Alternative investments Yields remain compelling

Yields remain compelling

Alternative investments have become increasingly established as a building block of portfolios, particularly in today’s world of low-for-longer interest rates and yields. They are appreciated not only for their diversification benefits, but also for providing stability to portfolios. We start by looking at real estate, which we expect to see a still positive environment in 2020.

Real estate investors have witnessed a number of structural shifts in recent years. As a result, they have had to adjust their strategy to capture the most promising opportunities.

E-commerce benefits industrial assets

In terms of real estate sectors, we believe that the structural trend away from bricks-and-mortar retail outlets to e-commerce will continue to put pressure on traditional retail locations (e.g. non-prime shopping centers and non-prime high-street stores). In contrast, industrial assets should benefit from this shift as the e-commerce supply chain requires considerably more warehouse and logistics space.

Another much-discussed structural change is the growth of flexible office space, which now accounts for a sizable percentage of total take-up: around 10% in major US markets, 15% in the UK, and 12% in the rest of Europe, according to Property Market Analysis. Investors may be able to increase occupancy levels and widen their tenant base by collaborating with flexible office space providers. That said, the long-term impact on rental values is debatable and there is a risk that large amounts of office space are released into the market when short-term leases expire.

Focus on income generation and uncorrelated investments

The projected environment of moderate economic expansion and accommodative monetary policy is in general supportive for both listed and direct real estate worldwide. Against this backdrop, we prefer direct real estate where lower interest rates do not yet appear fully reflected in the price. While property yields in most real estate markets are at the lower end of their historical range, recent rate cuts are likely to attract further investor capital. Returns in direct real estate tend to be rather stable due to the rental income component, which is favorable in a potentially volatile late-cycle environment.

Yields on bonds, global equities and real estate equities (in %)

Real estate yield advantage persists

Yields on bonds, global equities and real estate equities (in %)

In terms of investment strategy, we look for high quality assets where the fall in yields is not yet fully reflected in valuations (e.g. core assets focusing on properties in good locations with long-term leases). So-called value-add strategies, which have a low correlation to the overall market, may also generate excess returns. Here, value is added by actively reconfiguring and refurbishing properties, for instance.

In contrast, global real estate equities already reflect lower rates with historically high valuations. Moreover, earnings upside is limited as growth slows in underlying markets. While multiple expansion and lower yields drove most of the strong 2019 performance, we expect this to be less the case in 2020.

Seek regions with high dividends

From a regional point of view, we focus on relatively high dividends rather than growth. As such, we favor the Eurozone with a yield spread over government bond yields of approximately 500 bps as of the editorial deadline, which is above the long-term average. In case of an orderly Brexit, we also believe that UK listed real estate offers potential given undemanding valuations, the conservative debt structure of real estate companies, and a potential rebound in underlying markets, especially London office space. Upside for US listed real estate, however, seems limited as lower interest rates and improving earnings expectations are already reflected in the pricing.