_What are the themes influencing the future of global real estate investment?

As we discuss in The environment for global investments, the macroeconomic backdrop is at the early stages of significant change across many fronts: the recovery begins to approach its zenith in much of the world; money markets react to the end of a 40-year decline in interest rates; and central banks gradually move to unwind balance sheets.

Politics, sometimes regarded as a sideshow by economists, is proving to be anything but for real estate, with taxation, anti-corruption measures and state diktats just some of the levers being used to redirect the global flow of real estate capital, whether intentionally or not.

More positively, newfound stability in some of the world’s largest economies combined with the long anticipated rise of the emerging middle classes is set to unlock huge demand for pensions and insurance products, with a corresponding need to invest the savings thus accrued.

Meanwhile, the equivalent vehicles in developed markets are continuing a structural reweighting towards real estate, and recent volatility spikes in equity and bond markets are likely to have strengthened their resolve.

Cross-border activity will continue to increase

Our view is that, in the short term, the overall volume of global real estate investment will continue to fluctuate within the relatively narrow range seen over the past three years, with around US$1 trillion representing the recent high point.

This is somewhat lower than the peak volumes recorded prior to the global financial crisis. However, the more interesting point is that the proportion of this total that relates to cross-border activity is rising. What’s more, we expect this trend to continue for a number of reasons:

• As the real estate cycle extends, some investors are choosing to move up the risk curve in search of return and for some, this entails looking beyond the confines of their domestic markets.

• Many of the sovereign wealth funds and much of the emerging private wealth are being created in locations without a deep or transparent local real estate market, making overseas investment the only practical option.

• While much of the world’s real estate remains uninvestible even in mature economies, liquidity is being enhanced by the likes of private equity funds and listed real estate investment trusts (REITs), which assemble, manage and ultimately resell assets or portfolios.

So, where will this investment be directed? It’s no secret that a significant share of cross-border capital to date has been focused on continental European markets, and we do not expect this to change fundamentally in the short term. Despite rising pricing, the combination of healthy rental growth prospects underpinned by economic stability will remain attractive to investors.

Indeed, our gravity model suggests that the fundamentals of some of the largest European markets warrant additional cross-border inflows. Nevertheless, some of the most rapid growth in inflows continues to be found in emerging real estate markets.

Again, our gravity model predicts potential for additional investment in fast-growing markets in emerging Asia, as well as middle income regions of south and central America.

Demanding investors

Institutional investors with long-term liabilities will remain one of the key forces in global real estate investment, with INREV’s capital raising survey indicating that global pension funds accounted for over 35% of capital raised for non-listed funds in 2017, followed by insurance companies with 13.2%.

Whether investing directly though their own real estate funds and vehicles, or indirectly via third parties such as private equity funds, their pursuit of performance in order to make up the ground lost following the global financial crisis remains undiminished.

In the longer term, we expect institutions to continue to gradually ratchet up allocations towards real estate, not only in light of the strength of recent returns, but also with a view towards cautious capital preservation.

Indeed, another sign of such caution is the proliferation of real estate debt funds. This follows the logic that (as long as loan-to-value ratios are sensible), lending to real estate is less risky than owning it, if there is any question over the direction of pricing. Does this mean that the market is at risk of a return to unhealthy levels of debt provision?

Not necessarily. If anything, debt in real estate overall remains less prevalent, especially taking into account the lack of a liquid commercial mortgage-backed securities market in most countries or the reduction in debt held by major REITs. However, among funds at least, the appetite to lend has returned, and ultimately this represents an additional driver of demand.

We expect that the coming years will see the reactivation of mandates from a number of regions with significant investment firepower. The re-emergence of Japan as a major purchaser investor could reinvigorate cross-border trade if even a tiny additional share of domestic investment found its way into overseas markets.

Middle Eastern investors, many recently buoyed by oil prices once again returning to profitable levels, are likely to take the opportunity to deploy capital abroad, with the clear objective of achieving diversification.

Investors in these locations have a long history of acquiring non-domestic real estate, meaning that wehn they decide to do so again, their focus will not neccessarily be on the locations and sectors favoured by first time investors abroad.

Private wealth will remain a key source of demand for global real estate, growing in scale and becoming increasingly sophisticated and willing to invest beyond core assets in gateway locations.

Pricing: a theory of relativity

With yields reaching record lows in many developed markets, the issue of pricing has become hotter than ever. There is logic to the view that real estate yields are low simply because both central bank interest rates and yields on much larger asset classes, such as bonds, are also low. Applying the same logic in reverse, should rising interest rates therefore indicate rising yields?

Ultimately, yes: but the relationship is not so strong that real estate yields will move in lockstep with interest rates or bond yields. For a start, the gap between real estate yields and bond yields remains large enough to offer a significant cushion – bond rates can rise by many tens or even hundreds of basis points before the impact on real estate yields is felt.

The US is a case in point. Of the world’s major central banks, the Federal Reserve has gone furthest towards normalising interest rates, raising the target rate by 150 basis points since the end of 2015, during which time 10-year treasuries have moved from just over 2% to above 3%. Meanwhile, yields on US real estate have remained largely stable.

A broader mix of assets in play

Office and residential property has been the mainstay of cross-border investment over the past decade, but in the longer term we expect that capital will be directed towards a broader mix of real estate.

The logistics sector provides the roadmap for this transition: a sector once largely the domain of domestic investors has, with the combination of a compelling demand story and healthy return prospects, become coveted by the world’s largest cross-border investors. The catalyst was the creation of portfolios and platforms of significant scale, undertaken by private equity and institutional funds.

Which sectors will the next wave of internationalisation take in? Despite seeing increasing volumes of domestic investment, sectors such as the private rented sector, retirement living, healthcare and student housing currently account for smaller volumes of global cross-border transactions.

However, they all offer the key ingredient of structural occupier demand, which ultimately drives return. They will be attractive sectors for investors who can access these markets with sufficient scale, either through platform acquisitions or portfolio creation.