by Alice Breheny*
Perhaps the biggest problem for large funds investing in commercial real estate is finding the investments. Certainly that’s the case in Australia and, increasingly, there is only one option: go global. TH Real Estate tells how to go about it.
Investors in search of attractive commercial real estate opportunities must recognise that the asset class has become globalised. Cross-border investment in the sector by sophisticated institutional funds is growing, partly because they have simply outgrown their domestic markets. Another reason is because investors recognise that overseas commercial real estate has a number of important attractions – not least of which is the potential for further diversification within investment portfolios.
As a result, commercial real estate has become a globalised asset class, where investors are increasingly assessing an opportunity relative to opportunities in other countries.
This raises an important question: what is a suitable way of assessing potential risks and returns from commercial real estate, that can be applied to office, retail or industrial opportunities in any city around the world?
In most countries, the yield that is available from a long-term government bond is a suitable proxy for the ‘risk free rate of return’ available to investors. However, there are also four risk factors that are specific to commercial real estate: liquidity, volatility, income security and transparency.
By taking into account the risk free rate of return and the four risk factors, it should be possible to identify the rate of return over a reasonably long period of time – say five years – that is required to compensate for the risk.
Assessment of the risks invariably involves some value judgements. Partly for this reason, a market where the expected return over the coming five years or so is lower than the required return is not necessarily a market that should be avoided. However, it is a market where the particular properties acquired need to outperform relative to others in that market, in order to compensate for the risks.
Four risk factors
Liquidity, or the ability to sell a property at any point in the real estate cycle, is the factor that has the highest weighting in our proprietary TH Real Estate Risk Model. We assess liquidity by looking at the volumes of transactions that have taken place in each city that we consider, plus the share of that city in the relevant global market (office, retail or industrial). New York, London and Paris are the most liquid markets globally. At the other extreme, investors need to take into account the lack of liquidity in struggling markets such as Athens and emerging markets such as Kuala Lumpur.
For a global investor who does not necessarily have a very detailed understanding of the local business culture, the level of transparency in commercial real estate markets is a key risk factor. Global consultants JLL have produced a useful global real estate Transparency Index, which we also incorporate in the TH Real Estate Risk Model. We think that the UK is the most transparent national market for commercial real estate investors. Conversely, cities in China and Malaysia represent the most opaque markets.
Another key element is income security – the quality and length of the underlying rental income stream. We measure income security by looking at the length of standard leases as well as the presence of international occupiers. International retail chains, office or logistics tenants usually have higher covenant strengths than smaller, local organisations. Globally, we consider that the UK and the United States have the best combination of long lease structures and large numbers of tenants with good covenant structures. Chinese cities are in the middle ranking in this respect. Japanese second-tier cities are the weakest.
A fourth key element of the TH Real Estate Global Risk Model is the volatility of income. Some of the cities that score best for liquidity and income security – such as London and New York – are characterised by high volatility of income. Conversely, the larger German cities, and Washington DC are typically less volatile.
Putting it all into practice
Using the TH Real Estate Risk Model to assess office markets around the world, it becomes clear that the overall risk levels are closely associated with the maturity of the economy in question and the overall size of the market. The UK and the United States clearly lead in terms of liquidity and score well for transparency. Conversely, German cities stand out for low volatility of income. This is because the leading tenants include a diversity of non-financial multi-national companies. In the Asia-Pacific region, Australia scores well because of the transparency and the large numbers of multi-nationals that are present in the key markets of Sydney and Melbourne.
Over time, it is possible that conventional wisdom in a number of national markets for commercial real estate will be challenged as commentators increasingly look at risks, returns and valuations in a global context.
Click here for the TH Real estate research, Think Global: Risk and Return
*Alice Breheny is global head of research at TH Real Estate.