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Late cycle investing: balancing rising risk with return expectations

While the competition for top quality – particularly logistics – real estate remains healthy, bidding is thinner for more challenging assets and retail is roundly unloved. Meanwhile, new funds raised for real estate fell about 9% between 2015 and 2018, according to Preqin.

The share of capital raised for higher risk strategies has shifted from ~60% in 2014 and 2017 and ~72% in 2015 and again in 2018 (see chart). UBS-AM says this underestimates the capital available for real estate, particularly at the core end of the spectrum.

Investor intentions surveys, such as those issued by INREV and the Urban Land Institute, indicate a desire from institutions to boost their allocation to real estate –

A long-running trend which shows little sign of abating. This is further reinforced by recent equity and bond market volatility which support the appeal of hard assets with secure income and more stable valuations.

That said, UBS-AM says we are entering achallenging time for real estate pricing. Entry yields are historically very low while price growth is slowing, driven increasingly by idiosyncratic rental growth rather than market yield compression.

Globally, the number of markets showing yield reductions (mostly logistics) is almost equally balanced by the number of markets showing yield expansion, mostly retail, explained UBS-AM.  This multi-year trend reversed slightly in Q4 due to a pickup in yield compression in Germany and second-tier European markets. In contrast, yield expansion in retail continued unabated, concentrated in the UK and the US.

“This typical late cycle phenomenon creates pressure as investment managers risk frustrating investors by keeping their powder dry. At the same time, going up the risk curve also carries its challenges. If growth is slowing and entry prices are high, it will be harder to realise the target returns from value-add strategies. As we have said a number of times, the operating environment for real estate investors will continue to become more challenging.

“At this stage of the cycle, with returns deteriorating and driven increasingly if not exclusively by income, there can be a temptation to take more risk to achieve higher returns. The fundraising statistics suggest this is in fact underway, though we re-emphasise that this reflects only private equity funds and low-balls the capital available for core real estate. There are also many ways to take risks:

  • higher leverage;
  • properties in lower liquidity markets;
  • investing in more operational assets;
  • buildings which require more work;
  • older properties, etc.

“Historically, late cycle vintage higher risk funds on average have underperformed. This is because assets purchased late cycle often have elevated entry prices, while value-add returns depend on a measure of future growth. If we have a meaningful reversal in the economy in the near future, it will be much harder to capture the pickup in demand needed to achieve the rents underwritten. Unfortunately, these reversals are only guaranteed in hindsight.”