We have held a positive view of UK property in recent years, as investors seem to have consistently underestimated the market’s growth potential. But even before the referendum last year, the economy was shifting gears, prompting us to adjust our UK exposure away from more economically sensitive real estate.
Since voting to leave the EU, the UK economy has faced even more pressure. The declining pound and rising cost of imports, the prospect of businesses departing for other parts of the EU, general uncertainty surrounding Brexit, and anticipated job losses—particularly in London City—all suggest rising vacancies for the major UK office, retail and residential sectors. Compounding the challenge is the high supply of new offices coming to market.
We still see bright spots, however, especially in more defensive sectors such as self-storage, student housing and healthcare landlords, which should be more resilient in the event of a downturn. But for UK investors, we believe the case for diversifying globally is increasing. As the UK faces Brexit-induced headwinds, many of the major global real estate markets are seeing stronger operating fundamentals amid accelerating economic growth and favourable monetary conditions.
‘Continental Europe boosted by return to growth’
We hold a constructive view of continental Europe’s property markets. In contrast to the UK, economic growth in the region is expected to remain healthy, which should bolster real estate demand.
Germany is enjoying strong economic, population and job growth and we particularly favour residential and office properties, predominantly in major cities like Berlin, where demand far exceeds supply. We also like dominant shopping centres in major cities that stand to benefit from improved retail spending.
Spain is on course for its third consecutive year of economic growth of more than 3% and the office market recovery appears to be gaining momentum. We also hold office landlords in France, as Paris is gradually recovering, and they, like other major European centers, are likely to gather new tenants relocating from London.
‘Expect positive earnings surprises in the US’
With US REITs, we anticipate the demand for commercial real estate will continue to outstrip new supply across most sectors, driving rents and cash flows. Many REIT managements have given conservative earnings guidance this year, creating the potential for positive earnings surprises as the year unfolds.
Our US allocation is positioned in favour of sectors that we believe stand to benefit most from faster economic growth, low unemployment and rising incomes, such as offices located in central business districts in certain markets. We also favour residential rental sectors, including apartments, single family homes, manufactured homes and student housing.
The rise of e-commerce is driving overweights to sectors such as data storage centres and cell phone towers. With the continued adoption of cloud computing, e-commerce and digital media, there is a growing need for data storage and computing power. The cash flow growth for the data centre sector will exceed most other US REIT sectors for the next several years.
‘Strong fundamentals in Japan and Hong Kong’
In Japan, we believe developers continue to trade at attractive valuations. The dividend growth prospects for some leading REITs appear to be improving, backed by rent increases and lower interest costs.
Residential demand in Hong Kong has continued unabated, despite the government’s announcement of more measures for cooling the market, which has witnessed strong momentum over the past year. Office fundamentals have been supported by low vacancies, and demand from Chinese companies should remain healthy as the mainland economy improves. We prefer developers with a large land inventory and strong recurrent income to support dividend growth.
The Australian economy continues to improve, aided by firmer commodity prices and a healthier China. We expect the Sydney office market to experience net demand growth in the coming quarters, while new supply tapers off, giving a substantial boost to occupancies and rental rates. However, if Amazon disrupts the Australian retail market in the way it has in the US, we anticipate valuation premiums for Australian malls could decline during the next several years.
With pressures building in the UK, we believe funds that invest in European or global property securities have a distinct advantage over UK focused direct funds in that they can provide access to overseas markets and sectors with superior fundamentals. We believe the case for European and global property securities has never been stronger for UK investors, especially with Brexit looming.
Rogier Quirijns is senior vice president and portfolio manager at Cohen & Steers