The close of the cycle or a land of opportunity?
17 December 2018
Many investors will fondly remember the days when they could buy an asset – be it an office block or a piece of infrastructure – then sit back for a few years and then sell it at a handsome profit. Try that investment strategy today, and you’re likely to experience a very different outcome.
Yet prices for UK real assets remain sky-high, putting the market in no-man’s land. Ask a real estate or infrastructure investor where the market is now, and they’ll tell you it’s either very long in the cycle or two years past the end. Why? Because with real asset prices still pumped up to eye-watering levels, yet defying gravity, returns from buying and selling real assets of all kinds have plummeted.
High prices – falling profit expectations
These conditions are fully reflected in our Emerging Trends in Real Estate: Europe 2019 study, conducted jointly with the Urban Land Institute. Based on a survey of 885 real asset professionals across 22 European countries, the research shows that 80% of respondents agree returns are becoming more difficult to achieve, and 79% believe investors will need to take more risk to get them.
Given such findings, it’s hardly surprising that profit expectations have fallen sharply. Nearly a third (30%) of respondents are expecting lower returns compared to previous years, and almost half are expecting risk-adjusted returns of 5% to 10%, with two-thirds holding assets for five years or more. The biggest worry between now and the end of 2019 is availability of suitable assets, voiced by 68% of interviewees.
A massive transfer of risk…
So, what’s happening in the market? The tightening of margins has had two major knock-on effects. The first has been a transfer of risk from West to East in terms of capital flows, as western investors have moved to sell assets at full prices to lower capital-cost and trophy-hunting investors, often from Asia. Many of the incoming buyers are repositioning these assets as sources of income to be managed, rather than capital gains to be bought and sold, and have reset their profit expectations accordingly.
…and diversification in search of returns
This trend has helped trigger the second effect: a move by sophisticated buyers seeking returns into new and different assets. In real estate, they’re looking beyond traditional assets like retail and office space, and migrating towards investments that include an operating business with real estate underpinning it, offering an income rather than capital return. These assets include the likes of hotels, apartment blocks, healthcare, senior and retirement living and private rented housing – all of which offer reliable future cash flows. 71% of respondents to Emerging Trends in Real Estate: Europe 2019 agree that achieving returns in the current environment will require a widening of the definition of traditional real estate to include real assets and related service businesses.
Meanwhile in infrastructure, with pricing still at peak levels and internal rates of return (IRRs) significantly lower than five years ago, there’s a similar shift towards “core-plus” assets to secure income streams in order to offset lost capital returns. This involves refocusing on more service-related assets that carry more operating than regulatory risk, as well as specific management attention and focus, such as storage terminals, renewable energy facilities, telecoms data and fibre businesses and transport-related assets like car parks and ferries.
These changes in investor focus across the real assets spectrum have been accompanied by an expansion into new geographies. With prices in the UK remaining stubbornly high, assets – notably infrastructure – in emerging markets and regions like Latin America, Asia and Central/Eastern Europe can offer more attractive returns, albeit accompanied by higher levels of risk.
More investors – and a move up the risk curve
All of this is taking place in an environment that has seen a huge increase in “dry powder” in the past decade, with established funds continuing to raise even larger funds. This period has also seen a dramatic expansion in the number of market players, especially in infrastructure investment – a sector that now includes not just infrastructure funds but also sovereign wealth funds, pension funds, public-private partnerships, private finance initiative, private equity, and insurance. The industry is now bigger and investing larger sums than ever.
This expansion in demand – combined with a relatively positive performance from the UK economy, despite Brexit-related uncertainty – has helped to keep asset prices at their continuing high levels. With the margins from buying and selling assets under pressure as a result, investors looking to make a profit from asset-trading are having to do something intelligent with the assets while they own them. This involves moving up the risk curve, and getting involved in activities like development, roll-ups and creating operating platforms – all of which can add value to the core asset on sale.
A blurring of real asset boundaries – hastened by the issues on the high street
As ever, the billion-dollar question is what happens next. It can be argued that the UK real asset cycle peaked two years ago, a turning-point partly reflected by the current discount against net asset value for REITS and listed real estate companies. With asset prices still high, interest rates starting to rise again and inflationary pressures beginning to return, today’s high prices appear more than ever to be on borrowed time – and a decline looks inevitable.
On the real estate side, the most immediate issue is the current developments in the high-street retail sector. As the challenges for bricks-and-mortar retailers – ranging from aggressive online entrants to waning consumer confidence – continue to escalate, the impact on real assets are now becoming clear. With landlords already taking a fair share of the pain, and a glut of empty retail space set to come onto the market, it’s only a matter of time before asset valuations start to show material falls.
However, the infrastructure side is in a slightly different position. While valuations remain high, the underlying businesses are generally performing well. And while prices may come off slightly, there’s no real prospect of the bubble bursting, as could happen in certain parts of the real estate market. Against this background, a number of real asset investors are rebalancing their portfolios away from real estate and towards infrastructure. This is accelerating the shift we noted above towards income-producing assets, and blurring the traditional dividing-line between real estate and infrastructure in terms of real assets investment. The message is clear. In overall terms, the end of the real asset cycle is certainly nigh. But the way it ends will vary in different sectors of the market. And those differences are where the opportunity lies for smart investors.