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Articles

Tailwind Waning for Real Estate Funds and Real Estate Equities

The returns on indirect real estate investments such as real estate funds and real estate equities are still impressive, as illustrated by the Credit Suisse study on the real estate market in 2018. Low interest rates and high premiums for real estate funds are likely to shape the market in the next few years.

Thanks to the end-of-year rally, investors in indirect Swiss real estate investments can look back on another successful year. With an overall performance of 10.1% (listed real estate equities) and 6.6% (listed real estate funds), the outstanding results of 2016 were only marginally fallen short of despite the fact that the interest tailwind subsided somewhat and another high volume of capital increases and new listings (around CHF 3 billion) was recorded for funds.

However, the performance was significantly down on the previous year in relation to foreign real estate investments and investment alternatives at home, with the Swiss Performance Index achieving a total return of 19.9% and real estate equities in the Eurozone performing even better at 27.3%.

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Performance of indirect real estate investments

Overall performance, index: 1 January 2016 = 100, return on ten-year Swiss government bonds

Past performance is no guarantee of future results. Performance can be impaired by commissions, fees and other costs as well as exchange rate fluctuations.

Source: Datastream, Credit Suisse

Low Interest Rates Supported Real Estate Investments

Equity prices were boosted by the depreciation of the franc in combination with an economic upturn. However, the upturn also entails an increased risk of higher interest rates that would curb real estate investments. The possibility of the Swiss National Bank (SNB) already carrying out an initial hike of base rates in the current year has increased due to the improved economic and exchange rate environment.

However, we consider it more likely that the SNB will wait for an initial interest rate move by the European Central Bank and not take any action before 2019. The underlying macroeconomic and monetary conditions are thus set to support real estate investments for a further year and prevent a slump in performance despite the tense situation on the end user markets.

Real Estate Funds Considered Alternatives to Bonds

The core driver of the premiums (agios) paid on the stock exchange on the net asset values of real estate funds is the long-term interest rate that is negatively correlated with agios. The reason for this is that investors consider indirect real estate investments as an alternative to corporate and government bonds and reallocate their money via this substitute depending on the interest rate level.

Economic growth also exerts an impact on agios. However, in this case the correlation is positive as the real estate earnings prospects also rise as the economy prospers. Finally, capital increases, new listings and launches also play a significant role as they bring about a redistribution of assets for instance from index-based funds and are therefore negatively correlated with agios.

Premiums for Real Estate Funds Likely to Remain Nearly Consistent on Average

Based on the above factors, Credit Suisse has developed a forecast model for the performance of the agios of real estate funds. The average agio level of 2017 (around 30%) is set approximately to be maintained in the next five years (27%–29%), although significant ups and downs are likely in the short term. The main determinant of the forecast development is the long-term interest rate that is on average also likely to remain at a low level over the next five years.

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Agios of real estate funds incl. forecast

Estimated and observed agio, as % of net asset value (listed real estate funds); dashed: forecasts and scenarios

Past performance is no guarantee of future results. Performance can be impaired by commissions, fees and other costs as well as exchange rate fluctuations.

Source: Datastream, annual and semi-annual fund reports, Credit Suisse

No Scenario Projects Increasing Premiums for Real Estate Funds

The strong and the weak scenario lie very close to each other, which can partially be explained by contrary effects of the factors. According to the model, the highest agios result in the weak economic scenario shaped by low long-term interest rates and modest economic growth.

We have additionally predicted a scenario in which long-term interest rates develop in a similarly dynamic manner to between 2005 and 2008 when the longterm interest rate went up from 1.9% to 3.3%. In this scenario to which we only attribute a low probability of occurrence, the agio would decline by around ten percentage points over the coming five years. There is therefore no further tailwind to be expected from the agios in any of the scenarios considered.

Median Return on Real Estate Investments Declines

Apart from the agio, we must also include the two other core components, the dividend yield and the change in the net asset value, in determining the outlook for the total returns of indirect real estate investments.

A slightly adapted model that alongside long-term also takes account of short-term interest rates has therefore been used to create a forecast of total returns. This model yields an average total return for the next five years of 3.5% to 4.0%, which would entail a clear decline compared with the previous five years (5.8%).

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Return on indirect real estate investments

Annual total return of SXI Real Estate Funds Index; dashed: forecasts and scenarios

Past performance is no guarantee of future results. Performance can be impaired by commissions, fees and other costs as well as exchange rate fluctuations.

Source: Datastream, annual and semi-annual fund reports, Credit Suisse

Return on Real Estate Funds and Real Estate Equities Likely to Remain Positive

Although the agios disappear as return drivers, they do not exert a negative impact as no major changes are expected for them in the main scenario. However, the net asset values are set to perform worse than in the recent past owing to the sideways trend for long-term interest rates and the slight upward trend in short-term interest rates.

In the alternative scenario in which not only long-term interest rates rise sharply but the base rate is also hiked at a similar speed to between 2004 and 2008, we expect a considerably lower but nevertheless positive annual total return of 1.3%. Altogether we therefore anticipate a slight downturn in the performance of indirect real estate investments in the next few years but not a collapse of the market.