Historically, Australian, European and US institutional investors have exhibited a strong home bias in their real estate investments. Concerns about transparency, lack of local knowledge, and currency and hedging risk, made the potential returns from offshore markets appear unjustified by the additional risk. Particularly when compared with a compelling return outlook at home.
In recent years, however, views have started to change. There is growing understanding that diversification away from Australia’s small local market is inherently beneficial to the overall risk/return profile of a real-estate portfolio. At the same time, mandatory contributions to superannuation have resulted in more capital competing for the same assets, putting downward pressure on returns. Many of the larger super funds now accept that offshore exposure is essential to offset a crowded, small and competitive local market.
In addition, institutions are increasingly taking a strategic, long-term view of real estate. Investors are increasingly viewing an allocation to offshore real estate markets from a long-term, strategic asset allocation standpoint.
For those Australian investors seeking real-estate opportunities offshore, what lessons can we learn from 2017 and what are the themes likely to influence returns in 2018?
2017: The triumph of economics over politics
History shows that economics is rarely disconnected from politics for long. On this basis, the political and policy turbulence of the last 12 months should have been challenging for world economies. Globally, the rise of nativism and protectionism in the UK, Austria, France and Germany has contributed to deep political and social angst. Despite this, the world economy entered a period of synchronised growth, revealing an unexpected but welcome disconnect between politics and economics wherein economics seems to have got the upper hand, at least for the moment.
Given the positive correlation between economic growth and real-estate returns, the big question for investors now is whether global economic growth and the disconnect from politics will continue, and what this means for real estate strategy.
In our view, there are a number of key themes likely to influence global real estate returns in 2018.
Economics will continue to top politics, for now
Political stress and uncertainty will probably remain top of mind this year, yet we expect synchronised global growth to continue, given the positive catalysts in place. This is good news for commercial real estate generally, although investors should take care to remain conservative in their return expectations. Stronger economic growth will not necessarily translate into higher investment returns. Double-digit returns from core real estate are largely behind us, but cash flow will remain attractive, as investors will probably focus on net operating income, as opposed to capital appreciation, in the short term. Going forward, the ability to push rents will increasingly be the key to adding value.
Synchronicity in global growth will continue
For the first time since 2010, the global economy is accelerating in unison, and indications are that above-average growth will continue into 2018. The US economy is continuing to expand and the outlook for the eurozone is favourable.
Short-term interest rates on rise
Rates will go up, but in a tempered, rather than abrupt, increase. Monetary policy is becoming less accommodative, and for real-estate investors this will translate into a higher cost of capital. While the long end of the US yield curve has moved sharply recently, further increases will probably take more into account long-term inflation and growth expectations.
Secular trends to influence sector returns
There are several secular trends with global consequences for real estate. In office space, for example, the trend towards denser use of space, alternative work practices and smaller, shared work spaces is affecting demand in some markets.
In the retail sector, the rise of e-commerce has intensified an already competitive landscape. The UK and the US have been at the forefront of the e-commerce revolution, but the entrance of Amazon into the Australian market will probably produce serious disruption over the next three to four years.
In spite of elevated global uncertainty on a number of fronts, the world economy has entered a welcome period of synchronised growth, resulting in a generally constructive outlook for real estate in 2018. At the same time, risk management will be key, as several uncertainties lie ahead for investors. The challenge is to pinpoint when any of these will bubbling over. Perhaps the best advice we can give real-estate investors is to expect the best, but be prepared for uncertainty.
Indraneel Karlekar is senior managing director and global head of research and strategy at Principal Real Estate. He spoke at the Investment Magazine Real Estate and Private Markets Conference on February 27-28.