Just another cycle – or a whole new ball game?May 2016
Real estate conundrums
conundrum/ke’nundrem/
nouna confusing and difficult problem or question. “one of the most difficult conundrums for the experts” synonyms: problem, difficult question, vexed question, difficulty, quandary, dilemma
Introduction: Shifting benchmarksReal estate markets are cyclical. But behind the scenes, long-term structural changes are always at work. Structural changes are often harder to identify; but over time they can have a profound impact on real estate investment performance. This is because, more than other asset classes, real estate is a long duration commitment. Development plans can take years to mature; decisions are costly to reverse; building life cycles are measured in decades, and the preferred valuation metrics – yields and capitalisation rates – implicitly assume any investment is a perpetuity.
A response to the challenge of navigating real estate markets is to identify long-term valuation and performance benchmarks – yields, IRR’s, workspace ratios, rates of household formation, retail turnover per square meter, for example. But right now many of these benchmarks are up for review. It is not simply that benchmarks have changed. Some metrics, such as workspace ratios and retail turnover ratios, may no longer even be relevant in the shifting world of workplace mobility and IT connectivity.
The Global Financial Crisis is a convenient scapegoat for the breakdown in previously trusted rules of thumb. And for some benchmarks the years 2007/8 do seem to mark a clear break with the patterns of the past – rent-free incentives in office markets are an example. But many trends have been evident for far longer than that. Interest rates are close to all-time lows, but they have been declining for thirty years - this is not a GFC-driven event. Technology and urbanisation have been gathering pace for decades; the contraction of working age cohorts and the ageing of populations are no surprise.
A challenge for investors right now is that numerous structural and cyclical shifts are emerging, converging and interacting with each other. Perhaps it is only a coincidence that the first cohort of baby-boomers turned 60 in 2007, the peak of the global real estate cycle and the same year as the launch of the first generation iPhone.
Here are a few of the conundrums faced by every decision maker in real estate – investors, tenants, financiers, developers and analysts.
2 JLL
* IRR derived from market yields and future inflation implied by nominal vs. real bond rates.
Source: RBA, JLL Research
Source: JLL Research
Figure 1: Prime Australian CBD office yields and long term bond rates Figure 2: CBD office prime grade investment returns: IRR implied in current market pricing*
• “Yield compression” is often equated with “rising values”, but this is only correct if rental growth remains stable. This is unlikely to be the case in the new low/low/low economy. Future investment returns are likely to be lower in nominal terms. Lower returns are implied in current market pricing (Figure 2).
• The long-term implied IRR for Australian prime CBD office assets is 7.9%, the lowest for at least thirty years. Globally, survey evidence suggests that major institutions are targeting returns of 8.2% p.a. for real estate portfolios compared with an historic three-year average of 10.9%; the Asia-Pacific target is 7.7% vs. a three year historical average of 9.6%2.
• Implicit in JLL Research forecasts is a downward structural shift in interest rates and real estate yields – in other words, the “lower for longer” theory is correct.
• This does not mean that cycles have been abolished. But average yields are likely to be lower than in the past.
Have real estate yields shifted to a permanently lower level or will they bounce back?• Globally, and domestically, the low growth/low inflation/low interest
rate economy seems to be here to stay. But this is not a post-GFC event. The decline in global and Australian interest rates is a thirty-year trend and the impact of the GFC does not figure prominently in the long-run trend (Figure 1). Real returns on equities also show a long-term decline.
• Therefore, delaying decisions pending a future return to “normal” conditions is a risky strategy.
• While bond yields and short-term interest rates have been falling, prime CBD office yields in Australia have remained relatively stable, as Figure 1 shows. The gap between real interest rates and yields in office, retail and industrial markets is high by historical benchmarks in Australia and globally – so the “global hunt for yield” will continue to attract capital to real estate1.
Yields – lower for longer?1
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Real estate conundrums: Just another cycle – or a whole new ball game? 3
1 The spread remains relatively wide even after adjustment is made for exceptional features of the Australian office market, such as rent-free incentives. 2 2015 Institutional Real Estate Allocations Monitor, Cornell University, Hodes Weill & Assoc. p 13.
* Transactions > AUD 5 million, office, industrial and retail.Source: JLL Research
Cross border investment – spike or plateau?
Figure 3 Offshore buyers and sellers in Australia*
Source: 2015 Institutional Real Estate Allocations Monitor, Cornell, Hodes Weill & Assoc., JLL Research
Figure 4 Global Institutions: Actual vs target real estate allocations
Will the current inflow of offshore investment reverse, or are foreign investors here to stay?• In Australia cross border investors accounted for 42% or all
commercial property transactions in 2015 (54% in the office market, 26% in the retail sector and 31% in the industrial sector).
• Historically, cross border investment flows into Australia’s real estate markets have been cyclical – but this time may be different. Tenants and investment institutions are globalising. So too are regulators of banking and financial institutions, driving a global investment in improving the quality and availability of real estate data3.
• The three key drivers of cross-border real estate investment flows are (i) risk reduction through portfolio diversification, (ii) a mismatch between domestic pools of capital and the availability of investment grade assets, and (iii) the search for liquidity and market transparency.
• All three motives are particularly evident in the Asia-Pacific region where savings rates are high, availability of investment grade assets in many markets is low and many real estate markets are relatively opaque. The JLL Transparency Index (2014) ranks Australia (3) and New Zealand (4) as the only Asia-Pacific markets in the Top 10 globally. Other major Asia-Pacific markets are Singapore (13), Hong Kong (14), Japan (26) and Malaysia (27). China (Tier-1 cities) ranks 35.
• Globally, survey evidence shows that 59% of institutional investors are below target allocation, and the gap is particularly wide in the Asia-Pacific region where exposure will need to rise by 13% if the target allocation is to be achieved (Figure 4).
• Sovereign wealth funds tend to be long-term investors. They typically have a preference for cross border portfolio investment as a means of limiting asset–specific and sovereign risk. The
Australian Future Fund, for example, reported a 69% exposure to offshore markets in its property portfolio (June 2015).
• Supported by growth in global pools of capital and a search for yield, JLL calculates that global cross border investment will continue to grow over the medium term:
• Real estate investment will increasingly be driven by cross border activity which is set to surpass 50% of transactional activity at over US$500 billion annually4.
• The impact of this global portfolio switch is emphasized by considering the relative size of the global equity, bond and “alternatives” (including real estate) markets – a 1% reduction in global bond and equity market exposures in favour of real estate equates broadly to an increase of around 16% in real estate portfolio exposure. If this capital were allocated to global real estate market pro-rata to the existing institutional real estate portfolio this would equate to an additional USD 29 billion to the domestic commercial real estate market.
• In the short term the supply of real estate assets is inelastic, therefore rapid portfolio shifts in favour of real estate carry a risk of a temporary price spike followed by a strong construction cycle. The evidence of this in Australia limited, currently. Construction pipelines are disciplined, levels of pre-commitments are high (around 70% preleased in CBD office markets) and withdrawals are high, supported by rising obsolescence and conversion.
• In a market where investors as well as tenants are globalising we would expect to see a convergence between markets across a range of metrics - effective yields, but also lease terms and conditions and requirements for property management metrics and reporting tools. This implies increased investment in IT and administration processes.
2
-6.01991
Offshore Buyers Offshore Sellers1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015
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Percent Invested Target
EMEA APAC
4 JLL
3 For example, the G20 “Data Gaps Initiative” http://www.imf.org/external/np/g20/pdf/2015/6thprogressrep.pdf 4 US$ 1 trillion to be pumped into global real estate as investment landscape changes, JLL Global Capital Markets Report, March 2016.
Cross border investment – spike or plateau?
Box A
Technology – finally making a difference?
• A major shift is underway in the preferred office layout.• The preference is for open plan accommodation, often with
offices and meeting rooms in the core.• Change is often instigated by the expiry of a lease, or
outgrowing existing accommodation• Increasingly a desire to achieve cultural change is the driver…Tenant Demand, BOMA Leading Edge Report, September 1995
Will technology finally have an impact of real estate values and locations?• Potentially, technology has a big impact across all real estate
sectors affecting choice of location, how space is used and ultimately asset values, development activity and investment returns. But the direction and speed of impact of technology are notoriously hard to predict.
• The advent of the Internet in the early 1990s and the World Wide Web (launched in August 1991) were predicted to stimulate a wave of decentralisation, increased mobility, telecommuting and a revolution in workplace practices. The popular catch phrases in the early 1990s were: “Work is an activity, not a place” and “If you’re not on line you’ll be on the bread line”.
3• Box A, from a Property Council of Australia (BOMA) 1995 survey,
conveys the flavour of expectations about technology at that time. It sounds remarkably up-to-date…not much has changed. Indeed, technology-induced change over the past twenty years has been much slower than anticipated; CBD’s remain magnets for office and retail tenants, despite rising travel and congestion costs, and inner-city residential demand (which was not foreseen) has increased substantially.
• The increase in CBD and near-CBD resident populations increases the incentive for companies to remain in CBD locations even if rents are higher.
• Technology however does not follow a smooth linear trend. Perhaps the falling cost of technology, the advent of wireless capabilities, combined with the rising cost and scarcity of skilled labour and rising wages (that puts a premium on commuting travel times) will lead to a measurable change in real estate investment returns and a re-ranking of market values in CBD and non-CBD locations? If location premiums erode, non-CBD and suburban office locations will be rewarding to investors. On-line shopping has already had a discernable impact on tenancy mix and stock management in the retail sector. And investment in transport and communications infrastructure will likely lead to a re-ranking of industrial location premiums.
• Prediction, however, remains hazardous. The most recent evidence is that many skilled white collar workers prefer inner city locations for both living and working purposes. For now, one of the aspirations of the early 1990s – satellite office clusters in the Blue Mountains – remains a minority choice.
Real estate conundrums: Just another cycle – or a whole new ball game? 5
00 0100 100150 150200 20050 50250
Males
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Population ( thousands )
Retirement villages
Empty nesters
Upgraders
First home buyers
Student accommodation
Childcare
Baby-boomers
Females
1971
Source: ABS, JLL Research Source: ABS, JLL Research
Demography (and urbanization) – is it destiny?
Figure 6 – while population will grow across all age categories, some age groups will grow much faster than others
Are we under-estimating the impact of the changing population age profile?• Discussions of demographic challenges gravitate quickly to the
baby-boom generation. But the age profile of Australia’s population shows many other challenges. Underlying the increase in gross numbers, the age profile of Australia’s population will change sharply over the next few decades and the pace of change accelerates from now.
• Baby-boomers and first home buyers are important – but over time there are many other impacts on real estate to consider – childcare, student housing, retirement living as well as the age profile within the working age population.
4• Urbanisation usually begins with growth in the manufacturing
sector – since the Industrial Revolution rural workers have moved to towns in search of factory jobs. Wages may be low, but life is more interesting and less precarious than subsistence farming. The first generation of urban dwellers may aspire to retire back in the village; but social links, and claims on rural land, quickly erode. The extended family safety net vanishes. Urban societies and small urban apartments are not conducive to family support arrangements, especially where single child families predominate. Even rudimentary aged-care pensions, whether privately or publically provided, and healthcare, require extensive financial intermediation, planning and management. Savings rates rise. The growth of financial institutions and office occupancy follows from this.
0
100
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0 0100150200 50250 22515075Population ( thousands )
Retirement villages
Empty nesters
Upgraders
First home buyers
Student accommodation
Childcare
Males Age Females
1989 2007 2025 2043 2061
Baby-boomers
1971
6 JLL
0 0100150200 50250 22515075Population ( thousands )
Retirement villages
Empty nesters
Upgraders
First home buyers
Student accommodation
Childcare0
100
90
80
70
60
50
40
30
20
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Males Age Females
1989 2007 2025 2043 2061
Baby-boomers
1971
0 0100 150150 225200 50 75250Population ( thousands )
0
100
90
80
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60
50
40
30
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Males Age Females
1989 2007 2025 2043 2061
Baby-boomers
1971
Retirement villages
Empty nesters
Upgraders
First home buyers
Student accommodation
Childcare
Source: ABS, JLL Research Source: ABS, JLL Research
Source: JLL Research
Demography (and urbanization) – is it destiny? • The impact of population age and size is thoroughly researched in
the case of residential and retail shopping markets. But the impact on other real estate market sectors such as the office market is more complex. Across the Asia-Pacific region we do see a broad relationship between median population age, market size and office market rents. Rents are higher where office markets are larger and where populations are older. This suggests that investors seeking capital growth should consider those office markets with high growth profiles because they have relatively young populations – Jakarta, Manila and Tier One markets in India.
• Aside from changing age profiles, location also matters. Within Australia median age profiles currently show small divergences between cities – but ABS mid-range projections imply a re-ranking of cities over time. Perth (187%) and Brisbane (118%) are the cities with the highest projected percentage growth (2012-2061). Just behind is ACT (98%). By 2028 Perth will overtake Brisbane at 3 million people, while Melbourne will match Sydney with 7.9 million by 2053.
• As with all forecasting exercises, the past may be an unreliable guide to the future. Population projections are sensitive to interstate and international migration patterns which, over the past twenty years, have been volatile. But the message is that the relative ranking of office, retail and industrial markets is destined to change significantly in the future.
Figure 7: Asia-Pacific prime office market rents – Actual vs Predicted*
* Net face rent predictions based on vacancy, market size (‘000 sqm NLA) and median population age, June 2015 (R sqd = 0.80)
120
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ShanghaiMumbai
SeoulTaipei
Singapore
Manila
Tokyo
Jakarta
HK
SydneyMelbourneBrisbane
Perth
Canberra Adelaide
Real estate conundrums: Just another cycle – or a whole new ball game? 7
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