Judging investment performance

Real estate investors can be pessimistic or optimistic regarding 2020’s investment performance, depending on which facts they focus on.

On the pessimistic side, they face increasing shortfalls to their real estate asset allocation targets: during the fourth quarter of 2019, capital commitments to real estate funds fell to their lowest level since the global financial crisis, there is increasing difficulty in deploying capital into real estate and real estate return expectations continue to drop.

On the flipside: allocations to real estate continue to rise in percentage and dollar terms, while major real estate funds are increasing in scale, providing market price support; 2019 investment sales volumes remained at reasonable volumes; and real asset return premia remain relatively attractive, driving investment flows toward real estate.

So, should investors be optimistic or pessimistic? That this year brings ‘more of the same’ is the safest prediction to make for most annual projections. As a base forecast: real estate allocations will continue to grow; new capital commitments will remain in line with recent years; investment volumes will remain consistent with recent years; and total returns will be attractive given tightening cap rates – although expected future returns will drop as prices rise faster than real estate fundamentals improve. Perhaps the more interesting question is: why should the above hold true? Here are three reasons.

First is rapid investment fund growth driven by increasing needs to provide for: longevity risks as populations age; social programs being supported by investment funds rather than government PAYGO programs; and higher precautionary balances as financial risks shift to individuals from institutions. Meanwhile growing funds drive more competition for investments, raising investment prices and reducing their returns.

Second is the slower growth of relatively safe investable assets with reasonable yields. Many bonds are trading with low/negative yields and major equity markets continue to appear highly priced, offering low ex-ante returns. Real estate investments look increasingly attractive by comparison, driving investment funds into the sector.

Third, we are in a low return environment with low interest rates driven by moderate to negative demographics in most high GDP countries, higher debt levels, and slowing productivity growth. Further, there are generally low risk premia over one-year investing horizons and global capital flows are driving a convergence toward low returns across markets.

That said, there are factors which could change my 2020 view. Unexpectedly high inflation is one. That could raise nominal discount rates driving down nominal prices and one-year total returns. Another would be a severe capital market disruption (monetary or fiscal policy, trade, destruction of financial capital could each cause a disruption) that damages confidence and increases liquidity preferences.

Widening risk

If we avoid these problems, then a likelier candidate to impact 2020 returns is a gradual widening of risk premia either absolutely or relatively for real estate investments. So, what might drive an increase in real estate risk premia pricing, and how would that be reflected?
Risk premia might widen due to an increase in the pricing of systemic risk – generally priced low today. If investors become increasingly uncertain over future events, their term premia will go up. If they become less comfortable with current events, the level of one-year risk premia will rise from their generally low levels.

“There are factors which could change my 2020 view. Unexpectedly high inflation is one”

Relative risk perceptions across asset classes could shift. For example, if real estate were perceived as more risky than other asset classes – let’s say due to a growing perception of previously unforeseen environmental remediation or climate change costs – then real estate would reprice downward against other asset classes, even if the level of systemic risk was relatively stable. Real estate returns would suffer under all these scenarios.

While the best bet for tomorrow is that it will be similar to today, shocks to the pricing of risk can occur that could drive a significant negative repricing of real estate, even in a low interest rate environment.

Beware of risk pricing! And plan your portfolio risk management accordingly.