Capital flows

The movement of capital from East to West is likely to remain the major influence on real estate in 2015, according to interviewees and respondents to the surveys conducted for all three Emerging Trends in Real Estate reports.

Asia has seen a structural shift in the last couple of years in the role that its institutional capital - from sovereign wealth funds, pension funds and insurance companies - is now playing in the industry, with a big increase in local money being directed into global markets.

For now, much of this new capital is sourced from China and South Korea. In the future, it is likely to be supplemented by substantial amounts of pension fund capital emerging from Japan.

At the moment, this money tends to be targeted at core assets by way of direct investments in gateway cities in the US and the UK. New patterns are evolving, however, according to the three reports.

As more capital flows into these cities and as Asian investors become more experienced in operating internationally, new investments are now being directed at assets in Germany and France - primarily Paris - and into US cities such as Atlanta, Chicago and Houston.

Another new trend is an increase in the volume of private capital originating from Asian markets. This has been led by a group of large Chinese developers - although Singaporean and Malaysian players are also prominent - that invest mainly in residential projects both regionally and globally, and whose products are aimed largely at buyers from mainland China.

The conclusions of the three Emerging Trends reports follow another strong year for direct investment. According to Real Capital Analytics (RCA), transactions involving income-producing real estate totaled $770.2bn globally in 2014, up 9 percent from 2013. Sales of developable land added another $373.3bn to the total, albeit 29 percent lower than in 2013 due to slowing of activity in China.

RCA says Europe attracted well over half of all cross-border investment in 2014, indicating that investors still perceive good value in property there despite economic uncertainty across much of the eurozone. “What's really driving all this activity is the availability of capital rather than the underlying fundamentals. It just comes down to people needing to deploy capital,” says one banker interviewed for Emerging Trends Europe. Another interviewee claims: “The wall of money is even bigger than before the crisis.”

Last year's Emerging Trends Europe found cautious optimism over an increased availability of equity and debt, and the need to be the best of the best to win either. This year, it is a given that capital of all kinds will be flowing much more freely in most markets.

Of those canvassed by Emerging Trends Europe, 56 percent expect there to be moderately more equity in the market in 2015, with 15 percent expecting it to be significantly greater. Sovereign wealth, superannuation funds and institutional investors of all stripes are “shifting from fixed-income to real estate”. European respondents anticipate that much of the capital will come from the Americas as well as Asia Pacific.

But as one interviewee observes: “The availability of capital, whether it is equity or debt, is not an issue. The problem is more that there is too much equity and debt and too few investment opportunities.”

The corollary of so much capital focusing on limited real estate stock is higher prices. Core property is overpriced in almost all markets, say 61 percent of those surveyed. “If you have the capital, you should have spent it yesterday,” says one UK opportunity fund manager.

Unsurprisingly, around the same proportion who think core property is overpriced - around three-fifths of Emerging Trends Europe respondents - say that finding the required rate of return will involve taking on more risk.

But if spending the money effectively is a challenge, there is no doubt that it wants to go into real estate. The overwhelming majority - 70 percent - of those surveyed by Emerging Trends Europe expect more equity and debt to flow into their markets in 2015. What is more, 83 percent believe capital flows from Asia Pacific into European real estate will increase in 2015.

Much the same sentiment is evident in the US, where international investment has been ramped up over the past year. From coast to coast, Chinese investors, for instance, have been grabbing headlines with deals like the $1bn acquisition by Greenland Holdings of the Metropolis project in Los Angeles from CalSTRS and its 70 percent stake in Brooklyn's 14-building Atlantic Yards development, joining Forest City Ratner. China Vanke, meanwhile, is working with Tishman Speyer in a 655-unit apartment project in the South of Market neighbourhood in San Francisco.

Yet China is just one of many sources of inbound investment, albeit perhaps the most visible because of the predilection of the Chinese for eye-popping deals.

Emerging Trends interviewees know first hand the breadth of the offshore equity capital rushing into the US.A New York-based value-add owner/ operator rattles off those buying pieces of his deals in the past year: “Israelis, Koreans, Egyptians, Russians, Mexicans and others have all come to us for a piece of Manhattan.”

Gateway cities are still the principal targets for offshore investors, with the list now including Houston and Seattle in addition to the big California markets, Miami, and the Boston-Washington corridor. And according to one investor, “The heartland is now actively considered by Russian, South American, Middle Eastern [and] Asian investors. They like the fundamentals but are really capital [yield] driven.”

There is the strong prospect of more capital. According to Emerging Trends Asia Pacific, the new institutional players from Asia either have new capital to deploy, want to invest in real estate for the first time or are increasing existing allocations. Right now, Asia-based investors on average currently have allocations to real estate of 6.9 percent.

The expectation is that they will increase to thresholds common in the West, such as 10.2 percent in Europe, and some interviewees suggest that 12 percent could be the Asian benchmark.

Longer term, global real estate markets could also benefit from Japanese pension funds. These funds - in particular, the US$1.2 trillion Government Pension Investment Fund (GPIF) - hold some of the largest pools of capital in the world today, mostly in the form of low-yielding Japanese government bonds (JGBs). Changing demographics in Japan mean these funds must now boost income beyond what they earn via JGBs.

But just as the flow of capital from Asia has boosted investment activity in the US and Europe, transaction volumes have fallen in many Asian markets. As Emerging Trends Asia Pacific points out, one reason so much new Asian capital is suddenly in international circulation is that some of the institutions have accumulated more capital than can be deployed at home without distorting their local markets.

One interviewee observes, “I think the market in Asia is pretty flat - we've had pretty much a ten-year bull market and rents are softening, so why buy in Shanghai at 4.5 percent net yield when I can buy in London and other markets at 5 percent to 6 percent? I think we're going to see a very slow Asia for the next 12 months.”

There is another important consideration for investors across all three regions - “event risk”. Geopolitical risks multiplied in number and intensity in 2014 and threaten to escalate in 2015, and that has pushed the notion of “flight to safety” in global capital to the fore. In that context, many real estate markets tend to look safe, at least when compared to equities.

For the time being, there are probably more concerns over pricing than event risks and they are being assuaged by the fact that in a low interest rate environment, the income returns of real estate look good against those of other asset classes.

As one European fund manager puts it, “Real estate just looks so attractive to a pension fund. It is one of the highest yielding asset classes on the planet.”

This is an extract from Emerging Trends in Real Estate: The global outlook for 2015. See www.pwc.com/emergingtrends.