer spending is up due to increased disposable income and low unemployment, which should support retail sales in 2018. The mall/lifestyle and power center segments are facing higher availability with space-for-lease increasing by 80 bps to 5.8% and 6.6%, respectively, over 2017. Stability in high-quality properties is offset by deterioration in others. At 9.6%, availability in Neighborhood, Community and Strip (NCS) retail is up 60 bps in 2017 with landlords sacrificing some occupancy to grow rents by 2.5%.
Chart 15: Rent growth trends in 4Q (YoY, %) Source: CBRE-Econometric Advisors and Axiometrics as at September 2017 Capital markets Income return dominates US real estate performance as commercial real estate is now nearly two years into a period of sustainable, income-driven returns, exhibit R3. Historically, the income return component has generated 70% to 90% of property-level total return in the US. Chart 16: NCRIEF Property Index returns (%) Source: NCREIF Property Index as of December 2017 Past performance is not indicative of future results. The transaction market remains liquid with the absolute volume of sales of USD 425 billion in the year ended December 2017.
US transaction volume is softer than last year with 2017 sales 6.5% below the year-ago pace, influencing our expectation that cap rates are likely to continue to flatten. Transaction volume continues to track lower for downtown offices, retail and hotels but is up in the apartment and industrial sectors, exhibit R4.Real estate debt capital is low cost and generally available, but not free-flowing, as was the case prior to the last downturn. Debt markets can be described as operational, but not excessive, which encourages development but not an abundance of supply.
Chart 17: US transactions (Four-quarter rolling total, USD billions) Source: Real Captial Analystics as of December 2017 2 4 6 Apartments Industrial Office-downtown Office-suburbs Retail-neighborhood/community 0.0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 1Q11 4Q11 3Q12 2Q13 1Q14 4Q14 3Q15 2Q16 1Q17 4Q17 Income return Appreciation return 20 40 60 80 100 120 140 1Q16 2Q16 3Q16 4Q16 1Q17 2Q17 3Q17 4Q17 Office Industrial Retail Apartments Hotels
Real Estate Summary Edition 1, 2018 24 In the US public market, shares of retail-focused Real Estate Investment Trusts (REITs) are trading at large discounts to the underlying property values, making them interesting targets for mergers and takeover bids.
Long-term interest rates remain low relative to US history but increased 40 bps in early 2018. The 10-year US Treasury rate was 2.40 at the end of 2017 but rose to 2.88% by mid- February 2018 (see chart 18).With little movement in cap rates, the upward move in Treasury rates condensed spreads available in US real estate. Recent spreads offered by real estate investments are below long-term expectations, representing a change from the wide spreads that drew capital so quickly in the wake of the last recession and relieving one of the pressures that had been pushing cap rates lower. Chart 18: US 10-year Treasury rate (%) Source: Moody's Analytics as of December 2017 Low unemployment and positive economic growth translate into on-going demand for commercial and multifamily real estate.
In-line with expectations, real GDP (Gross Domestic Product) grew 2.3% in 2017, exhibit R1, which is near the top of the recent range of economic growth.
During fourth quarter 2017, job growth averaged 203,000 per month, see exhibit R2, which is about 30,000 jobs higher than our expectation for 2018 and includes a drag from retail-sector employment. In the coming year, the hiring market faces constraints from an elevated number of openings and a low unemployment rate. December 2017 marked the third consecutive month with unemployment at 4.1%, the lowest rate since 2000. Chart 19: US unemployment (Jobs (thousands % ) Source: Moody's Analytics as of December 2017 The labor market is strong enough and inflation is just high enough to justify expectations for increasing the Federal Reserve's monetary tightening efforts relative to recent years.
Consumer price inflation was 2.1% in the year ended December 2017. Our base case expectation is that the Fed continues to tighten at a pace the markets can absorb. There is an increased risk that the perception of rising inflationary pressures could cause the Fed to act too quickly in raising rates and reducing holdings of long-term bonds. Some of this concern may be reflected in recent market volatility. In the near-term, we do not anticipate any transmission to private commercial real estate markets where income expectations remain quite positive; however, a rising cost of capital would eventually pressure the pricing of all valued assets, including real estate.
1.5 1.7 1.9 2.1 2.3 2.5 2.7 Jun-17 Jul-17 Aug-17 Sep-17 Oct-17 Nov-17 Dec-17 3.6 3.8 4.0 4.2 4.4 4.6 4.8 5.0 50 100 150 200 250 300 Jan- 17 Feb- 17 Mar- 17 Apr- 17 May- 17 Jun- 17 Jul- 17 Aug- 17 Sep- 17 Oct- 17 Nov- 17 Dec- 17
Real Estate Summary Edition 1, 2018 25 Strategy viewpoint We expect 2018 to be a continuation of relative calm. US real estate began a long-anticipated, orderly transition from double-digit returns to single-digit normalization more than two years ago. No bubbles. No shocks. Appreciation just moved slower and leveled off by mid-2016, as shown in exhibit 42.
Investors should be reassured that slower appreciation was expected and the transition happened without market disruption. Property values are increasing at about the pace of inflation, as the ultra-low interest rates and faster inbound flows of capital are no longer driving down cap rates. Appreciation in the market today relates back to the positive income generated by properties, as opposed to heated capital market conditions. As long-term investors, we take comfort in income-generated performance. The positive outlook for economic growth reinforces our view that income should continue to grow faster than inflation in 2018.
Fairly level occupancy rates and moderate rent growth leads us to conclude that most property sectors are near or moving toward equilibrium levels of supply and demand, a market condition that points investors toward the benefit of balanced allocations. With less variance in real estate performance across sectors, diversification is only growing in importance. We expect markets will continue on a stabilized path, which will likely result in continued convergence in expected performance and, relative to past years, limit the investment opportunities that seem "obvious"..
Real Estate Summary Edition 1, 2018 26 For more information please contact UBS Asset Management Real Estate & Private Markets Research & Strategy Paul Guest +44-20-7901 5302 firstname.lastname@example.org www.ubs.com/realestate This publication is not to be construed as a solicitation of an offer to buy or sell any securities or other financial instruments relating to UBS AG or its affiliates in Switzerland, the United States or any other jurisdiction.
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Source for all data / charts, if not stated otherwise: UBS Asset Management, Real Estate & Private Markets. The views expressed are as of December 2017 and are a general guide to the views of UBS Asset Management, Real Estate & Private Markets. All information as at December 2017 unless stated otherwise. Published February 2018. Approved for global use.
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