Given varying dynamics in the three major regions regarding commercial real estate pricing, it is easier to speak at the individual region level.
Pricing for core real estate in the US reflects the effects of Quantitative Easing, which has pushed capital into risk assets. Yields for private equity real estate have fallen to historical lows in an environment of low Treasury bond yields. We monitor the spreads between the yield for commercial real estate and that for several other market indicators. Those spreads are shown below. Current spreads are presented, along with spreads on a long-term basis (past 20 years), where spreads were as of the eve of the Global Financial Crisis, and spreads during the late 1990s period of “irrational exuberance” (to quote Alan Greenspan, then Chair of the US Federal Reserve). In this analysis, commercial real estate looks fairly priced relative to Treasuries, inflation-protected Treasury securities, the highest quality corporate bonds, and public real estate. In addition, the relationship between real estate yields and the cost of long-term real estate debt appears in order. The only place where spreads don’t exceed the long-term average is in non-investment grade bonds, which saw yields spike during Q3, largely driven by higher risk premia for some energy firms.
Our expectation is that there will be upward pressure on Treasury Yields, whether or not the Fed elects to raise short-term rates, if US economic growth accelerates. Recent data suggest it will, led by healthier than expected job growth in October and much faster wage growth than has occurred since the recession ended. Both trends should fuel stronger consumer spending and greater GDP growth.
Cap Rate Spreads 2015 Q31
We are operating on the premise that spreads to Treasuries will narrow first before there is any upward pressure on private real estate yields. The historical relationship between Treasuries and real estate yields shows that they don’t move in lock step. If Treasury yields are rising in response to accelerating economic growth, real estate yields have tended to fall, not rise, as investors are willing to take less in initial yield with the expectation that a property’s income will increase. That was the case in the period from Q2 2005 and Q2 2006, when Treasury yields rose from 4.16% to 5.07%. Over that time, which has parallels to the current period, capitalization rates fell from 6.25% to 5.75%. Inflation was higher then, running at 2.5% to 4.3%, and real estate’s inflation-hedging characteristics were part of its attraction to investors. Though inflation is low today, investors still seek the inflation-hedging characteristics real estate offers on the premise that faster economic growth will, at some point, unlock inflationary forces. This is particularly relevant as the boost of lower gasoline prices fades.
Our near-term view, therefore, is that valuations for core real estate in the US aren’t likely to move down anytime soon, particularly given strong inflows from domestic and foreign capital sources. Foreign investors accounted for their highest share ever of commercial real estate transactions during the first half of 2015 since Real Capital Analytics began tracking crossborder flows in 2001. Chinese investors have been especially active in the US. They acquired $3.7 billion of US real estate in the first half of 2015, up from $1 billion in the same period in 2014. Asian investors have announced plans to expand their global allocations to real estate significantly, per Prequin. GIC, for example, recently increased its target allocation to real estate from 7% to 13%, CIC plans to go from 5% to 13%, NPS from 4% to 10%, while Malaysia’s EPF goes from 2.5% to 6%, and Japan’s GPIF goes from no allocation to real estate to 5%. The US was the top location globally for real estate, according to Real Capital Analytics, in 2013, 2014, and the first half of 2015, as measured by transaction volume. This fits with 2014 survey data from the Association of Foreign Investors in Real Estate, in which the US was described as being “perceived to provide a stable environment in which to invest and is the best market for capital” (as quoted in Pensions & Investments, November 17, 2014).
Transaction volume should hit a post-GFC high in 2015. Investments during the first three quarters of 2015 totaled $375 billion or 87% of 2014’s full year total of $431 billion. Q4 is shaping up to be a big quarter, as is typical of the final quarter of the year, with multiple major asset and portfolio trade announcements. They include Marriott’s planned acquisition of Starwood Hotels for $12.2 billion, Starwood’s intent to acquire a $5.4 billion portfolio from apartment REIT Equity Residential and its acquisition of the $1.9 billion Landmark Apartment Trust, as well as Blackstone’s $5.3 billion purchase of Stuyvesant Town/Peter Cooper Village and its acquisition of Strategic Hotels for just under $4 billion.
Despite real estate’s low yields, domestic institutional investors have been increasing their allocations to real estate. For example, CalPERS has upped its target for real estate from 9% to 10%. The State Board of Administration of Florida took its allocation from 7% to 10% in 2014. At the same time, Illinois Teachers Retirement System increased its real estate target from 11.7% to 14%.
It is important to note that fluctuations are likely within property types. So, while cap rates may be trending down for real estate as a whole, individual property types may display different behavior. Cap rate movements reflect investor demand — we are hearing of upward pressure on hotel cap rates, owing to the expected dampening effect on room rates and occupancy of significant hotel construction. Given that supply and demand are well matched elsewhere, we are not seeing similar trends in other property types. But we are in the late stage of this cycle and construction is picking up across all property types. To date, supply has been in-line with demand. Were that to change, cap rates for individual property types or for markets like Houston seeing a sudden shift in fortunes, could well break from the pack.
In many European markets, the absolute level of core yields is now equal to or below their pre-crisis lows. As in the US, however, benchmark bond yields (both government and corporate) and equity market P/E ratios are such that relative real estate pricing does not look expensive. Indeed, the chart below shows that the spread between property yields and government bonds has approached record wide levels. This provides quite a cushion for rates to rise or property yields to continue to fall.
CRE Yield Spreads by Country, bps
In fact, Europe’s underlying benchmark bond yields are likely to fall further in the face of longer and stronger European Central Bank (ECB) quantitative easing (QE). Having missed consensus expectations, disappointing Q3 2015 Eurozone real GDP growth numbers have probably sealed the case for decisive action by the ECB. Meanwhile, October’s surprisingly strong US job growth report solidifies the likelihood of a monetary policy divergence between the Europe and North America. While, as noted above, we do not see a causal linkage between rising interest rates and cap rate expansion, the prospect of further monetary loosening by the ECB means that Europe will have to wait even longer to test this proposition than the US. (It should be noted that the likely trajectory of monetary policy in the UK is somewhere between that of the eurozone and the US. The UK economy has been doing well of late and its jobs market is tightening, although signals from Bank of England governor Mark Carney suggest that rate rises are not yet on the table.)
Again, even when rates do begin to rise in Europe, we do not see that as necessarily predictive of cap rate expansion. According to an analysis by Real Capital Analytics, the correlation between interest rates and real estate pricing is tenuous at best. Over the long run, there is actually a weak negative correlation between the Bank of England base rate/UK 10-year government bonds and UK property yields. The negative yield gap between UK government bond yields and property yields at the height of the last cycle shows the myriad of other factors at play when it comes to influencing real estate pricing and investment. This is consistent with our findings for the US market.
Speculative real estate supply in Europe remains low compared to historical standards, arguably even lower than in the US. One important exception is Central London offices, where the size of the pipeline is considerable but justified by (at least today’s) reasonable expectations of absorption. As such, we do not expect an overhang of supply to undermine valuations for core European real estate. Rates of growth appear strong enough to support a slow but steady occupier market recovery, but not strong enough to generate enough confidence and risk capital to re-start the spec development machine, or to prompt monetary tightening. That said, it is prudent to watch for potential sources of bond market disruption that could feed through to real estate pricing. In particular, the UK referendum on EU membership, expected in late 2016 or 2017, has the potential to add a premium to UK gilts while also having a negative impact on office demand, especially in the finance-centric City of London.
Excessive risk spreads between the most core/prime assets and all other real estate, an anomaly of real estate pricing in Europe that had persisted for quite some time since the crisis, appear to be on their way to normalizing. Indeed, the market’s definition of core, which had narrowed to include only the most trophy-like, long-let buildings in a small number of globally visible submarkets, is expanding again. Some of the sharpest declines in yields over the past year have been in geographies, property types, or quality segments that had seen the widest risk spreads. The chart below, which shows the prime vs. non-prime spreads in the European logistics market, clearly illustrates this pattern. Across Europe, logistics assets as well as regional office and retail properties have seen sharp yield compression, while core assets in Southern European markets are again trading at yields within striking distance of Northern European core. Only Central Europe is lagging in this respect, owing to its smaller depth of assets and concerns about occupier conditions in its largest market segment, Warsaw office.
Consistent with the US case, investor demand remains very strong. Pan-European investment volumes for the first three quarters of 2015 were €200.7 billion, up 30% compared to the same period the year prior. There are some signs that volumes are slowing when taking a shorter view, however, with pan-European volumes in Q3 up only 6% on a year-over-year basis, driven by a decline of -14% in the UK versus increases in all the key continental markets (+35% in Germany, +46% in France, +19% in Sweden, +100% in the Netherlands). It is our view that the slowdown in UK volumes is reflective of a lack of available product for sale rather than weakness in demand. In part, this is driven by the fact that many value-added investments traded in 2013–2014 and these assets are in the midst of their business plans and are therefore not on the market. On the core side, the growth of long-term sovereign wealth ownership in London may play a part, with assets coming to market less frequently. In any case, there are a number of big assets currently for sale in London, so this trend may reverse in Q4.
As in the US, international institutional and sovereign investment into European assets remains strong. On a year-to-date basis, the volume of North American investment into European real estate was up 46% year-over-year, according to Real Capital Analytics, driven by a perception of relative value versus domestic US markets. Middle Eastern investment into Europe was up 61%, intra-European cross-border investment was up 46%, and investment from Asia was up 9%. Notable recent transactions by international investors include the acquisition of Christ Church Court in the City of London by Hui Wing Mau (China) and the purchase of 39 Victoria Street near London’s Victoria Station by Ho Bee Investment (Singapore). Major retail deals by global investors include the acquisition of a shopping center in Antwerp by the China Investment Corp. and the acquisition of a center in Zaragoza, Spain, by CPP Investment Board (Canada).
That said, isolated examples of Chinese and Middle Eastern buyers pulling out of transactions have recently been a source of market chatter. Do they hint at fallout from pressure on Chinese economics/markets and oil prices (respectively)? In general, a common thread among these stories has been a lack of experience or sophistication on the part of the retreating buyer. For example, a deal to acquire the Broadgate Quarter, a well located but older asset adjacent to Liverpool Street Station in the City of London that is set to lose one of its largest tenants, recently fell through at a late stage. It would have been the first transaction in Europe for a yet-unnamed Chinese group, which had priced it as a core asset despite its challenged rent roll profile. The asset ultimately traded at a 5.0% cap rate, compared to the extremely sharp 4.5% it had been tied up for. The fact that a queue of under-bidders were ready to step up and pay a price in line with expectations going into the transaction suggests that the market remains robust. While the market may have lost a transaction that would have shown a marginal bidder setting a new record low for risk-adjusted yield, we do not see this as indicative of a retreat in pricing.
In summary, the European market core market appears attractively priced as compared to other asset classes. The expectation of further monetary easing should continue to support this relationship, even given the prospect of rising rates elsewhere. Local and global investor interest in Europe is strong, despite a small number of idiosyncratic broken deals. Capital has moved beyond the safe haven markets, allowing the definition of “core” to expand again, although it remains far from its pre-crisis norm.
The economies typically considered as suitable for sourcing core real estate opportunities in Asia-Pacific (Japan, Australia, Hong Kong, Singapore, South Korea, New Zealand, and arguably Tier I cities in China) exhibit meaningful structural differences and clear variation currently exists in their economic and real estate cycles. Nonetheless, in-line with global trends, all have continued to experience substantial investor demand for core real estate. This is due to a combination of factors: maturation and growing transparency in Asia-Pacific’s investment markets; relatively high spreads to risk-free rates, enhanced by regional central bank policy easing; global investors’ reduction in risk appetite and slowing levels of regional economic growth, pushing investors toward income vs. growth strategies. In addition, the prospect of US monetary tightening combined with Asian central bank policy easing has pushed the majority of Asia’s currencies down against the USD, making purchases for USD denominated investors relatively cheaper.
Over the last 18 months, there has been a clear expansion in investor activity in purchasing assets directly or indirectly through core/core plus funds. Sovereign funds and large institutional investors/pension plans such as GIC, Norges Bank, CIC, QIA, NPS, KIC, and BVK have been actively investing or searching for opportunities in this space during 2015. Likewise, the number of commingled funds, particularly open-ended, is growing with major names in private real estate equity actively raising capital and expanding their capabilities in response to investor demand. In addition, corporate investors — particularly Chinese and Japanese — remain active in purchasing high-quality buildings for their own use.
This competition for high-quality assets has fed into pricing. The chart below shows yields across the three main property types through the weighted average of cities in Australia, Japan, Hong Kong, Singapore, and China Tier 1. Over the last 12 months, the only market where yields have softened is Singapore due to macroeconomic slowdown and concerns about the level of new supply.
The major challenge across the region in investing in core is access to stock. Both private individuals and REITs (often themselves majority family held) control significant swathes of the best quality real estate, particularly in retail and office. Hong Kong, Singapore, and central Tokyo are very difficult markets in which to source Class-A product. Where that stock is available, typically in the office market, pricing is extremely competitive. In Hong Kong, China Life recently purchased Wheelock’s Harbour One development in Hung Hom for their own occupation at US$755 million, a price that we estimate equates to a 3% gross yield. Almost simultaneously, Evergrande, the Chinese Developer, bought Mass Mutual Tower for US$1.6 billion, which breaks back to around a 1.4% yield. This transaction has complexity around it so shouldn’t be used to set prime yield benchmarks, but nonetheless illustrates the weight of capital at work in the region. In Singapore, the largest office transaction in 2015 to-date was BlackRock’s sale of AXA tower for US$860 million, which equates to a 4.0% yield. This asset would be considered at the lower quality end of core. BlackRock is also in the process selling their Asia Square development, with a pricing expectation of US$2.5 billion, equating to a yield of around 3.5%.
In Japan, prime office yields are 3.1% as of Q3 according to JLL, down 70 bps since Q3 2013. However, the majority of the non-related entity larger transactions have been at levels beneath this. Examples over the last 12 months include Sekisui’s purchase of Akasaka Garden City for US$373 million at a 2.7% cap, Mitsubishi’s purchase of Shibuya Sakuragaoka Square for US$144 million at a 3.0% cap, LaSalle/CIC’s purchase of Meguro Gajoen for US$1.2 billion at a rumored sub-3% cap, and GIC’s purchase of Pacific Century Plaza for $US1.7 billion at a 2.8% cap rate. Given these pricing metrics, there has been a growth in international investment in Seoul, where prime yields are over 200 bps higher than Tokyo, reflecting historically lower liquidity and transparency.
Australia is the most open and transparent of the region’s real estate markets and whilst there is clearly a deep and well capitalized domestic investor base, stock is more readily transacted in this market. Australia has been a major beneficiary of demand for core real estate over the last 12 months with AUD 11.9 billion of office, AUD 4.9 billion of retail, and AUD 3.9 billion of logistics assets traded in the first three quarters of 2015. We estimate that core investments contributed about half of this total. Pricing records were set in both office and industrial through 2015 as yields fell beneath 2007 levels. In the former, CIC bought the 10 asset Investa office portfolio for $2.5 billion at a blended yield in the low 5’s. This was after a Blackstone/Ivanhoe Cambridege JV established new pricing for a 50% stake in ANZ Tower, a Premium Grade Tower in Sydney, at 5.6% in Q1. Benchmark prime yields in Sydney and Melbourne were 5.5% and 5.75%, respectively, in Q2 2015; these fell to 5.25% in both markets in Q3. Average prime yields have tightened 125 bps in Sydney since the end of 2012. There are two major office buildings — 420 George St in Sydney and Southern Cross Tower in Melbourne — likely to trade before year-end and market expectation is that both prices will represent sub-5% yields. We have also seen in 2015 the largest industrial portfolio ever traded in Australia — GIC/Australand’s 27-asset holding — which was sold to Ascendas for above $1 billion and a cap rate close to 6%. There was also the largest individual transaction of an industrial asset, as Mapletree bought Coles’ Chilled Distribution Centre from Goodman for $253 million at a 5.8% cap-rate. The national weighted prime average yield moved 23 bps in Q3 2015 to fall beneath 7% for the first time this cycle, and Sydney prime logistics yields now sit at 6.25%
One of the major routes in accessing core stock, as demonstrated in some of the transactions outlined above, is to buy from developers, often as pre-commitments. However, developers are showing an increased tendency to retain control of their developments, either in spinning them off into REITs or separate private vehicles with a longer term hold. One of Hong Kong’s well-known private equity real estate managers with a historic focus on development is looking to transfer two recently developed retail assets — one in Hong Kong and one in Shanghai — from its opportunistic fund into a new core fund. If this trend continues, the limited number of core offerings to the market combined with capital appetite should maintain pricing in the near-term, despite transactions looking relatively expensive in a historical context.
As we look forward into 2016, we expect regional monetary policy to remain accommodative as Asian growth slows and central banks seek to boost domestic demand as export activity remains weak. Given recent labor market data, it is less rather than more likely that the Reserve Bank of Australia will cut rates again; however, we expect they will remain on hold through 2016. Given the pricing dynamics outlined in the preceding paragraph, we expect market yield metrics to continue to tighten through at least the first half of the year, though this current yield cycle is likely close to the bottom. In Japan, all recent economic data point to further QE from the BoJ over the next one to two quarters. This would increase the duration of the easing cycle and raise barriers to any major adjustment in debt markets or yields. In China, policy easing will limit the scale of adjustment in pricing, though international investors may be cautious of further RMB depreciation. In contrast with 2007, transactions are made in an environment where yields are at a positive spread to debt and purchasers are funding with high levels of equity. Development, in the main, remains contained in the region and it is more likely that any regional pricing adjustment will be delivered by either a major pickup in development or a major convulsion in the debt markets.
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