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Real estate investment: why cash flow is king

Robert Game is Head of Real Estate Advisory at The Citigroup Private Bank Europe.

Although signs of economic recovery are emerging in key markets around the globe, Robert Game suggests that investors looking to extend their property portfolios should look at the big picture before taking the plunge, particularly in terms of capital appreciation versus wealth preservation

Real estate is an important part of a high net worth individual's (HNWI) portfolio for two reasons. Primarily, real estate can be used within a portfolio as a means of diversifying risk. But real estate has another allure. It is probably the ultimate status symbol, providing a cachet that is simply not there with most other investments.

When planning or extending a portfolio, it is important to look beyond this, to take a holistic view of what you are trying to be achieve – is it capital appreciation, or wealth preservation? Are you risk averse or are you happy to look at more potentially volatile investments?

Real estate and liquidity
Traditionally, there has been a good risk/return relationship associated with investments in commercial real estate – meaning that real estate is less volatile than equities over an extended period, yet providing comparable returns, as well as a steady income. Investors have become accustomed to real estate outperforming other asset classes. Latterly, this relationship has looked even more healthy as we have seen increases in the price of investment properties. This has been driven in part by a lack of interest in the equity markets – money likes to work, but the HNWIs' attraction to property began long before the equity market massacre. However, real estate is considerably less liquid than many other asset classes and this should be taken into consideration.

Understanding the place that real estate assumes within a portfolio is only the start. A key to successfully investing in particular asset classes lies in being able to forecast their behaviour – in terms of long-term return and risk – which requires knowledge of the underlying economic drivers. This is as true for real estate as it is for any other class of asset. So what have we seen in the wider economic market in 2003 that has affected investor behaviour in the property market, and what can we expect to see this year?

Rising equity markets
Last year saw a steady climb in the equity markets, strong economic growth in the US with more limited growth in the Eurozone and Japan, and a successful conclusion to the Iraq campaign, which has relieved some of the uncertainty investors had been feeling. However, there remains residual uncertainty in the markets over such issues as the stop, start middle east peace process and fundamental concerns over the US current account deficit and falling dollar.

For 2004 the best forecasts suggest a continued improvement in the international climate, off the back of an ongoing period of growth in the US, with business investment picking up and a revival in corporate IT spending. That having been said, investors will still need to be prudent, since the slow growth of the world economy is creating stress in many US and European real estate markets.

In 2003 many HNWIs held off investing in the real estate market or bought into secure positions – opting for more risk averse options. In the main, HNWIs have been looking to protect capital and this means they have bought in mature, established markets, in properties which have long leases and secure tenants. There are of course investors who have speculated on the health of the market, but I feel they will be the losers in 2004.

Soft rental markets
Prudent investors have been waiting for a price adjustment. Returns for real estate fell in 2003, because of the soft rental market, but this has not translated into a fall in prices yet. The signs are there – office rents and tenant demand is soft in all markets. Right now we are in a tenants market, where they have the power to negotiate favourable rents. In certain markets, take-up rates are below their historic low and there is now a significant surplus of vacant accommodation which, when compared with average take-up figures, could take a number of years to absorb. Given the plethora of available office space, it looks like rents will remain flat for at least the next year and possibly beyond.

I would not be surprised to see strong pricing maintained by the weight of investor money in early 2004. The second half of the year could see prices ease by as much as five to 10%, particularly for the least desirable properties and in the most troubled markets. An underlying cause of this might be a shift in lenders' attitudes away from weakening cashflow. This could create selling opportunities in the near term as well as buying opportunities further down the road.

Which all adds up to a flight to quality. Anything else, and investors will end up paying a premium for risk. Looking at the market, there doesn't appear to be enough differentiation between risk and return for some people. This will almost certainly change. HNWIs need to position themselves to take advantage of any price rises. It is worth buying into long-term income streams as they are in a better position to ride out any downturn in the market.

Emerging markets
As the real estate market continues to soften globally, some investors might be attracted by the prospect of investing in emerging real estate markets such as eastern Europe and China. Several of the eastern European markets have already seen substantial growth with some serious German investments, but I do not believe that they have the political stability, maturity, transparency and legal framework to undermine traditional centres – at least not for a number of years.

It is true that in some emerging markets, demand remains strong, but only in certain key spots. Investors need to be careful when looking at these markets – there are many variables. Beware of currency and interest rate risks – borrow in local currency and hedge against interest rate movements. Tax regimes need to be scrutinised also – they could quite easily change with little notice. Also, in determining the sustainability of prices in markets like China you should consider how easy it is to turn on the supply pipeline. I would be hesitant about investing in these types of markets for the foreseeable future.

Globally, commercial real estate will continue to be an attractive long-term vehicle for investors who are looking for portfolio diversification as well as a source of relatively steady income. However, they and market forecasters appear ignorant of the falling occupancies, rents and the threat of rising interest rates. This should be a warning signal. In this scenario, investors should go back to basics – remember, cashflow is king.

Which asset class?
In 2004 investors should tread cautiously. Certain institutional investors are holding off from the market because prices are too high. I would advise HNWI investors to do the same, at least until the back end of the year. We have seen that real estate has slowed across most markets. It can only be a matter of time before the remaining markets follow it as investors look to put more money into other asset classes as their appetite for risk increases.

Some analysts within the real estate industry argue that strong capital flows to real estate are here to stay. These proponents of low capitalisation rates for real estate argue that weak performance in the other investment sectors and a steady cashflow from real estate will keep prices high.

Other analysts however, argue that low capitalisation rates are merely a result of low interest rates, the existence of long-term leases that have yet to expire and a current, but temporary, lack of performance from other investment sectors. While it is not clear which pricing scenario will play out, this is not the first time that real estate insiders have proclaimed that low capitalisation rates were here to stay, only to see them rise substantially.

Steady as she goes
My view is that capitalisation rates will increase over the next 12-18 months and prices will fall as result, perhaps 5-10% on average for commercial real estate. This, in turn, will create new buying opportunities in the future and a number of selling opportunities over the next few months.

I do not expect to see the pricing adjustments approach those of the early 1990s. Low interest rates, better underwriting standards throughout the past real estate cycle and heavy capital flows from foreign buyers and institutions should limit the downward pressure on real estate prices.

This means that with most real estate prices remaining high and continued high vacancy rates and weak demand, the focus for investors should be towards stabilised income-generating real estate opportunities rather than opportunistic capital appreciation investments that traditionally exhibit higher volatility. Short dated cashflow properties look particularly risky – there is too much emphasis on being able to generate cashflow and not enough on absolute returns. In short, look for properties with long-term secure tenants, such as governments, and don't overpay for risk.

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