Commercial Real Estate - Investors drawn to yield

Global capital flows into real estate have rebounded since a low point at the end of 2008. The key driver remains yield. A sustained low interest rate environment means investors are seeking new sources of income. The global correction in real estate prices between 2007 and 2009, combined with generally improving conditions for occupiers as the economic recovery takes hold, means today's yield is rather appealing to investors. The security and sustainable nature of that cash flow is also increasingly recognised: a contractual obligation by tenants to pay their rent which ranks ahead of their obligation to bond and equity holders and premises without which their businesses would likely cease to operate.

Where to invest?

Commercial real estate is now truly a global market. The UK is further into the recovery phase than many other Western markets. Nevertheless, it still looks attractively priced relative to history and other asset classes, with income yields roughly 3% higher than those on UK gilts. Continental European markets are around six months behind the UK, with Paris now behaving much like Central London was in the summer. In fact, London and Paris illustrate a theme across many global office markets; they are in remarkably similar positions to, say, New York, Washington, Sydney, Hong Kong or Stockholm.

With tenant demand now recovering, there are precious few empty good quality buildings to choose from and landlords are gaining more power over rental negotiations. This power is feeding through into strengthening returns for investors and is evident through the rally in office REITs in the last year.

In the less cyclical areas of the market, yields in German and Central European logistics properties can offer as much as 4% above the domestic 10-year government bond. With both markets identified as key growth locations for international retailers demanding high specification warehousing, clearly these markets are increasingly attractive.

The less cyclical and generally higher yielding Canadian real estate market also looks appealing at this stage of the cycle. Coupled with low interest rates and a strong banking system, demand for property is high. Both equity and debt buyers are competing for assets, and in turn pushing up prices. Moving to South America, investors can capture true emerging market returns in Brazil as the supply of institutional quality stock struggles to cope with the strength of domestic and international demand.

Any concerns?

Value matters! Some parts of the Asian real estate market have become overheated, particularly high-end housing in China. Hence, government intervention is specifically targeting speculative investors and developers.

While commercial markets in China are less affected by such activity, a number of tier one cities remain oversupplied. Given the volume of liquidity across Asian markets in the last year, house prices have also got a little out of control in Hong Kong and Singapore, and recent government intervention is aiming to stifle the speed of growth.

And returns?

Forecasts for returns from commercial real estate are based on an important assumption, namely that the UK and other major economies might see weak or even stagnant growth but will not experience a recession lasting, say, three or four quarters. In this context, real estate should continue to provide healthy solid income returns over the next few years with an additional growth in capital values and rents when tenants do begin investing further in business expansion and are faced with a lack of choice. Avoiding the risky hotspots mentioned earlier, investors in global real estate could achieve nominal returns of between 8% and 10% per annum for the next three years.

Anne Breen, Head of Real Estate Research and Strategy,
Standard Life Investments