Executive summary

• Strong corporate fundamentals and a favourable interest rate environment continue to support the European commercial real estate market. However, several areas of heightened risk are emerging as Europe enters the late stages of one of the longest real estate investment cycles in history.
• Finding value in the current market without compromising on asset quality or moving up the risk curve will remain a key challenge. This means that risk mitigation will continue to be a major theme across all sectors and geographies.
• A prudent direct real estate investor should keep a close watch on pockets of mispricing and behavioural biases. ‘Herding bias’ is of most concern, typically triggered by the weight of capital and intense competition. In particular there is a risk that direct real estate investors will not be suitably discriminating on purchases in the industrial and logistics sector.
• On the upside, as existing investors benefit from the extended cycle, we see 2018 as a window of opportunity for selective asset disposal - an opportunity to take profit and refresh existing portfolios at the same time.
• Finally, it is important to consider broad macro trends and developments in other asset classes in carving out a successful real estate investment strategy. In today’s globalised world, economies and investment markets are so interlinked that no established real estate market can claim to be truly local.

Extended real estate cycle: assessing cumulative risk

At a first glance, the much talked about extended European real estate investment cycle is nothing but positive news. On the investment side, the weight of capital targeting real estate continues unabated and Europe remains ‘the region of choice’.

Institutions have become increasingly concerned about the Americas due to stretched valuations and rising interest rates. As a result, the EMEA region had the highest Real Estate Conviction Index level in 2017 at 5.4 (a measure of investment confidence on a scale of one to ten), and was the only region to report a year-on-year increase.

Source: Fidelity International, Jones Lang LaSalle, June 2018. LTA = Long-term average.

Supported by corporate strength, European occupational markets are experiencing healthy demand, while supply continues to lag in most places as markets are quick to absorb new completions. In the office sector, for example, five-year average annual take-up levels are forecast to run at two and a half times the completion equivalent - 10.3 million sq m per annum vs 4.2 million sq m per annum respectively (see Chart 1). And while there are pockets of stronger supply emerging, especially in Dublin and Berlin, and to a lesser extent in markets such as Barcelona, Frankfurt and Paris La Défense, near-term vacancy rates are forecast to remain below their long-term averages in most markets.

That said, risks, which in isolation might be easy to mitigate, tend to accumulate over time. And as one of the longest investment cycles in history extends further, our macro and real estate market insights point to several areas of heightened risk for a prudent direct real estate investor to keep a close watch on:

1. Mispricing

Mispricing and a tendency to move away from a core strategy or up the risk curve are the two key symptoms of any late cycle. Typically invoked by the weight of capital and intense competition, current market conditions are ripe for these tendencies to flourish.

However, with yields at record lows the scope for further yield compression is narrowing. Furthermore, at present there is little sign of aggressive secondary pricing or the widespread moves into the secondary/tertiary market that were seen at the top of the previous investment cycle in 2006 and 2007. This is evident by the fact that the spread between core eurozone prime and secondary yields has held well above 200 bps in this cycle. This is in a sharp contrast to the 65-70 bps premium reported back in 2007 (see Chart 2).

However, we think there are some segments of non-prime markets that are now being priced as steeply as prime - and the H1 2018 deal flow provides further evidence of such pockets of mispricing emerging.

Source: Fidelity International, CBRE, June 2018. Core eurozone = Germany, France and the BeNeLux.

The key for direct real estate investors is to remain prudent in their pricing assumptions and risk assessment of potential new acquisitions. The fundamental building block of a successful real estate strategy is a fund manager’s ability to carefully make short-term decisions (be it about new capital deployment, or performance boost / optimisation), without compromising the overarching strategy and long-term returns. In the current market it may well mean not always being the highest bidder.

2. Behavioural biases

Market inefficiency, high transaction costs, low pricing visibility and the heterogeneous nature of real estate as an asset class are just some of the reasons why investment in the sector tends to be more heavily exposed to behavioural biases. The understanding of and ability to recognise these behavioural biases should serve as a significant competitive advantage to enhance risk mitigation. Our research on addressing built-in biases in real estate investment explores the topic in depth and makes a timely read as it is in the late stage of the cycle that investors tend to make decisions that are the most detrimental to performance. The study is anchored around five main behavioural biases, but we believe the ‘herding bias’ to be most evident in today’s market.

Under conditions of uncertainty, complexity and incomplete information, some direct real estate investors believe there is value in following the strategies of other market participants, such as first movers or specialists. While the ‘herding bias’ might prove profitable in some cases or for a short period of time, it can lead to pricing bubbles. The industrial sector may be a good example of this.

Source: Fidelity International, CBRE Research, Real Capital Analytics, March 2018.

The CBRE 2018 European Investor Intentions Survey reveals that 33% of direct real estate investors surveyed chose industrial and logistics as the most attractive sector for new real estate acquisitions in 2018, well ahead of offices, which came second with 26%. Accepting the fact that this is an intentions survey and not hard target capital allocations, the numbers still demonstrate a clear example of a ‘herding bias’. At 33%, the proportion of investors highlighting industrial and logistics as most attractive for new investments is more than double the sector’s 14% share of the European investment market (see Chart 3).

Underpinned by structural changes in supply chain and consumer behaviour, we believe that the industrial and logistics sector will continue to be a top performer over the mid-term. However, one must be mindful that the sheer amount of capital targeting the sector is likely to skew pricing for new acquisitions and across most assets, including those of poorer quality or not as strategically located.

The lesson here is that ‘one size doesn’t fit all’, and it is the better quality and the last mile space that look to be the main winners today and also in the longer term. Maintaining a balanced ‘price discrimination’ when searching for new acquisitions in the sector will be key.

3. Denominator effect

There are many reasons why target real estate allocations within an institutional investor’s overall investment portfolio are likely to increase. As a result we do not expect the 'denominator effect’ to be a current risk to real estate markets. The ‘denominator effect’ is when a notable correction in other asset classes (for example equity markets) results in institutional portfolios being overweight in real estate, causing capital outflows and triggering a market correction, as was the case immediately after the equity market collapse in the 2008 global financial crisis.

The role of real estate in the overall asset allocation of an institutional portfolio today is very different to what it was ten years ago. The sector continues to evolve and mature, with average real estate target allocations on course to surpass the 10% threshold in 2018.1 There are several push factors that suggest that these real estate allocations should be notably higher. These can be categorised into short-term tactical triggers, asset characteristics, and, most importantly, long-term structural push factors:

• Tactical triggers: the 2018 multi-asset outlook is muted, and stretched equity valuations, concerns over potential monetary policy missteps, and, most recently, Donald Trump’s steel tariffs give little reason to believe in a major upside. Portfolio diversification and strong demand for alternatives form part of the solution to improve performance.
• Characteristics of the asset class: the real estate sector’s partial inflation hedge and attractive and relatively stable income properties are now better understood and valued by investors and will remain attractive in the current environment.
• Long-term structural shift: the changing demographics play a particularly important role. The old age dependency ratio is increasing at a considerable rate as people are living longer at the same time as the birth rate is falling. This creates a growing need for liability matching and an annuity type of income - resulting in more demand for income producing investments, including real estate.

4. Major external event

Real estate fundamentals remain sound, and while it looks like several lessons from previous cycles have been learnt, it is important not to overlook the possibility of a major external event disrupting the real estate cycle. A major correction in equity markets is just one of the examples. China’s economic slowdown, Trump‘s tariffs and on-going geopolitical tensions remain on investors’ minds.

Conclusions

The increasingly familiar extended cycle environment presents many challenges:

• Finding value in the current market without compromising on asset quality or moving up the risk curve will remain a key challenge. Steering clear of the record low-yielding prime market segment is our key recommendation.
• ‘Asset picking’ in established second-tier locations, while maintaining prudence in pricing assumptions and risk assessment, is where we see opportunity for new ac We believe supply shortages to be the main factor behind near-term outperformance, regardless of geography, for both new and existing investments. Micro-markets where occupier demand is exceptionally strong and supply continues to lag are our medium-term favourites, with an added rental growth upside.
• We also see 2018 as a window of opportunity for selective asset disposal - a unique opportunity to take profit and refresh existing portfolios at the same time.
• Equally, we are eager to highlight the importance of considering broad macro trends and developments in other asset classes in carving out a successful real estate investment strategy. In today’s globalised world, economies and investment markets are so interlinked that no established real estate market can claim to be truly local.