International and Emerging Real Estate Semi-Annual Outlook
November 2022*
Real Estate Bracing for Global Slowdown
The real estate sector faces multiple headwinds from rising interest rates to a global slowdown. But tentative signs that the worst of the inflationary period may be behind us and attractive valuations make the case for real estate. Across sectors, favourable structural trends favour industrial and residential.
Real estate widely underperformed other asset classes over the past six months as the lagged impact of monetary tightening filtered through into real activity. Typically, monetary tightening does not bode well for interest rate sensitive sectors like real estate. But real estate’s inherent qualities as an inflation hedge should partially offset this impact, making the asset class attractive in the current environment. However, real estate’s disappointing outturn over the past six months suggests this was not the case. This likely reflects the fact that real rates have risen sharply, resulting in a broad-based de-rating to duration sensitive assets.
Therefore, signs that inflation is moderating, and the pace of rate hikes is slowing in some countries (e.g. the US), bode well for the real estate sector. Indeed, the latest US CPI print revealed that both headline and core inflation dipped below consensus expectations in October. Moreover, the Fed acknowledged at its November meeting the lagged effect of monetary policy while noting that the future path of policy would take into account previous tightening. While it is likely too soon to herald this as a “Fed pivot”, given still-high inflation, it suggests that the Fed is opening the door to a possibly slower pace of tightening. Most major central banks are expected to continue tightening into 2023 before embarking on rate cuts by the end of the year. Downward pressure on bond yields should support real estate valuations.
Meanwhile, real estate debt and liquidity are still ample, albeit the latter has reduced in recent quarters. More importantly, real estate valuations are still attractive, with the spread between trailing dividend yields for real estate and equities (as measured by the MSCI ACWI Index) above its five-year average. As such, we still view real estate favourably as an asset class.
Office: Leasing activity continued to hold up in Q3, with global volumes up 10% yoy. That being said, there are signs of momentum moderating as global net absorption was positive but fell on the year. Rental values, particularly those in Asian Pacific markets, will come under pressure from elevated completions, which are expected to peak next year. The flight to quality will continue to prop up high-quality assets, leading to a bifurcated sector.
Retail: The cost-of-living crisis has weighed on retail sales, which bodes ill for the retail sector. In addition, retailers face an ongoing headwind from e-commerce. In Asia, where countries have moved to an endemic stage of COVID-19, retail rents are still recovering.
Residential: House price growth has eased as monetary tightening bites, while rental growth will moderate on the back of higher living costs. Longer term, the sector faces favourable prospects of undersupply and urbanisation trends in Emerging Markets (EM).
Industrial: Rental growth continues to accelerate as demand outpaces supply. While softer retail demand will drag on e-commerce space needs, demand is still elevated.
Market Strategy
EM real estate (as measured by the FTSE EPRA/NAREIT Emerging Index) underperformed Developed Market (DM) ex-US real estate (as measured by the FTSE EPRA/NAREIT Developed ex-US Index) by 5.7% points over the past six months. While the dividend yield gap between EM and DM ex-US real estate equities has narrowed, this is mainly because of the many Chinese companies that have stopped paying dividends. Similarly, given China’s 34% weighting, the near-40% decline in forward earnings over the past six months can be attributed to the almost 50% fall in China’s forward earnings. As such, we retain our overweight allocation to EM as there are still opportunities within the index. Moreover, there is an upside risk to real estate equities from China adjusting its zero-Covid policy over the coming months.
Among DM, we move the eurozone to underweight, as the weak economic outlook offsets cheap valuations. Elsewhere, we move the UK to neutral, considering sterling weakness and attractive valuations. We keep our underweight allocation in Japan as the boost from the plunging yen is limited, while we stay underweight in Hong Kong due to its exposure to China. We maintain our neutral allocation in Australia and Singapore as valuations do not yet provide an attractive entry point.
Allocation Breakdown
| -2 | -1 | 0 | +1 | +2 | ||
| Eurozone | ↓ | |||||
| Japan | - | |||||
| UK | ↑ | |||||
| Australia | - | |||||
| Hong Kong | - | |||||
| Singapore | - | |||||
| EM | - |
*The publication reflects asset performance up to October 31, 2022, and macro events and data releases up to November 10, 2022, unless indicated otherwise. Data about mobility and footfall are from Google, while data about real estate rents, net absorption and supply are from JLL.
The information contained herein is obtained from sources believed by City of London Investment Management Company Limited to be accurate and reliable. No responsibility can be accepted under any circumstances for errors of fact or omission. Any forward looking statements or forecasts are based on assumptions and actual results may vary from any such statements or forecasts.
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