Author: NN Investment Partners
We see signs that US – and to a lesser extent also European – commercial real estate segments are having increasing trouble with digesting digital disruption in retail space. Hence we downgraded global real estate from overweight to neutral in our tactical asset allocation.
The market environment has not been very friendly for global real estate equities this year. Year-to-date, the asset class (the FTSE EPRA/NAREIT Developed Markets index) has lost almost 6% measured in euros. At first sight, one might think this has something to do with the upward drift in bond yields, as real estate performance is usually negatively correlated with (long-term) bond yields.
Bond yields do not explain US real estate underperformance
However, as US 10-year bond yields have been in a downward slope for most of the year, this should have been more a headwind for the Eurozone than for the US. Yet, in reality Eurozone real estate has done 5% better than US real estate YTD. Historically, the real estate/interest rate cycles of the US and the Eurozone are comparable, but not this time. This discrepancy is well illustrated in the chart above, which plots the performance of real estate relative to the return of the local bond market. The graphs of the US and the Eurozone have started to diverge since April of this year.
Retail real estate under increasing pressure from online retail
Hence, we think factors other than the bond markets have been at work. Probably the most important one is the structural shift that is taking place in the retail real estate segment from the traditional brick & mortar towards e-commerce. This shift is more advanced in the US than in the Eurozone. The chart below shows that especially in April and May this shift is likely to have impacted market performance. The chart shows the performance of the retail and residential real estate segments in the US and Europe. Although the performance gap is very clear for the US, we can see that Europe is not immune to this trend. Also here we observe a similar performance gap between retail and residential real estate. But given the more balanced sector composition between both segments in Europe, the impact is less and explains why the Eurozone real estate market has done better. And because US retail real estate represents about 12% of the global real estate benchmark, this explains the negative impact of the sector on the global index performance. In comparison, European retail represents 4% of the global index. For residential real estate, the weights are 10% for the US and 4% for Europe.
Amazon is shaking up the retail sector
Going forward it is likely that the structural headwinds for retail real estate will continue to build. The growth prospects for retail are best illustrated by Amazon targeting new verticals in the retail distribution channel. High Street book stores were driven out of business years ago, but now also food, drug and convenience retailers are under threat. Last June, when Amazon announced the takeover of Whole Foods Markets, the sixth-largest US grocery store, shares of food retailers around the world came under heavy pressure. This USD 13 billion deal happened just two years after Whole Foods’ CEO John Mackey predicted that Amazon’s grocery delivery service, through its AmazonFresh initiative, would be “Amazon’s Waterloo”.
It now appears that these reports of “Amazon’s death” have been greatly exaggerated. The company continues to gain household wallet share. It has built a superior infrastructure, has a strong mobile presence and a loyal, almost captive customer base. There are still ample secular growth opportunities for online retail. Even in the US, online penetration is only just over 10%. We believe there will be more disruption and traditional retailers will become under increasing pressure to adjust their business model and, for example, invest heavily in technology solutions.
These developments are likely to keep profit margins of the retail sector under pressure. Retail profitability, together with footfall (the number of visitors), is an important metric to determine the rental price for a store. There is a real risk that this trend will intensify also in Europe, even if the largest quoted companies active in this retail segment (Unibail-Rodamco and Klépierre) have a prime portfolio that should, in theory, resist better.
Outlook for residential real estate is better
The outlook for residential real estate looks better, even if this segment may be more sensitive to a rise in (mortgage) interest rates. House prices are rising and cash is plentiful, as lending standards have become easier. In the US, house prices have increased around 5.5% year-on-year. Also in the UK the average house price rose over 5% outside London and even 10% in London (mix-adjusted). In Germany, the most important market for residential real estate, the latest figure was 6.5%. This represents nevertheless a slowdown from the double-digit growth at the end of 2016.
Having said this, most cyclical drivers of real estate are supportive. A strengthening labour market and accelerating corporate profits should lead to an increase in confidence and higher demand for office space, logistics and housing (rental or ownership). The better prospects for residential housing might mean that the European real estate market looks like a safer bet, although the probability of an earlier or steeper monetary policy normalisation of the ECB is a risk factor. We do however not expect this to happen.
We downgraded global real estate to neutral
Although the cyclical outlook remains supportive, the structural headwinds for real estate such as e-commerce, and to a lesser extent the trend of decreasing office space per worker, are reasons for us to downgrade global real estate from overweight to neutral in our tactical asset allocation.