But as the economy becomes increasingly digital and we can shop, work and entertain ourselves from the comfort of our homes, will this relationship break down? Probably not, but the relationship is changing, different factors and new opportunities are emerging.
This piece was also published by React News on Thursday 9 November 2023.
Economic shocks and the effects of monetary policy
The correlation between the UK’s GDP growth and UK ‘All Property’ total returns since the 1980s is 0.47, demonstrating a clear positive relationship – the strongest correlation with economic growth of all the major asset classes. The correlation between UK property returns and GDP was strongest in the 1980s and 1990s — at an average of 0.7 – before drifting lower to average 0.3 in 2012-22.
Recent economic shocks and the effects of ultra-loose monetary policy temporarily boosted the correlation. But, after adjusting for these exceptional events, the relationship seems to be softening. We see four main reasons for this.
First, there has been significant growth in international capital flows, diversifying the capital-market pressures. Cross-border capital now accounts for half of all property transactions in many countries, influencing capital-value trends and distorting domestic-market pressures.
Then there’s no denying that real estate has become institutional and increasingly compared to investments in fixed-income assets. So, the relative pricing of assets has begun to influence property valuations, at times more than underlying economic growth. The use of borrowed money and debt costs have further diluted the link to economic growth.
Also, in addition to offices, retail, industrial and multi-family properties, the property sector now includes ‘operational’ assets, such as student accommodation, data centres, healthcare facilities, cinemas, marinas and even cemeteries and golf-driving ranges. The INREV ODCE index – which covers diversified European property funds – has a 17% weighting to so-called ‘living’ sectors (as of June 2023), up from less than 1% in 2018. These sectors are less tied to short-term economic developments.
How real estate plays a significate role in sustainability
Then there is sustainability. Real estate is responsible for some 40% of global greenhouse-gas emissions, so ESG credentials now play a significant role in differentiation. Polarisation is emerging; some offices may become ‘stranded’ assets, while other energy-efficient properties should be easier to lease and carry lower capital-expenditure requirements to meet decarbonisation targets. This could be the most important driver of real estate performance over the coming decade.
At abrdn, we don’t think the relationship between real estate and GDP growth will completely fade as in a downturn, we do need less space, financing is tougher, and investors retrench.
Some sectors will sustain a stronger link to the economy. ‘Pro-cyclical’ sectors – offices, retail, light industrials, logistics and leisure – are likely to hurt more during an economic downturn and recover faster when the economy rebounds.
At abrdn, we believe investors are still not factoring in the effects of climate change…asset quality and building efficiency will be key drivers of performance, so should be a significant focus.
Meanwhile, sectors such as residential, student accommodation, senior living, healthcare, and data centres are likely to be resilient due to other long-term demand drivers. For example, France’s over-65 population will grow by some 5 million by 2050, but the provision rate of publicly or privately financed later-life accommodation is less than 4%. This applies in most countries.
Real estate and longer-term returns
So, is real estate the perfect inflation hedge? The short answer is no. The longer answer is, partially. Real estate total returns demonstrate a low annual correlation with inflation (even when lagged), so would not constitute a perfect hedge. However, over the long term, the asset class has delivered above-inflation ‘real’ – inflation adjusted – total returns, supported by resilient cash flows and capital appreciation.
Comparing inflation-adjusted real estate returns against inflation-adjusted government bond returns paints a clearer picture. Since 1988, real UK government bond returns have delivered -0.1% per annum, while real UK real estate returns have delivered roughly 6.3% over the same period. That is a healthy relative return, even factoring in the risk premium required to invest in illiquid real estate assets. It has happened in other countries too.
In the short term, we are moving through a distinct three-phase real estate cycle. First comes, re-valuation – an ongoing re-adjustment of real estate yields in the higher interest-rate environment. We believe this is about 75% complete, given the expectations for rates to peak this year.
Likely to follow is recession, a period of performance dispersion based on asset quality and the strength of economic linkages by sector. The sectors we believe are the most recession proof are logistics, residential (including private-rented residential, student accommodation, micro-living and senior living) and select components of the core office and retail sectors.
Then we’ll probably see rental growth with elevated cashflow generation and income growth, resulting from a decade of insufficient development and low levels of new supply in the pipeline.
Finally, at abrdn we believe investors are still not factoring in the effect climate change, energy efficiency and regulation will have on real estate performance in the coming years. Asset quality and building efficiency will be key drivers of performance, so should be a significant focus.