Is Global Real Estate Entering A Positive Cycle?

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 – Now a cyclically favourable time for global real estate
 – Standard Life expects allocations to the asset class will increase
 – JP Morgan expects further cap rate compression in Australia
 – Quality portfolios best placed to benefit 

By Chris Shaw

Global investment manager Standard Life Investments have examined likely future drivers and prospects for the global real estate sector. The group's conclusion is now is a cyclically favourable time to increase allocations to the asset class, as expectations are for high single digit nominal global returns for the next three to five years.

In the view of Standard Life's head of real estate research and strategy, Anne Breen, the real estate pricing environment has changed and this provides greater clarity on the outlook for many markets. Pricing relative to government and corporate bonds is attractive relative to historical levels, while the outlook for economic expansion and tenant activity is also improving in Breen's view.

As Standard Life's analysis shows, real estate is typically a function of the economy, in that rents and rent inflation are driven by the balance of tenants looking to lease space. As the last cycle did not include a construction boom for commercial real estate there is now less spare capacity, meaning any uptick in economic activity could flow through to rent increases.

Even allowing for subdued demand from tenants over the next two to three years, the fact supply and demand is balanced, so Standard Life expects the yield from real estate assets will be sustainable in the years ahead.

On Standard Life's numbers, relative yield suggest markets are pricing real estate income as significantly higher risk than corporate bonds, as the current spread suggests income from real estate portfolios could fall by as much as 30% in coming years.

Such a fall is unlikely in Standard Life's view, with a slow and protracted recovery the more likely outcome in the group's view. A return to more sustainable economic growth offers upside risk to real estimate pricing.

Key lead indicators such as pricing relative to government and corporate bonds, the outlook for economic expansion and tenant activity suggest to Standard Life a turning point in the market is imminent and nominal returns from the real estate sector should be at high single-digit levels over the next three to five years.

Looking more specifically at Australian real estate investment trusts (REITs), JP Morgan suggest the recent rally in the sector has delivered a material improvement in the cost of capital. This trend is expected to see A-REITs move from being net sellers of assets as has been the case over the past two years to net buyers in 2013.

This offers scope for some compression in cap rates, which could deliver some improvement in asset pricing and property returns in the expected absence of any positive surprises in terms of rent growth. 

In terms of how best to play an environment of cap rate compression, JP Morgan's preference is for quality assets given lower cash flow risk, higher institutional demand and the fact there continues to be some modest cap rate expansion in secondary assets.

Analysis by JP Morgan suggests cap rates are too high relative to the real long bond rate at present, as spreads across most commercial property sectors in Australia are well up on long-term averages at present. 

Assuming cap rates do compress further, JP Morgan suggests the most upside in the sector is in Carindale Property ((CDP)), Westfield Retail ((WRT)), Commonwealth Property Office ((CPA)), Challenger Diversified Property ((CDI)), CFS Retail ((CFX)), Investa Office ((IOF)) and GPT ((GPT)).

Assuming a 25-basis point compression in cap rates, all of these stocks would have net tangible assets more than 10% above their current share prices on JP Morgan's numbers. The broker retains Overweight ratings on GPT, Westfield Retail and Dexus ((DXS)), this given the view these companies have the best portfolios in the sector.

JP Morgan's other Overweight rating is for Stockland ((SGP)), this given the best capacity to grow retail rents thanks to attractive relative occupancy costs and a reasonable sales growth outlook. 
 

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