Transcript: Global Real Estate: Adjusting to the New Normal
AIR DATE: June 12, 2023 | 12:00 PM, EST
Caroline: Good afternoon, everyone, and thanks for joining us. I'd like to welcome you to this week's Monday Minute Live Chat hosted by the Canadian Leadership Congress. The topic today is "Global Real Estate: Adjusting to the New Normal."" Here to talk about it is Thomas Au, a managing director and investment strategist at Invesco Real Estate. Welcome, Thomas.
Thomas: Hello. Thank you for having me.
Caroline: Needless to say, it's been a tumultuous few years for global real estate. How's 2023 shaping up?
Thomas: Yes, it wasn't a very exciting 2022, obviously. The last year was characterized by very limited transaction volumes as investors and property owners were observing and adjusting to the new environment. Global transaction volumes in the last quarter of 2022, actually, almost half the level recorded in the same quarter of 2021. Volume recorded in Asia Pacific, Europe, and North America have all recorded the most notable decline post‑GFC.
Despite rising interest rates globally, repricing of real estate was only noticeable in some markets or some property sectors thus far. The MSCI Global Quarterly Property Fund Index indicated that capital value of private real estate funds dropped by only 5% in 2022, despite the turmoil that we saw in the listed equities and bond markets.
Now, coming into 2023, it is likely to be a year of change and opportunity. The higher inflation and interest rate environment seem to stay for a while. Also, all key economies have now reopened their borders – key economies in the region (we're slightly later in Asia) opened their borders and triggered the post-COVID rebound.
In some markets where pricing has moved, investors may be more willing and able to acquire properties at discounted prices. In markets where land is still tight, owners have been pretending and extending and probably will have to make a decision either to sell or doing something else. Occupiers will soon make the move as business environments stabilize. This is going to give some more flow, either capital or just activity to be seen.
This environment obviously creates a lot of opportunity from distress, forced sale, bad debt, life structure, prime properties for better price, et cetera. Of course, the conditions and opportunity set could be very different in different markets.
Caroline: Yes, and let's talk about those conditions a little bit. One big condition that's happening globally is rising interest rates. I'd love your views on how real estate has and is weathering that, and what impact we're seeing importantly on pricing and cost.
Thomas: Sure. Rising interest rates will affect costs, obviously, that is the most direct and obvious impact. Rising interest rates will affect the landing costs, borrowing costs for property investments which– for borrowing costs to surge over such a short period of time, it's making underwriting individual investments very difficult.
For example, pre-COVID, we can perhaps buy a prime property, a prime office building in Melbourne, Australia, at 5% cap rate thereabout, and borrow at slightly more than maybe somewhere between 3.5% or 4% borrowing cost all in, whereas now value at around 4% cap rate but the borrowing cost is closer to 6. There is, instead of a positive yield carry, now it is a negative yield, borrowing spread. That means income growth assumptions have to be very strong to be able to make sense in investment.
Now, the general macro environment, however, does not seem to be supportive of that robust rent or demand growth at the moment. Now on pricing, as we have touched on user expanding depending on markets so far by around 50 to 150 basis point or thereabout, highly leveraged properties or non‑performing assets will go under pressure of matching their DSCR or even LGB covenants with rising interest costs plus the value decline.
Caroline: We've heard of other factors impacting real estate as well. Those are some really interesting numbers but are there any major structural shifts other than interest rates that you think have impacted the space?
Thomas: Yes, of course. In fact, many or most of these structural factors were already here and impacting occupier demand for some time even before COVID. For example, one of the most popular topics in our conversations with peers and clients and investors is the future of the office.
Now, over COVID, work from home or remote working has become very popular although there is a little bit of neutralization. Is that trend going to stay and therefore reduce the aggregated demand for offices? Remote working is like a pendulum that swings from strict, no, before COVID, to absolutely, yes, during COVID. Now seems to be a little bit more settled in between the hybrid style.
Now from our perspective, obviously, the best office will continue to survive and do well. After all, there are certain functions that we need offices but for some of the more peripheral assets and wrongly located assets, that might be an issue.
Then there are regional and locational differences. Now, that trend probably is more notable and more prominent in North America than in Asia because Asia, in general, people have a very tight living space. It is just very difficult for people to execute work from home. Yes, that discussion definitely is there. There are also other structural factors like a transition from offline to online shopping. How does that affect the growth of logistic assets or somewhat affecting the traditional retail format? Aging population across all the developed markets, this is going to drive a strong demand for senior housing or health care. Of course, digitalization, again, being propelled by COVID that supports the growth of data centers.
Caroline: I really love those comments around those differences between living spaces in Asia and being more conducive to going to the office, versus North America. Looking at that a little bit more, I'd love to get your perspective on how Asia is performing relative to the rest of the world, which perhaps is maybe lagging a little bit. Are certain segments of the market a bit better positioned than others?
Thomas: Over the years, we have been seeing that the economic growth of the Asia Pacific region has been stronger than overall North America and Europe. This trend is likely to continue in the next immediate and medium terms. It has been less hit by some of the current headwinds at the moment.
Inflation, yes, there is also inflation in Asia Pacific, but the root of the problem is not really here. The central bank has been fairly measured over COVID in terms of printing money. That is not as severe as what we have seen in the US or in the UK.
Some of this, as we talked about remote working, again, less prominent here. More importantly, I think, yes, there are certain global trends that Asia is also following. High interest rates are going to deter investment intention and things like that will happen. Slower economic growth going forward because of the global slowdown, that will happen.
More importantly, Asia Pacific is a large region with economies at very different stages of their cycles under different constraints. There are always different types of opportunities offered at different time. For instance, the two largest economies of the region, Japan and China, were among the last key economies to open borders, and therefore, still are enjoying the post‑COVID rebound. They are also the exception of the global monetary tightening trend. Hence, real estate continues to offer positive yield carry in those two markets.
Now, in contrast, South Korea, Australia, also very important markets for our region. The central banks there since last year and they have been taking up rates the most aggressively. The sharp rising interest rates are creating opportunities for debt or debt‑like investment at the moment. There is certain financial stress going on.
Caroline: With that in mind, do you think asset owners should be rethinking the role of real estate and their portfolios? Should they be viewing liquidity risk in perhaps a different way?
Thomas: Well, I would say that real estate should always have a place in a global multi-asset portfolio. It is definitely a good diversifier given the nature of return. Real estate return comes from both income as well as the capital value appreciation. The nature of leases, like the tenancy, give predictable income and reduce volatility of this total return.
Now, income returns, which averaged around 4.4% over the last 10 years were approximately 60% of total return. We can see this relatively more stable part is accounting for a bigger part of the total return. In fact, performance of global private property funds has been strong. For the 12 months ending December 2022, it outperformed equities, listed real estate, and bonds. Over a 3, 5, 10 years horizon, it outperformed listed real estate and bonds very comfortably and underperformed equities, but that relative softness also came with better stability.
Now, you mentioned liquidity. It could be a concern at a certain time of the cycle if banks are not landing or suddenly close like turning off the tap. It would create a bit of a period of vacuum, especially if an investment is located in the wrong place at the wrong time. When the market is bad, if you hold a secondary quality asset in a secondary location, usually, it will be even harder to get it sold or even get a lease.
From our perspective, we tend to give a sharper focus or very sharp focus on the prime segment in the key gateway cities, especially for our longer‑time horizon investment strategies. These markets usually can trade all the time. It's easier to get in and out, and those markets usually. Even if there is a short period of slowdown, they will come back earlier and stronger.
One more point about this is that there may be a period of time that investors may have to wait for timing to liquidate their assets, but anyhow, in most cases, as long as your properties are in a right location, you still receive rental income that could underpin and help you weather the storm.
Caroline: For sure. A lot of big tectonic shifts are going on, I feel like in the global economy, whether it's what we call reverse globalization or pegging or onshoring. Within that context, when we look at emerging markets real estate, where do you see it evolving given the shift that's happening, particularly the growing division if you're looking specifically at Asia between China and the US, right?
Thomas: Right. That is a good question. In general, the demand for real estate is well supported by some of the structural trends that we mentioned before. The evolution of supply chain to a logistics property, the concentration of population, or urbanization, even in markets like Tokyo.
Japan, we all know that it's a depopulating country, but Tokyo's population continues to increase. The aging population, basically, is a common problem of all the developed markets in the world and that includes China. China is actually the market that ages particularly fast at the moment, but then there is also an exception Australia. That is, I think one of, if not only, the only G20 markets that is seeing population growth, strong growth actually. Digitalization, that all these things are supporting different types of real estate demand.
Other than these factors in a more economic context, China you mentioned, it is huge. It is probably one‑third of the overall Asia Pacific investment stock. It is too big to ignore in a way, and it is also rising quickly in terms of personal wealth and income, that has continued to support certain themes like consumption and basically, investments going forward.
Korea, for example, is actually the second largest semiconductor manufacturer in the world, so semiconductor chips. That is something that is of high demand globally. Japanese corporates, despite all the slow growth numbers that you are seeing for Japan, the Japanese corporates’ profit to sales ratio are at their multi-decade high at the moment. It is the highest level since their bubble burst in the early '90s. Australia, a net exporter of food and energy, again, something that is very valuable at the moment. These are strong foundations for stable and growing economies as well as real estate demand.
Caroline: We've touched a little bit on geopolitics. I don't think we can avoid that when we talk about the Asian region. What are the risks you're seeing right now?
Thomas: As you say, geopolitical is something that, I have to say, the risk is mounting given China, Russia, and the rest of the world. That conflict is likely to go on for some time. Other than that, there are also some more economic factors that I will see being risks on the downside, mainly on say, fundamentals.
Has the interest rates cycle peaked? Are we really getting into a recession? The market seems to be rising, the US is going through a recession at the moment. Is that going to be true and how deep that recession is going to be?
I think, after all, these things are more geopolitical. A war is going to have a big impact. This is something that it is very difficult to assess. There are still a lot of moving factors on that, but a recession is very real. If people are really losing jobs, reducing income or real income, then that definitely is going to affect the overall demand for real estate.
Caroline: When you look at the Asia region, which I think is definitely one of your big specialties, what is the biggest opportunity you see right now?
Thomas: That is a good one because go back to what I said about it being a big region. There are different economies offering different opportunity sets. In markets like Korea and Australia, the funding gap, because of the tightened liquidity, because of the high‑interest rate, is really creating a gap or window of opportunities for private lenders to go into these markets. Very interesting. It is very specially targeted to construction projects, for example. Local banks are the main lenders in our region. We don't really have a big CMBS market, for example. They are really shying away from some of the higher‑risk lending such as a new logistic center development at the skirt of Seoul, for example.
Now, basically, it is very, very hard, if not impossible, to get a loan. How can they complete the project? The construction cost has also increased by that much over the last two years. That really offers an opportunity for investors either to look into a land‑to‑own type of strategy or purely lending or do some preferred equity type of investment.
On the other hand, Japan continues to have that positive yield carry, although the nominal yields are low, but borrowing rates are really [chuckles] low. Probably we can buy a property, a reasonable quality location at around 3.5%, but the borrowing costs are still below 1. The leveraged income could still be very attractive. There are different types of opportunities, I would say. It is more about how you read the market and approach the market.
Caroline: That's great. Well, look, thanks so much, Thomas, for your excellent insights today. Thanks, everyone, for joining us. For more insights and excellent content, follow Canadian Leadership Congress on LinkedIn and sign up for our monthly newsletter by visiting our website, leadershipcongress.ca. Thanks again, Thomas, and thanks again everyone for joining us.
Thomas: Thank you.