Income from the fringes

Real estate returns, while relatively safe, are likely to shrink in some sectors, writes Roxane McMeeken.

The quest for portfolio diversification will lead European investors to boost their allocations to real estate. While the returns yielded by this asset class are set to slow slightly, it will remain a decent performer and an increasingly popular route to spreading risk. So says the latest research from global property expert, LaSalle Investment Management. Gerry Blundell, head of European strategy and author of the report, says: “real estate offers a potent source of diversification from equities and bonds for two reasons:

• first, it offers truly local exposure, reflecting the fortunes of the economy in which it is situated, and
• second, its form of contract means that income stream is more predictable than equity dividends.” Local exposure According to LaSalle, because of the fixed nature of its business, property offers local exposure to an economy – sometimes even at the City rather than regional level – in a way that equities and bonds do not. The latter two increasingly reflect international influences in their pricing and their returns and are therefore more synchronised. Property is also an attractive source of diversification because – at least in continental Europe – leases tend to be 10-15 years long, with changes of tenant frequently occurring at three or five year intervals. In the UK and Ireland, longer unbroken leases are the norm, with upwards-only rent review steps every five years. All this means that the income from real estate is much more predictable than equity dividends. Also, low vacancy rates compared with, for example, the US, inhibit tenants from breaking contracts. As a result, real estate returns are less volatile than those of equities. The form of contract further reduces real estate’s risk to equities and bonds by having a senior claim on tenants’ cash flow, ahead of dividends and bond coupons. It is also payable in advance as opposed to in arrears and in most European contracts is exclusive of insurance, repairs and local taxation, which are the responsibility of the tenant. Tougher times However, Mr Blundell admits that European real estate returns might soon suffer a setback. The average return on a property investment throughout the present bear market has been 8 per cent. This is particularly impressive compared to average equity returns, which for the past three years have been down 19 per cent. But LaSalle estimates that the next three years will be tougher for real estate, with some returns falling to 6 per cent. This is largely due to the knock-on effect that the bursting of the TMT bubble is having on property investment, in particular the office sector. However, the LaSalle report emphasises the robustness of the warehousing and retail sectors, noting that returns of 10 per cent will still be possible to achieve. Fringe markets Mr Blundell says that real estate yields are likely to be compressed in Europe because of the increase of fund flows into the asset class, particularly in the relatively illiquid markets of the fringe regions surrounding the older economic core of Europe. Nonetheless, he says that some of the best opportunities will be found in the fringe markets, which are growing at 3 per cent a year. “Both warehousing and retail sectors will reward providers of appropriate space,” says Mr Blundell. Meanwhile, “superior returns will be largely driven by timing”. The influx of investment in European property will be facilitated and perhaps even spurred by the emergence of relatively tax efficient vehicles. Currently the majority of real estate investment is carried by institutions taking direct ownership.

‘Real estate offers a potent source of diversification from equities and bonds’
Gerry Blundell, LaSalle