Improving real estate fundamentals strengthening occupier markets should offset potential interest rate headwinds

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Phoebe Fields
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1 The Invesco White Paper Series Invesco Global Real Estate Improving real estate fundamentals strengthening occupier markets should offset potential interest rate headwinds Tim Bellman, Head of Global Research Invesco Real Estate Twice a year, Invesco Real Estate formulates its house view. In this article, we summarize our main findings. Our analysis ends on an optimistic note, since fundamentals are improving and investors are rediscovering real estate. Nevertheless, regional differences remain, which should be taken into account when developing real estate investment strategies. For a complete assessment of the different markets and strategies, we would like to refer you to our recently published H Invesco Real Estate House View Global Market Outlook, which is available on request from your Invesco representative. For several years, commercial real estate has been attracting investors looking for an income return that compares favorably with other asset classes. That flow of capital has helped to drive up real estate values. Looking forward, as economies improve, we believe that increasingly real estate performance may be driven as much by improving occupier market fundamentals as by the strength of capital flows. As a result variations in both the local pace and timing of strengthening market fundamentals will likely differentiate the growth of real estate values at the asset level and across cities and sectors around the world. Yet at the same time those values will also be influenced by macro conditions and the relative attractiveness of other asset classes. How may these intertwined forces play out in ? The balance of risk appears to be changing A simple conceptual framework of the outlook for real estate and the attendant risks is shown in figure 1. It is predicated on the notion that most risks associated with real estate investment can be grouped into two broad categories: occupier market fundamentals and capital markets. Figure 1: Thinking About Risks to the Outlook Different Risk Levers may be Appropriate at Different Times The document is intended only for Professional Clients and Financial Advisers in Continental Europe, in Dubai, Ireland, the Isle of Man, Jersey and Guernsey, and the UK for Professional Clients, in Australia for Institutional Investors, in Hong Kong for Professional Investors, in Japan for Qualified Institutional Investors, in for Institutional Investors, in Taiwan for Qualified Institutions/ Sophisticated Investors and in the USA for Institutional Investors. In Canada, the document is intended only for accredited investors as defined under National Instrument In Chile, Panama or Peru, the document is for one-to-one institutional investors only. It is not intended for and should not be distributed to, or relied upon, by the public or retail investors. Consider investing with sharp focus on the entry price Capital market risk Consider general buy/hold where outlook warrants High capital market risk Low real estate Low capital market risk Low real estate Market High capital market risk High real estate Low capital market risk High real estate Consider general hold/sell if outlook warrants Consider investing with sharp focus on the asset quality Source: Invesco Real Estate, as at March For illustrative purposes only. Based on current market conditions, subject to change.

2 Where are we in this framework today? Although varying from city-to-city and sector-to-sector, generally it seems that real estate may be moving from the bottom left hand quadrant (low capital market risk and low market fundamental risk) to the top left hand quadrant (high capital market risk and low market fundamental risk). This suggests that while there are still many investment opportunities, a more selective approach to those opportunities is prudent, with a sharp focus on entry/exit price relative to asset quality designed to unlock underappreciated value. Strengthening real estate market fundamentals should lower risk Better economic conditions suggest occupier demand may strengthen in many markets in as the global economy continues on its path of a long, drawn out and bumpy recovery: The US private sector economic recovery appears to be gaining traction. The outlook for several countries in Europe markedly improved over the past six months. It appears that Abenomics will deliver stronger growth in Japan, at least in the short term. China is expected to experience only a mild slowdown. Some emerging markets appear vulnerable, especially Brazil, Russia and Turkey. This suggests that as economies improve, city-level differences in employment prospects may become more important. Oxford Economics forecasts of city-level employment growth over the period are summarized in figure 2. Employment is likely to grow faster in some cities in than over the last decade. In others it is expected to grow more slowly. The main patterns are: Driven by tech and energy, stronger employment growth in major US cities is forecast than in most cities in Asia Pacific and Europe and above their own averages for the last decade. Forecast employment growth in London, Madrid and Stockholm is at or above the average for the last decade but in other European cities it is expected to be below that average. In Asia Pacific, employment growth is likely to be weaker than over the past decade, especially in Tokyo, but strong growth in and is expected by world standards. Figure 2: Forecast Employment Growth Most US Cities Are Expected to Grow Faster Than in the Last Decade forecast average +/-1 standard deviation 10 8 Houston New York Washington Boston Los Angeles San Francisco London Stockholm Warsaw Madrid Seoul Sydney Munich Hong Kong Paris Shanghai Frankfurt Tokyo Source: Invesco Real Estate. Based on data from Oxford Economics as at March For illustrative purposes only. Based on current market conditions, subject to change. 2

3 What of new supply? Variation in the supply response may become a bigger differentiator in real estate market prospects in more cities and sectors. Since the Global Financial Crisis, new construction has been limited in many cities by lack of demand and lack of development finance. This may be expected to change as economic growth picks up and occupiers become more willing to commit capital expenditure to new premises. The construction cycle is already much further advanced, for example, in the apartment sector in many US cities. Looking forward, the development pipeline may start to increase in some of the fast-growing higher value markets/sectors in developed economies. This may potentially provide first mover advantage to develop to core opportunities. But in time this may inhibit rental growth. Nevertheless, wide-spread significant increases in supply are not likely to be delivered for several years. Hence stronger occupier demand in should help to boost occupancy, rent and values. For the time being the risks in market fundamentals appear to be in abatement. The strength of real estate capital markets may elevate risks According to Real Capital Analytics, real estate transaction volume (all property types including land) was approximately USD1.2 trillion in 2013, close to the pre-crisis record level in It is noteworthy that a wider range of markets and asset types in those markets were transacted by a wider range of capital sources: The rising share of distressed transactions in several cities in Europe is one manifestation 66% of EUR2.2 billion transactions in Dublin and 25% of EUR1.9 billion in Madrid were in some way distressed transactions in Cross-border investment flows reached USD234 billion, a record level, in 2013 (20% of global transaction volume). In gateway cities such as London, Paris or Sydney, the proportion was significantly higher. For the first time since 2008, the volume of transactions outside gateway cities increased more rapidly in 2013 than in the gateway cities. The volume of transactions (excluding land) in selected major cities since the Global Financial Crisis is shown in figure 3. The cities are grouped into three broad tiers based on size and function: global gateway cities (New York, London and Tokyo), regional gateway cities (e.g. Los Angeles, Paris and Hong Kong) and other cities (e.g. Chicago, Osaka and Berlin). Three patterns emerge: Transaction volume in 2013 was a post Global Financial Crisis high in 21 cities with only San Francisco, Paris, Stockholm, Hong Kong,, Shanghai and notably lower. The global gateway cities (London, New York and Tokyo) had a higher transaction volume than any regional gateway city or other major city. Transaction volume in Berlin, Chicago, Houston and Dallas was greater in 2013 than in some regional gateway cities (e.g. Frankfurt,, Munich and Stockholm). Figure 3: Annual Transaction Volume in 2013 Gateway Cities Continue to Dominate Annual Transaction Volumes RCA All Property Transaction Volume Excluding Land, USD bn 50 NYC Metro London Metro Tokyo Metro LA Metro SF Metro DC Metro Paris Hong Kong Sydney Boston Shanghai Seoul Stockholm Munich Frankfurt Berlin Chicago Houston Dallas Atlanta Toronto Moscow South Florida Rhine-Ruhr Osaka Denver Phoenix Global Regional Gateway Cities Other Cities Source: Invesco Real Estate. Based on data from Real Capital Analytics as at February

4 As the global economy proceeds through the next stage of its long, drawn-out and bumpy economic recovery, our central case is predicated on the view that policy interest rates will likely remain low for some time. While tapering of quantitative easing may lead long-term interest rates to rise, they are likely to do so steadily and not necessarily back to long-term average levels. How might rising long-term interest rates affect real estate? This is likely to depend on the interplay between three macro forces in the capital markets: Cyclical effects. Real estate markets are inherently cyclical. Over the cycle one would expect market yields/cap rates to rise/fall depending on the market growth prospects. Quantitative easing effects. It is axiomatic that as quantitative easing policies designed in part to boost asset prices are tapered and ultimately withdrawn, asset prices will face a headwind. Structural effects. Due to globalization and the rise of institutional savings in many countries, the best real estate assets in the best markets may now have structurally lower yields/cap rates. Over the past few years, real estate prices have been a beneficiary of all three of these capital market forces. The cyclical, quantitative easing and structural effects were all working in the same direction to lower yields/cap rates in the US, UK and Germany in They have started to do so in Japan and other parts of Continental Europe more recently. The consequence has been strong downward pressure on yields/cap rates that is spreading from the best properties in the best markets up the risk curve to secondary properties, secondary markets and other risk strategies. We expect quantitative easing to be withdrawn in developed economies but only at a pace and time that does not undermine economic growth. At present it appears that moves towards the normalization of monetary policy are likely to come sooner in the US and the UK than in the euro zone or Japan. It is likely to be a long and careful process. Policy rates may not revert to long-term average levels any time soon. The timing is likely to vary depending on local market economic conditions. This suggests rising rates may start to create a capital market headwind for values in some markets but only at a time that market fundamentals provide a compensating tailwind. Global investment strategy considerations Invesco Real Estate continues to believe that there are core and higher risk investment opportunities in all regions. Key messages of our latest House View are summarized in figure 4. Perhaps the most important is that local variations in performance may become a more important global theme. Figure 4: Invesco Real Estate House View summary Local Variations in Performance May Become a More Important Global Theme Global Improving real estate market fundamentals may at least partially offset any drag on capital values should interest rates rise. Employment growth above the average of the last decade may drive stronger demand in many US and some European cities. Local and regional variation in real estate performance may become a more important global theme. Europe Improving economic momentum is expected to continue in We forecast stronger rental growth in the office sector than retail or logistics in The weight of capital flows may cause yields to harden modestly in gateway cities in US The desirability of high-quality US core real estate assets has become fully reflected in prices. Job growth may boost net operating income but construction may be a drag on apartments. Investment strategies emphasizing income growth remain critical to reinforce asset values. Asia Pacific The economic outlook is strengthening in Japan but moderating in China. Rents are expected to rise in most markets and sectors due to stable occupier demand in The level of supply is likely to become a key differentiator of relative rental growth performance. Source: Invesco Real Estate as at March For illustrative purposes only. Based on current market conditions, subject to change. There is no guarantee strategies are currently pursued or will be pursued by Invesco nor a recommendation to pursue the strategies. This does not constitute investment advice. 4

5 Buffeted by macro trends, real estate remains an asset class driven by local market conditions. Hence it is important to look beyond the global, regional and national level at city-level dynamics of supply and demand. The outlook for total returns for selected cities worldwide is summarized in figure 5. It shows a diverse range of performance for each sector with examples of cities in each region towards the top of the rankings for that sector. Of particular note is that there are more outperforming office markets:, Tokyo, Sydney and Seoul in Asia Pacific; Madrid and London in Europe; San Francisco, Houston, Boston, and Los Angeles in North America. In all these cities we forecast total returns in excess of 8% per annum over the period Figure 5: The Global Outlook for Total Returns Invesco Real Estate Intends to Overweight Certain Office Sectors Annual average forecast unleveraged total returns (% p.a.) 12 Riverside, Tokyo (23 Wards) Sydney, San Francisco Houston Sydney, Warsaw Madrid San Francisco Houston, London Hong Kong, Boston New York, Shanghai Los Angeles, Washington D.C. Munich, Paris CBD Paris, Houston, Madrid New York, Stockholm Boston, Los Angeles, Oakland Warsaw Paris Ile de France Madrid Boston, London City London West End Seoul, Los Angeles New York Stockholm, Shanghai Warsaw Paris Rive Gauche Munich Tokyo (23 Wards) San Francisco Boston Houston, Los Angeles, New York Shanghai 4 Stockholm Paris CBD Hong Kong Washington D.C. 2 Washington D.C. = -2.1% 0 Hong Kong = -3.9% Retail Industrial Office Apartment Source: Invesco Real Estate, as at March Bearing in mind local and regional differences, in 2014, for global core investment strategies we intend to: US: Continue a tactical overweight, but reduce to a mild overweight. This is largely because the near term return outlook remains strong due to strengthening fundamentals. The desirability of high quality US core real estate assets (and some value-add) appears to have become fully reflected in prices. Consequently we believe investment strategies emphasizing durable income growth remain critical to reinforce asset values. In this context, we expect job growth, largely driven by the tech and energy sectors, is likely to boost net operating income, although increasingly construction may be a drag on the apartment sector. Europe: Increase our allocation target to a mild underweight. Our forecasts suggest stronger real estate fundamentals are likely but that they will probably come later in the period than in the US. Improving economic momentum is expected to continue in The weight of capital flows may cause yields/cap rates to harden modestly especially in gateway cities in We forecast stronger rental growth in the office sector than in the retail or logistics sectors in Asia Pacific: Adopt a mild underweight due to the varied regional growth prospects. The economic outlook is strengthening in Japan but moderating in China. We expect stable occupier demand in 2014 and consequently for rents to rise in most sectors/markets. In time, the level of supply is likely to become a differentiator of rental growth. This suggests stronger short-term prospects in developed markets such as Japan and Australia. 5

6 For higher risk strategies, our focus is tied to asset-level opportunities with the appropriate combination of asset specific risk/return and duration of opportunity which varies according to local market conditions. In 2014, examples include: Focus our value-add strategies on locations forecast to sustain improving fundamentals over a two-three year time horizon, to enable time for asset-level execution and sale into markets with strengthening occupancy and rent. Consider development in Australia, China and the US for example. We believe good developers may need support from good equity partners. Target distressed opportunities in the US, Ireland, the UK and Spain. Considering potential deal flow and market fundamentals, we have more conviction now on European opportunities. 6

7 Important information The opinions expressed are those of the author and are based upon current market conditions and are subject to change without notice. This document does not form part of any prospectus. This document contains general information only and does not take into account individual objectives, taxation position or financial needs. Nor does this constitute a recommendation of the suitability of any investment strategy for a particular investor. While great care has been taken to ensure that the information contained herein is accurate, no responsibility can be accepted for any errors, mistakes or omissions or for any action taken in reliance thereon. Opinions and forecasts are subject to change without notice. The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested. Neither Invesco Ltd. nor any of its member companies guarantee the return of capital, distribution of income or the performance of any fund or strategy. Past performance is not a guide to future returns. This document is not an invitation to subscribe for shares in a fund nor is it to be construed as an offer to buy or sell any financial instruments. As with all investments, there are associated inherent risks. This document is by way of information only. This document has been prepared only for those persons to whom Invesco has provided it. It should not be relied upon by anyone else and you may only reproduce, circulate and use this document (or any part of it) with the consent of Invesco. Asset management services are provided by Invesco in accordance with appropriate local legislation and regulations. This publication is issued: in Australia by Invesco Australia Limited (ABN ), Level 26, 333 Collins Street, Melbourne, Victoria, 3000, which holds an Australian Financial Services Licence number in Austria by Invesco Asset Management Österreich GmbH, Rotenturmstraße 16-18, A-1010 Wien. in Canada by Invesco Canada Ltd., 5140 Yonge Street, Suite 800, Toronto, Ontario, M2N 6X7. in Dubai by Invesco Asset Management Limited, PO Box , DIFC Precinct Building No 4, Level 3, Office 305, Dubai, United Arab Emirates. Regulated by the Dubai Financial Services Authority. in France by Invesco Asset Management S.A., 18, rue de Londres, F Paris, which is authorised and regulated by the Autorité des marchés financiers in France. in Germany by Invesco Asset Management GmbH, An der Welle 5, D Frankfurt am Main, which is authorised and regulated by the Bundesanstalt für Finanzdienstleistungsaufsicht in Germany. in Hong Kong by INVESCO HONG KONG LIMITED 景順投資管理有限公司, 41/F, Citibank Tower, 3 Garden Road, Central, Hong Kong. in Ireland by Invesco Global Asset Management Limited, George s Quay House, 43 Townsend Street, Dublin 2, Ireland. Regulated in Ireland by the Central Bank of Ireland. in the Isle of Man by Invesco Global Asset Management Limited, George s Quay House, 43 Townsend Street, Dublin 2, Ireland. Regulated in Ireland by the Central Bank of Ireland. in Japan by Invesco Asset Management (Japan) Limited, Roppongi Hills Mori Tower 14F, Roppongi, Minato-ku, Tokyo , Japan, which holds a Japan Kanto Local finance Bureau Investment advisers licence number 306. in Jersey and Guernsey by Invesco International Limited, 2nd Floor, Orviss House, 17a Queen Street, St. Helier, Jersey, JE2 4WD. Invesco International Limited is regulated by the Jersey Financial Services Commission. in by Invesco Asset Management Limited, Tung Centre #10-03, 20 Collyer Quay, With effect from 11 August 2014, the office address for Invesco Asset Management Ltd will be changed to 9 Raffles Place, #18-01 Republic Plaza in Switzerland by Invesco Asset Management (Schweiz) AG, Stockerstrasse 14, CH-8002 Zürich (Location where the prospectus, annual and interim reports, Trust Deed and Articles can be obtained free of charge.). in Taiwan by Invesco Taiwan Limited, 22F, No.1, Songzhi Road, Taipei 11047, Taiwan, which holds a Taiwan Financial Supervisory Commission license number DB in the UK by Invesco Asset Management Limited, Perpetual Park, Perpetual Park Drive, Henley-on-Thames, Oxfordshire, RG9 1HH, United Kingdom. Authorised and regulated by the Financial Conduct Authority. in the United States of America by Invesco Advisers, Inc., Two Peachtree Pointe, 1555 Peachtree Street, N.E., Suite 1800, Atlanta, GA and by Invesco Private Capital, Inc., Invesco Senior Secured Management, Inc., and WL Ross & Co., 1166 Avenue of the Americas, New York, New York Data as at July 15, 2014 unless otherwise stated. institutional.invesco.com II-REA-WP-1-E 08/14 GL135

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