Bonanza with «Concrete Gold»

Several Highs in 2019

After just over mid-year, Swiss real estate stocks are up around 17%. The performance of real estate funds is also impressive at just under 12%. While that's less than the broad Swiss stock market, as the Swiss Performance Index (SPI) has already risen by 21% since the end of 2018. However, real estate stocks are significantly less volatile than other dividend stocks.

This particularly defensive character was demonstrated once again last year. During the bumpy period on international stock exchanges, the SPI lost around 9%, the Real-Index only 2%, and the funds slightly more at 5.3%. In general, losses in real estate investments are also rarer than in the broad market.

And what is most important for investors in the long term: Returns are also impressive. Over a 15-year period, real estate stocks are ahead with an average return of 8.9% per year. The SPI achieves 7.4% and real estate funds 5.7%. All this reads like a convincing job application for indirect real estate investments. However, the question must be how long this can continue. In the long run, it should not be possible to achieve higher returns with lower risks, as is the case with Swiss real estate stocks compared to the overall market.

Will the Lean Years Follow?

This question has been in the room for some time. Economists who answer it have been pointing out for years that the real estate market is subject to cycles and that lean years will follow the many fat ones. In addition to general economic development, interest rates play an important role. The low interest rate environment has led to rising real estate prices because numerous investors have replaced bonds with "concrete gold" on a large scale.

Although the returns generated through rental income have been gradually declining for many years. However, this effect was overcompensated by high gains on the value of properties, so that it hardly mattered. Now numerous experts assume that interest rates will not fall further and that the times of valuations are over for now. According to consulting firm EY, these still accounted for an average of 1.6% for Swiss real estate companies in 2018. If this component disappears, it means significantly slimmer overall returns than in recent years.

UBS, for example, expects income returns of 3.3% per year for multi-family homes until 2024. For value development, it anticipates slight corrections, so that the median total return should be 2%. Only through the use of debt capital can this total return be increased somewhat.

However, such warnings have existed for some time, and so far interest rates have only risen temporarily and to a limited extent. They are currently back at historic lows. As a result, the difference between the distribution yields of indirect real estate investments and those of ten-year federal bonds, which is relevant for many investors, has risen noticeably above 3 percentage points and is thus at a record level. According to the vast majority of experts, nothing will fundamentally change that anytime soon.

But even if one takes this effect into account, the high returns that investors have become accustomed to are likely to be a thing of the past for now. Not everything is in order in the real estate market. Due to high investment pressure, a lot has been built, and vacancies have been increasing for some time in the area of residential properties. This increases the risk of write-downs.

Rising Vacancies as a Danger

Such a scenario would suggest that investment pressure will hardly decrease and demand from institutional investors such as insurance companies and pension funds would remain at a high level. A more important role in the medium term should therefore be played by the development of vacancies. In the long run, a structural oversupply leads at least regionally to falling rents and the mentioned write-downs. UBS says that falling rents are replacing rising interest rates as risk drivers.

Vacancies are less of an issue in the office market. Here, a deterioration in the economy is considered the greatest risk factor. But investors don't seem to expect this. According to Credit Suisse, this constellation has led investors to increasingly demand vehicles that have a high proportion of office properties in recent times. This tends to apply more to real estate companies than to real estate funds. The major bank suspects that this also partly explains the better performance of real estate stocks compared to real estate funds in 2018.

Despite the rally in indirect real estate investments, their valuations do not currently appear excessive. This is particularly true for property funds. In mid-July, the average premium (agio) paid on the stock exchange compared to the valuations of real estate portfolios is 25%. This value is well below the highs of 38%. Purely mathematically, there would also be some room upwards if one were to view long-term interest rates as the sole determining factor of the agio or fund prices. In such a view, an agio of over 30% would be justified. The average agio of 20% for real estate stocks also seems moderate compared to the record value of 33%.

But even if the interest rate level is not expected to move noticeably upward in the near future, indirect real estate investments are not immune to temporary setbacks. For stocks, weak phases on the stock exchanges are primarily to be considered. For funds, it is more the extensive capital increases taking place in the segment. When one increases its capital or a new one is launched, especially passive investors reallocate funds from other vehicles.

Lower Returns Foreseeable

In the past two years, shares worth CHF 3 billion each were placed with investors, which temporarily weighed on the prices of real estate funds. There have also been shifts from listed to unlisted vehicles. Although it is currently not easy for real estate companies and funds to obtain attractive properties at favorable prices, there are usually enough properties in the portfolios where renovation or even expansion makes sense. It is therefore not to be expected that capital raising in the segment will decrease abruptly, especially since investor demand remains high.

All this together suggests that the success story of indirect real estate investments will not end so quickly. A sustainable rise in interest rates, which is very unlikely in the foreseeable future, would be most likely to cause a trend reversal. Much suggests that the coming years will be somewhat less fat, but not really lean yet. Corrections due to capital increases would then be more favorable entry opportunities. However, one should also keep an eye on the development of vacancies. Investors will increasingly pay attention to which real estate companies and funds manage to keep these low without making major concessions to their tenants.

(Michael Schäfer)