Real Estate for a changing world
THE CASE FOR UK PROPERTY
RESE ARCH
FEBRUARY 2016
•• INTRODUCTION
UK real estate offers a wide range of investment opportunities
across all strategies, and is capable of being accessed directly
or indirectly, through debt or equity. Whilst this paper will
focus on the attributes of direct property investment as an
asset class, ultimate investor returns will also be driven by
market uncertainty, funding costs, investor sentiment and
exchange rate fluctuations.
Furthermore, stock market performance has a very low correlation
with underlying GDP growth and as such is often a poor predictor
of the next major shock, however, short term market movements
can change perceptions of risk and attitudes towards investment
strategies.
15
16*
17*
18*
19*
20*
Real estate investment strategies, or styles, can be categorised
by their position on the risk/return spectrum, and these range
from core income producing real estate, perceived to be relatively
low risk, to opportunistic and development where risk is elevated
in return for greater potential rewards. At an overall fund level,
INREV provide a useful categorisation of real estate strategies
according to their target returns, income component, exposure
to development and levels of gearing that maintains relevance
across cycles.
UK – GDP growth
2.3
1.7
2.1
2.2
2.2
2.3
UK – Employment
growth
INREV STYLE CLASSIFICATION
1.4
0.9
1
0.1
0.2
0.4
London – GDP growth
3.5
2.7
2.9
2.7
2.9
3
London – Employment
growth
2.9
2.1
1.9
0.9
0.9
1.1
The latest economic forecasts from BNP Paribas show that
whilst 2016 is expected to see a slowdown in GDP growth,
the coming 5 years are forecast to deliver robust growth, with
London continuing to be a key driver.
KEY ECONOMIC VARIABLES
Whilst we are currently experiencing enhanced market
uncertainty, it is important we remain balanced in our views
on real estate and attempt to look beyond short term volatility
to long term performance generated by the asset class. As
such, the core investment credentials of real estate become
particularly relevant when discussing relative safe havens
and a future return of capital during times of heightened risk.
Many commentators have focussed on stock market volatility
as an indication of forthcoming events, however, stock markets
are naturally characterised by high volatility and swings are
common over cycles and this does not necessarily imply a
forthcoming recession.
Target of non-income
producing investments as a
percentage of fund GAV
Target return derived from
income
Target of redevelopment
exposure as a percentage of
fund GAV
Maximum loan-to-value
Value
added
Opportunistic
<15%
15%-40%
>40%
>60%
N/A
N/A
<5%
5%-25%
>25%
<60%
40%-60%
>60%
This paper will now explore the strategic investment case for real
estate in more detail by examining the major drivers of returns
from the asset class and answer the question, why UK real estate?
FTSE 100 INDEX
8000
UK Recession
UK Recession
7000
6000
5000
4000
3000
2000
1000
0
United Kingdom FTSE, 100, Index
Source: Macrobond
Core
•• THE CASE FOR UK PROPERTY
1. STABLE INCOME RETURNS
2. REAL ESTATE LIQUIDITY
UK property has delivered a consistent and stable income return
over time as shown by the chart below. Over the 15 years to
end 2015 UK property delivered an annualised 7.9% per annum
of which 6.1% was delivered by income and 1.7% delivered by
capital growth. Income from property can be seen to be consistent
over cycles even during times of extreme economic distress as
experienced in 2008. Capital growth introduces volatility into
returns, highlighting the importance of timing when relying on
capital growth to enhance returns.
Liquidity in real estate markets can be defined in numerous ways
and will vary across investors depending on their investment
thesis and time horizon. Market liquidity can be defined in terms of
overall investment volumes (cash or floorspace transacted), time
and cost to transact, diversity of players in a market or turnover
(activity as a % of market stock). A recent research study by the
IPF confirmed that there was a statistically strong relationship
between market liquidity (as defined by volumes) and pricing.
UK REAL ESTATE – COMPONENTS OF TOTAL RETURN
25.0
20.0
15.0
However, the list of the most liquid markets globally do differ
between those which exhibit the largest cash amounts transacted
and those which have experienced the largest amount of turnover
as a % of stock, as seen below.
Having said that, liquidity will always be perceived to be highest
in the large global cites such as London, NYC, Tokyo and Paris
which by definition will drive further activity attracting yet greater
quantities of capital from investors seeking global diversification.
These cities are also seen as long term investment destinations as
less stock is traded as a percentage of the total market size, hence
providing a safe haven for capital.
10.0
5.0
0.0
-5.0
-10.0
-15.0
-20.0
-25.0
-30.0
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
15yrs
AVERAGE VOLUME ($BN)
AVERAGE TURNOVER RATE (%)
London
23,928
Seoul
21.0
New York
17,425
San Francisco
19.2
Tokyo
15,692
Chicago
18.3
17.0
Paris
13,819
Beijing
15.2
15.0
Los Angeles
5,197
Sydney
14.5
13.0
Seoul
5,169
Melbourne
13.4
San Francisco
5,017
Boston
10.6
Sydney
4,380
London
9.5
Boston
4,369
Manchester
8.9
Chicago
4,284
Los Angeles
8.4
Singapore
3,978
Washington DC
7.4
Shanghai
3,887
Shanghai
7.3
Income Return
Capital Growth
Total Return
Source: MSCI
STANDARD DEVIATION OF OFFICE MARKET CAPITAL GROWTH
2001–2015
11.0
9.0
7.0
5.0
Source: IPF
Source: MSCI
Total returns from real estate are the combination of a stable
income return, plus capital growth and markets across the UK
exhibit different levels of capital growth volatility.
Central London office markets often exhibit more volatility in
capital growth than regional UK markets, and as such total returns
are generally more stable in regional markets than in Central
London, however, they are less likely to produce the level of
returns achievable in Central London. Therefore, given long term
performance from real estate is largely dependent on the income
return, particular attention should be given to lease duration and
covenant strength during the underwriting process.
Real estate is considered an illiquid asset class, particularly when
compared with equities and bonds. However, liquidity varies
according to lot size, sector and location, with locations such as
the City and West End of London attracting a wide range of capital
both domestically and globally.
During the market downturn of 2008, the UK, and specifically
Central London, were seen by many global investors as a safe haven
offering capital preservation. As such, the UK maintained a level
of liquidity during a time when many other markets, particularly
in the Eurozone, experienced a drying up of investment activity.
THE CASE FOR UK PROPERTY
This is clear from the chart below, during Q1 and Q2 2009
investment activity was very low in most major European markets
except London which continued to attract demand for real estate
even in the face of extreme economic distress.
EUROPEAN MARKETS: LIQUIDITY €M
12,000.00
10,000.00
8,000.00
4. DIVERSIFICATION
As shown by the table below, when included in a multi-asset
portfolio, UK property provides additional diversification benefits
when combined with UK equities and bonds. This relationship
holds true on both a national and global level and is driven by
market liquidity and asset pricing. Real estate values are not
as impacted by short term market volatility that is reflected
immediately in the pricing of both equities and bonds.
Portfolio construction can further exploit the diversification
benefits as sectors and locations exhibit different levels of
correlation with each other, and within real estate; the more
assets added to a portfolio, the more specific risk is diversified.
6,000.00
4,000.00
2,000.00
TOTAL RETURN CORRELATIONS 1981–2014
-
UK Equities
Source: RCA
Berlin
Frankfurt
London
Milan
Munich
Paris
UK EQUITIES
UK BONDS
UK PROPERTY
1.0
0.2
0.4
1.0
0.0
UK Bonds
UK Property
The UK market continues to attract an increasing amount of
capital from a wide range of investors, both domestic and cross
border. The proportion of cross-border investors in the UK office
market grew significantly from 2001 to 2007, and now represents
in excess of 50% of all buyer activity in 2015. UK institutions were
the dominant investor type in 2001 and have maintained a strong
position in the UK market across the cycle.
COMPOSITION OF INVESTORS IN UK OFFICES
100%
1.0
Source: MSCI, Macrobond
5. INFLATION HEDGING
Real estate is often described as providing a hedge for inflation
but the relationship between property values and rents, and
the underlying rate of inflation is variable. Generally, given that
long term real estate returns are driven by a strong income
component, the degree to which property can be considered a
hedge for inflation is dependent on the asset level specifics of
lease structures and income duration.
Some leases may be directly linked to changes in RPI (often
with a cap and collar) and others may be reviewed to an open
market valuation. The former cashflow clearly provides a direct
correlation with UK inflation. This type of structure is often more
prevalent in France and Germany where rental payments are
commonly linked to a national price index.
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
'01
'02
'03
'04
User/other
'05
Private
'06
'07
Listed/REITs
'08
'09
Inst'l/Eq Fund
'10
'11
'12
'13
'14
Cross-Border
Source: RCA
3. RISK AND RETURN
Direct investment in UK real estate is typically characterised as
exhibiting less volatility (and risk) than UK equities, and within the
asset class offers a wide range of risk/return opportunities, in part
due to the high income component of total return which typically
reduces volatility in markets where long term performance is
more driven by income than capital appreciation.
3
www.realestate.bnpparibas.com
Whilst the correlation between values and inflation is variable,
it is clear for the chart below that property delivers strong long
term real returns.
ALL PROPERTY TOTAL RETURNS V INFLATION (RPI)
Total Return
RPI
2500
2000
•• CONCLUSION
During a time of considerable market dislocation and falling
commodity prices, the case for real asset exposure becomes more
compelling. As equity markets continue to fall, the characteristics
of real estate outlined in this paper further highlight the benefits
of investing in a real asset such as property, offering both bondlike and equity returns and delivering strong long term risk
adjusted performance.
As we have seen, UK real estate offers a wide range of opportunities
across sectors, regions and strategies, however, in addition to the
factors that determine where an asset might reside on the risk/
return spectrum, there are additional exogenous risks that should
be factored into the underwriting of pricing and future real estate
performance.
1500
1000
500
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
0
Source: Oxford Economics/MSCI
BNP Paribas Real Estate constantly monitors these risks and
factors the potential impact of market ‘pollutants’ into its views of
future market performance.
CONTACTS
6. A REAL ASSET
As a real asset, returns from direct real estate will be somewhat
protected on the downside as there is always likely to be a residual
value to the real estate, even in the event of a tenant failure and
cessation of income. This is unlike holding an equity investment
whereby all future returns will cease in the event of company
failure, or on expiry of a bond.
7. ACTIVE MANAGEMENT
Given the tangible nature of real estate, it lends itself to active
management which can further enhance rental and capital value
for the investor.
Furthermore, there are a wide range of activities that be carried
out to a real estate asset, positioning it in a different place on
the risk/return spectrum. Whilst the specific location of an asset
cannot be changed, the locale can change over time (as seen
with emerging submarkets) and additional risks can be taken on
board that move the opportunity up the risk/return spectrum. The
objective of moving up the risk curve is to accept a level of risk in
the knowledge that management can resolve issues with either
the asset or the financial structure, and after doing so can exit at
core pricing, hence creating value. This can be achieved by a range
of activities including letting vacant space (existing or developed)
or through capital expenditure and refurbishment which can be
accretive to future performance and value creation.
RISK/RETURN SPECTRUM
Return
Core
Plus
Core
Risks
- Location
- Sector
- Vacancy
- Development
- Gearing
- Leasing
Risk
Source: BNP Paribas Real Estate
Simon Durkin
Head of Research
[email protected]
020 7338 4020
Alistair Kemp
Director
[email protected]
020 7338 4348
Kuldeep Gadhary
Associate Director
[email protected]
020 7338 4844
Taffy Harries
Data Analyst
[email protected]
020 7338 4120
Robert Taylor
Associate Director
[email protected]
020 7338 4257
Andrea Ferranti
Data Analyst
[email protected]
020 7338 4155
Nick Robinson
Senior Research Analyst
[email protected]
020 7338 1016
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BNP Paribas Real Estate
5 Aldermanbury Square
London EC2V 7BP
Tel.: 020 7338 4000