Positioning for the next real estate cycle
Real estate markets experience ups and downs, as they are deeply intertwined with business cycles. Hence, it is important to find out where we currently are in the business cycle, in order to adjust the portfolio allocation accordingly.
The 4 phases of the real estate cycle
Phase I: there is a high volume of sales on the market. Rents fall, and net initial yields rise, as investors require higher risk premia. This happened during the Global Financial Crisis.
Phase II: rents continue to fall, with net initial yields stabilizing. This was the case 2-3 years after the Global Financial Crisis.
Phase III: also known as the "Goldilocks"-phase. In this phase there is an ideal environment for real estate investments. Net initial yields start to fall, whereas rents increase. This happened during the last 3-5 years.
Phase IV: net initial yields stabilize, rents keep increasing, as there is still a dynamic market. This is the phase in which we currently are at or are gradually approaching.
Markets are approaching the last phase of the cycle — scenarios
By taking a closer look at prime rents and yields in over 100 markets, it becomes clear that Europe is just before or at the end of phase three, and slowly entering phase four.
This is obviously a generalized view, as some markets, e.g. London and Warsaw, are already in phase four, and other markets, such as Paris and Munich, are at the end of phase three and entering phase four.
Some leading indicators are pointing to a slowdown of the pressure on prime yields. Moreover, interest rates are expected to gradually increase.
Considering the current market environment, the focus should be on stabilizing or increasing income. Unnecessary risks should be avoided, and existing exotic investments gradually exited. At the moment, investors with long-term strategies shouldn’t be too risk friendly.
As the European real estate markets are entering the fourth and last market cycle phase in 2018, investors may benefit from a defensive investment approach, and from the acquisition and disposal of stabile assets. Lower yields should be accepted, instead of seeking higher yields that with a high likelihood may not be achieved.
Moreover, investors should sell assets that highly correlate with business cycles, i.e. those with short-term rental contracts, and older existing properties. Instead, the focus should be on defensive investment opportunities, in order to hedge against structural changes in cities and overall demographic changes. These include, among others, office properties in core central city locations with significant rental upside potential, urban logistic assets, and retail parks, especially the ones that successfully tap the growing “click-and-collect” market.
We recommend investments in assets with high alternative use capabilities, in growing sectors, and with rental upside potentials.Dynamic cities, that are profiting from the overall positive development in Europe, should particularly be targeted by investors.