17th December 2015
In his Global Real Estate Securities Outlook for 2016, Schroders’ Hugo Machin states that although higher interest rates may be unsettling to some investors, the right real estate securities are supported by a number of other factors…
Market commentators often refer to the ‘wall of worry’, and from the media alone it would be easy to believe that Armageddon is around the corner. Indeed, the world appears to be in a state of perpetual crisis, but is this because it is true, or because pessimism sells newspapers?
Looking to 2016, our view is of a calmer real estate horizon than many would have you believe. While we recognise that risks are out there for real estate investors, we aim to quantify those risks; using the data and the facts available to make informed decisions. If 2015 has shown us anything, it is that the world isn’t perfect. We do expect some squalls from financial markets, but we don’t see evidence of a storm on the horizon.
There are a number of reasons why we don’t think we are heading into a stormy 2016. The first is that interest rates remain very low. This means that finance costs and leverage ratios should remain stable for companies with solid balance sheets. Secondly, banks simply won’t lend to speculative real estate development any more. Recent changes in the regulatory backdrop mean that the ‘cost’ of regulatory capital is exorbitant. The days of property developers risking other people’s money for self-enrichment are gone.
The knock-on effect is that less development means less new space. Less new space means more stable, or even growing, rents. Demand for space – especially in higher barrier markets – is sufficient for the right companies to build considerable ‘pricing power’. Our view has long been that real estate is a commodity much like any other. If it is desirable, people will pay. We aim to invest in companies that own assets where people want to work, live, eat and shop as this is integral to defending your capital in turbulent markets.
Not all real estate is created equally. The assets that most concern us are ones that lack this pricing power. These are assets that we describe as ‘commoditised’. Essentially, if there are plenty of them to go round, why should an occupier pay more for a building when a cheaper rent can be found next door? You need to give occupiers a reason to pay rents.
The elephant in the room for investors in all asset classes seems to be the prospect of higher interest rates. Real estate is no different. The edging up of interest rates traditionally signals that inflation and growth are back in the financial system. If your real estate assets have pricing power, higher rents can offset higher borrowing costs. If, however, your assets lack pricing power, the tighter policy environment could pose a serious challenge.
In our view, exposure to commoditised real estate in inappropriate structures – where the fund is traded daily but the underlying assets are not – could provide the single biggest headache to real estate investors in the medium-term. If rates go up or the economy falters, then commoditised assets do not generate the rent growth to drive them through the storm.
We cannot say with any certainty what the next year will bring. However, we are reasonably optimistic about how the real estate companies we invest in will fare. Pricing power and a lack of new supply should bode well for positive returns.
Where we are concerned is the impact of rates and shifting market dynamics on ‘bog standard’ real estate assets.