Should we still expect a decrease in real estate yields?

“Every core investment opportunity today gets at least 10 bids, more than half of that is coming from international capital and of that half, non-traditional real estate investors.

As long as the bond markets and interest rates remain at their historically low levels whilst core deals become harder to find, we will see a push into real estate from all sorts of investors with different investment profiles continuing. Today, global investors who are getting almost zero returns on treasuries have piled into real estate to offset these negative returns. Even if one could manage a 4-5% or even below 4% cash on cash return, this intense weight of capital which we see today in all major markets will push yields down even further. Take for example investors from South Korea who invested almost EUR13bn last year in Europe alone, showing that real estate is hot right now and this shows no signs of abating.

It’s almost impossible to say where the breaking point in yields will go but what most investors are doing is seeking alternative investments. Offices, which traditionally offered a nice return of around 5% two to three years ago, have now dropped to almost 3-4% and there are few signs of cooling down. Subsequently, all investors are looking at every risk curve and asset class – investments into the logistics sector, for example, are booming and as hot as ever, given the rising demand of e-commerce.

How can we assess the “true value” of real estate today?

“During the start of the global financial crisis in 2008, this question was rather fundamental when a dearth of activity took place for well over three years; true value assessment became a prominent question for most investors, unhelpfully disappointing the will of any seller.

One may question how far into a bubble we really are. For us at Patrizia, we look at real estate from a long-term hold horizon and any value today will certainly not be the value of tomorrow. Real estate is supposed to fundamentally rise in price over the long-term but short term cycles up and down are not the qualifiers for investors who have long-term holds. Losses and gains are calculated generally over a 10-year hold and on an average fund level; losses are mitigated by gains elsewhere and vice versa, throughout a pan-European portfolio where upturns and downturns differ from asset classes, sectors and markets. In the very long term, certainly in core locations, the fundamentals are clear that rising land prices due to higher demand will continue, certainly in big cities where population growth is a major driver. With that in mind, we recently launched our first truly pan-European open-ended residential fund for a European client base which targets vibrant cities and includes assets in the so-called ‘living’ segment.

There is no doubt that the market will eventually slow down; a repeat of the credit crunch would be disastrous for the economy which in turn means real estate. Cashflow – our main driver in real estate – requires demand and supply balances and right now, certainly we see in Luxembourg the supply remains low and demand high for residential and offices (the main asset classes we focus on in Luxembourg).

Therefore, when we buy, we stick to core locations where we know that even during a market dip, the eventual outcome at exit in the long term will still be strongly supported by rising rents, increasing land values and strong inflation hedge (even if inflation is relatively low right now). In general, we are still able to give our investors an attractive cash on cash return on a case-by-case basis where yield is not the only factor which can be qualified. Capital values are of immense importance notwithstanding our tax structuring, so we assess an all-in long-term value not just based on today’s valuation.

Of course, some asset sectors are becoming increasingly narrow in terms of returns since the competition is very fierce, namely prime offices as well as residential. Logistics in some locations still have room to grow and specific funds geared towards value-add/seeking angles can still provide interesting returns so long as you have market experts on the ground analysing all these micro and macro fundamentals. Real estate is still a local business; global investors who come to our company to benefit from local expertise on the ground provided by the 19 offices across Europe.

The market needs to adapt; we aren’t looking at real estate the same way we did in 2008 – today disruptive factors have kicked in; look at coworking. Utilising defunct or alternative usage of floors has given rise to a whole new dynamic. Investors are thinking about communities and ecosystems – how best to maximise their bricks. Look at environmental factors and energy conscious, smart technologies. These are all huge but important investments which are catering to long-term value which we didn’t think about 10 years ago. We recently saw the rise of the millennials, which influences how people work – flexibility, mobility, technology – and puts emphasis on maximising efficiency, re-use of parking spaces, wellness and productivity whilst affording employees a harmonious place to work.    

Since Luxembourg economic and financial health is closely linked to European and global events, is the “black swan” theory plausible?

“There are many obvious events today which seem highly plausible black swan events; the list almost doesn’t stop. Could we have predicted the return of protectionism let alone Brexit? Or climate change and a ravaged ecosystem otherwise known as a ‘green swan’? (Over)dependency on China, disease, the Middle East crisis (oil!), cyber warfare, civil unrest (look at France), stock market overvaluations and failed IPOs of well-known and high-profile companies? There are so many black, green and orange swans out there now that you only need to bet on two.

However, for all the hysteria coupled with hard facts, we need to put the gloom aside but 2020 will be a year to watch. The stock market rallies are key to business confidence which in turn impacts construction and company growth. The coronavirus outbreak could be a major swan to keep an eye on, directly impacting equity investors notwithstanding a priority focus in China on its domestic health issues which effectively halted the Chinese New Year and impacted Chinese exports. Brexit is now a reality, although 2020 will be more a transition year rather, so how the United Kingdom will negotiate its trade deals still remains to be seen beyond 2021, meaning until then investors will not have the full picture.

Last but not least, the American presidential elections later this year will be a major determinant on future global trade after a fairly strong run in the last years. In Europe, civil unrest and the rise of populism remain key factors in the growth of Europe so the markets will continue to watch and anticipate how to manage them. This underscores the notion that nothing is any longer unexpected and quick reactionary policies from governments will remain in place so not to derail growth.”

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