The importance of looking for prime locations when investing in real estate has increased since the financial crisis, as investors have become more risk averse and are focused on wealth preservation.
“What changed the world in the last couple of years and cannot be ignored is that property can’t defy the wider economy,” says Chris de Pury at BLP partners, the UK-based experts in real estate law. “When you look at buying a property, you have to look at the underlying fundamentals, rather than just relying on an income stream and slicing and dicing on that basis.”
A couple of years ago, everybody piled into property thinking they could get “super returns” in a very short period of time explains Mr de Pury. In reality, they lost a lot of money, as tenants went bankrupt and the capital value went down dramatically by about 50 per cent from peak to trough.
As with any asset class, there is quite a strict correlation between the growth and the structure of the economy and real estate performance. Generally, property is expected to generate higher returns in those markets where the economy is relatively well balanced and growth is attractive.
Prime locations
“There is no point in buying a magnificent piece of real estate in an economy which is not going anywhere,” says Mr de Pury. Tenant demand and whether tenants are paying their rents on time is a key factor to consider, as is the ability to re-let the property. Core real estate in prime locations is what everybody is after, he says.
“The biggest challenge in real estate is the lack of product. Everybody is chasing core assets, the relatively well let, good covenant prime property in the main economic centres, such as London, Paris, Frankfurt, New York or Sydney.” Outside those main economic centres, there are no real markets, says Mr de Pury.
DTZ, a global property consultant, recently launched a series of Fair Value Indices – a global all-property index and 16 sectoral/regional indices – which offer insights into the relative attractiveness of commercial property across Europe, Asia Pacific and the US.
Index scores range from 0 to 100: scores close to 100 indicate that most of the markets covered by the index offer attractive returns (hot), and scores close to zero indicate that the markets covered generally offer inadequate returns (cold).
Markets are categorised by comparing expected returns with required returns. The latter are defined as the return available from a five-year government bond, plus a premium to allow for the additional cost and risk associated with property investment.
The premium takes into account the compensation required for depreciation, transaction costs, illiquidity and risk. Markets estimated to be more than 5 per cent under-valued are classified as hot. Those with more than 5 per cent over-valued are classified as cold, while markets trading in between this range are classified as warm.
The index score calculated for the second quarter of 2010 shows that the most attractive region for commercial real estate at the moment is the US, explains Hans Vrensen, global head of DTZ Research (see Figure 1 below).
“There are two factors that resolve in the US proving a very attractive market at this particular junction: prices have adjusted quite significantly and the required rate of return has come down significantly, as the government bond yields are very low at the moment.”
Asia-Pacific ranks only second. “Asia Pacific economies are growing very fast but this is not necessarily news and a lot of investors have already priced that into their decision,” says Mr Vrensen, explaining that investors are willing to pay the higher price for a property in the market where the rental growth is expected to be quite strong, but that is already reflected in the price they pay.
The markets that are least attractive at the moments are the UK, which has adjusted back on the upswing perhaps a little bit too aggressively and also Europe, particularly in the European office sector.
The UK has had its rally and yields appear to have stabilised, agrees Ed Protheroe, senior portfolio analyst, real estate, at M&G. In the absence of any rental growth, there is going to be little capital upside in the short-term, so that has to come from active asset management, he says.
Income return is estimated to account for 75 per cent of the total return, while capital return accounts for 25 per cent.
“Over the long run, our asset management teams have been very focussed on driving that income forward,” says Mr Protheroe. “Up to now, in the downturn, it has really been about securing that income, and making sure that we don’t trade on any landmines. But we are now anticipating the cycle turning up over the next couple of years and we have to start gearing up for strategies that actually push that income forwards, because that is where you get the capital growth going forward.”
