As we soldier on through the fourth year of the post-Lehman Brothers world (doesn’t time fly when you’re having fun?!), it remains de rigueur to focus more on risk than on return.
In the midst of a prolonged Eurozone crisis, the focus on risk aversion seems set to continue. Institutions have reacted to this extremely difficult market in two ways, one wholly unsurprising, the other slightly bewildering, and neither of them particularly positive for property markets. But a survey last month of more than 50 institutional investors in Asia and Europe, commissioned by Fidelity and carried out by Greenwich Associates, brings hope that things are about to change.
First, the unsurprising reaction: ever since ‘Lehman’, investors have been ‘de-risking’ their portfolios. This seems sensible; during a storm, you batten down the hatches. The second, slightly more bewildering reaction, ostensibly part of the de-risking process, has been to chase government bond yields to levels where, in real terms, negative returns are guaranteed. For example, in May, the German government raised €15bn for an issuance of 10-year bonds. Investors were happy with a 1.8% yield, yet CPI inflation in Germany is over 2%.
An often cited rationale for this is that investors are seeking ‘safe havens’. But one problem is that the pool of so-called safe haven AAA bonds in the world has shrunk by a staggering 70% in the past 12 months. This makes sense if investors fear other homes for their capital will lose money. With AAA bonds, they can be pretty confident they’ll get 100% of their capital back.
Another often cited defence of low returns is that liquidity is so valuable today that investors will pay a significant premium for it. But the arithme-tic on AAA bonds only works if investors hold them to maturity – i.e. if they plan not to use that liquidity and lock up their capital for 10 years. If, on the other hand, they need their capital in the interim and bond yields rise from 1.8% to, say, 2.5%, investors could lose more than a quarter of their capital – a hefty price to pay for liquidity.
In the meantime, capital flows into real estate have been slowing. Provisional Q2 data from Real Capital Analytics shows European real estate markets turnover looks to be down 20% or more compared to last year.
The Greenwich Associates survey clearly showed that the age of income is upon us, with investors typically targeting 4-5% yields and likely to focus much less on capital growth in the next few years. Secondly, it showed a shift into asset classes other than government bonds. Investment-grade bonds, real estate and infrastructure are top of the list for a ‘perceived trade-off between income yield and risk’. More allocations to real estate look likely.
Another striking thing about this survey was the analogy with our markets. A flight to safe haven AAA bonds in the fixed-income market echoes the rush to ‘prime’ and ‘long lease’ buildings in the property market. Arguably, both are now in bubble territory and carry significant capital risks.
The other striking feature was that while four or five different bond ‘flavours’ were categorised (high yield, investment-grade etc), ‘real estate direct investment’ was lumped into one. Many in the property market have been concerned that pricing for prime and long-leased assets is back to peak levels, while the gap between prime and secondary yields has increased to an all-time high.
It is encouraging that institutions are considering increasing real estate allocations again, but perhaps it is time we helped them by categorising the different options more clearly by riskiness, just as our cousins in the bond markets do.
‘Investment grade’ property doesn’t exist as a category, but that’s exactly where the attractive opportunities are. Non-prime, but high-quality buildings with strong tenants can provide institutional investors with just what they say they need: relatively high income, with relatively low risk. Nothing is risk-free anymore, but ‘investment grade’ property could offer some much needed safety from the traditional ‘safe havens’.
Neil Cable is head of European real estate at Fidelity Worldwide Investment