World markets started the year in a state of flux, with the economic slowdown in China and emerging markets, commodity prices in freefall, expectations of interest rate rises now nothing more than a memory, and some real tests on the political front.
Trying to decipher all of this to determine prospects for the real estate market is difficult. UK prices have risen through strong capital performance, and some rental growth has seeped
in; trading volumes have reached a high, yet there are fears of a bubble. It is true that the trading volumes in the latter half of 2015 were down on the equivalent period in 2014.
So, is real estate going to be in favour in this changing economic environment? First, the one thing that real estate offers is income, and in a world where it is clear interest rates and inflation are going to remain in non-threatening territory, this is an important and positive factor for asset allocation.
However, what is important to asset allocators is risk-free rates and risk quantification.
Here we have very different metrics. Risk-free rates have been falling and 10-year money in the UK reached a new low of around 1.4% in February.
This has widened the risk premium and explains why the latest Hodes Weill report with Cornell University, which surveys asset allocations among global investors, shows a healthy allocation, averaging almost 10%, to real estate and rising allocations over the past few years.
This trend was repeated in the recent Blackrock survey of its institutional clients, where allocations to equities and fixed income were likely to fall and those to real assets and real estate rise. The issue now is whether allocations have been met by the “denominator effect”, as falls in equity prices have inflated property holdings in percentage terms.
As to where the money is going, it is clear that investors are moving down the risk curve, so allocations are likely to focus on developed economies, which will put pressure on North America and northern Europe.
In London, with 60% of sovereign wealth being oil-related, there may be some changes, but the capital’s safe-haven status is still a key draw. And while we see prices in the UK peaking, the pound has fallen by about 17% against the dollar in the past six months. However, uncertainty around Brexit and the longer-term implications will affect sentiment even if the fundamentals look good.
Fundamentally, this is a time when you have to adjust investment sights. Yield compression due to the impact of quantitative easing is largely over and the economic environment does not point to huge rental growth. This is a time that tests appetite for lower but still very competitive comparable returns. There is going to be an increasing division between shorter-term value investors and longer-term “sovereign wealth” attitudes.
In terms of allocation, I would expect greater diversity. We must not forget the importance of UK funds as direct investors, creators of new vehicles, diversity seekers and joint venture partners to overseas investors.
UK funds will seek value outside London and back growth in key retail markets on the back of improved household income. Alternative sectors will continue to be a focus and, in the main, these will be outside London. The private rented sector might just find a more receptive supply market as SDLT and interest rate relief issues deter the private investment market at a time when housebuilders are in delivery mode.
On the occupational front, we have yet to see the return of a normal cycle with growth moving from higher to lower price centres.
In short, London is fairly fully priced but still the number one city for investors. However, the division will fall between those thinking long-term and those seeking profit now.
It is not the right time to call the market but, when sentiment and fundamentals are apart, for some it is time to take profits.
Andy Martin is senior partner at Strutt & Parker
