Late cycle investing: UBS AM advocates increased core allocation

Late cycle vintage higher risk funds historically have on average underperformed due to elevated asset purchase prices and lower economic growth to support the pickup in demand needed to achieve the rental levels business plans are underwritten at.

In a nutshell, this is why it can be ‘tricky’ to invest at this stage of the cycle. UBS-AM Real Estate & Private Markets advocates the largest allocation of new capital to core, more than we would have 12 or 18 months ago.

“Within core, however, we caution against portfolio churn. Returns have narrowed and transaction costs are high. It would make more sense to upgrade existing holdings than to acquire new ones. Thus, we will believe there is a rationale for sizeable value-add allocations – perhaps of the lighter, income-enhancing variety. We are conscious that the frontiers between core, core+, and value-add can blur.

“And what about pure-play high risk strategies? There is little if any distress and with both land and construction costs elevated and rising, speculative development only adds up in isolated circumstances. We do think there will be very interesting retail recovery strategies in the near future, particularly in the US and the UK, but the pricing gap between buyers and sellers is still too wide. We remain very selective in this high-risk space.”

European demand

Take-up is stable and rents continue to rise despite softening fundamentals. The development pipeline remains muted in most locations. On the demand side, 2018 was a difficult year for the eurozone. GDP has been sluggish across most of the major economies, with the main area of weakness was the industrial sector notably in German manufacturing and in the automotive sector.

However, UBS-AM says we have seen a synchronized drop, with France, Italy and Spain also reporting weak numbers exacerbated by political effects, including trade tensions, the slowdown in China, volatility in financial markets and the UK’s looming exit from the EU which are all weighing heavily on sentiment.

There are signs this is feeding into the office occupier market, says UBS-AM:

  • Most of the German cities saw flat to negative leasing activity when compared with 2017. Berlin, which has seen strong growth in tenant demand, saw take-up fall by around 9% while Frankfurt (-13.5%) also had a soft year. This will be of particular concern to the many investors who are betting on Frankfurt as a winner from the Brexit process;
  • Portuguese cities Porto (+177%) and Lisbon (+23.2%) saw sharp increases, albeit from a small base; and
  • UK regional cities saw high levels of take-up, although this was largely on the back of public sector deals. Nonetheless, Glasgow, Liverpool and Manchester all saw take-up rise by over 50%, an impressive outturn no matter what the driver was.

james.wallace@realassetmedia.com