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Real-estate rally still not run out of puff

13-02-2015 | UK | Insight | Folmer Pietersma Every Friday chief editor Peter van Kleef discusses thought-provoking topics with Robeco experts. This time: how durable is the real-estate rally?

Speed read:
  • Search for yield has led investors to real estate
  • Divergence between prime and non-prime real estate
  • Expected returns are still healthy
  • Volatility of listed real estate could decrease
If you thought the cookie jar was empty after a return of around 30% in 2014, you'll have been surprised in January when listed real estate managed to add a further 12% return to this recent success story. That caused a few raised eyebrows, as it's not going that well with the economy, surely, and vacancy in the real estate sector is still a serious problem. These impressive returns in the first trading month of 2015 are of course partly down to the currency effect. The decline in the euro, primarily versus the US dollar, is doing more than its fair share.

But in addition to the tailwind on the currency front, other external factors are also driving this rally. Over the last few years, the search for yield has led many investors to credits and high yield bonds, “but spreads have been pretty much exhausted”, says Folmer Pietersma, portfolio manager Real Estate. Not to mention the 10-year yield on government bonds. And in terms of equities, there was also the run on dividend stocks, but in that segment classic dividend sectors, such as energy and financials, are struggling. “It's pretty logical that investors would end up at listed real estate, with its dividend yield of 3 to 4%.”

That sounds like opportunistic money, which in the absence of any better options is flowing to the real-estate sector – a fickle phenomenon that can just as quickly turn against an asset. But that is just one side of the story, thinks Pietersma, as on the other hand real estate looks healthy in fundamental terms, at least a section of the market does. “A great deal has been devalued in recent years, and very little redevelopment or new construction has taken place due to the crisis as financing is still difficult to access, while the economy and thus demand is really increasing.”

Dichotomy
Within real estate, there is currently a major dichotomy, suggests Pietersma, between A-locations (prime real estate) and the less attractive locations (non-prime), not only for retail, but also for offices and homes. Prime real estate is doing fine, while there is a lot of vacancy at the lower levels and the outlook there is not improving. “London is a good example of a flourishing prime real estate market, as are Apple's Flagship Stores.”

It's striking that since the crisis, the TMT sector in particular (tech, media and telecom) has played a leading role, whereas this used to be the financial sector. “The sector is growing with offices at hip locations, which is leading to the cluster effect. Companies are gravitating to the same locations, and employees – mostly millennials – are looking for trendy accommodation in the direct vicinity.”

Many listed real estate players are mainly active in the upper segment of the market, which explains the robust returns – and that at a time when real estate as a whole is not yet exactly out of the dip. The question is – how durable is a rally that is partly being driven by external factors and is only being propped up by a part of the real-estate market? Pietersma recognizes the risk of rate hikes, for instance. “If 10-year yields rise, then the real-estate sector will feel the pinch. However, rising rates do not need to be a problem, though in historical terms real estate does tend to lag equities. As an investor, you've got the 3% dividend ‘in the pocket’, and together with the expected profit growth, you'll enjoy high single digit returns.”

Getting its own asset class
And then there is another event in the near future that could have an impact on real-estate investments. Index provider MSCI uses ten sector indices and up till now has always classified listed real estate under financials, but in March of this year they will decide whether to give real estate its own index from 31 August 2016. That could lead to extra inflows, but another – and more likely – result is that listed real estate will no longer move so much in tandem with financials.

Ideally this would lead to less volatility and a lower correlation with equities as a whole, thinks Pietersma, as real estate companies will then be assessed more on their own fundamentals and merits. “This could be especially favorable in terms of risk management. For the time being, real estate is in a threefold Goldilocks scenario, in which demand, supply and financing costs are all providing a tailwind.” Even though you can't really label real estate as extremely cheap, Pietersma does not expect the music to stop suddenly. But it would be a good idea to keep an eye on the 10-year yield.
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