Continued underperformance has left listed property markets in most countries at the lower end of their five-year net asset value (NAV) range and most trade at discounts to their NAVs, representing what we believe are attractive valuations. Those discounts mean that it’s cheaper to buy listed properties than to assemble a portfolio in the private market. Historically, when discounts occurred in periods of economic expansion and strong fundamentals, just like now, investors have been rewarded with compelling returns over the next 12 months.
Although volatility in real estate stocks may continue in the short run as investors seem focused on interest rates, bond yields are rising because of stronger growth and signs of higher inflation, both in US and abroad. We believe commercial real estate should continue to see improving operating fundamentals in most global markets amid solid economic growth, steady job creation, reasonable new supply levels, and monetary conditions that should remain relatively accommodative even as stimulus is gradually withdrawn.
We anticipate that real estate demand in US will moderately outpace new supply across most sectors in the coming months, but cyclical and secular changes to some sectors will result in widely divergent operating results. West Coast central business district offices should continue to benefit from strong job creation and low speculative supply, while New York and other East Coast office markets are decelerating due to substantial supply and weaker demand. Residential sectors are also benefitting from healthy demand, while supply remains in check in most markets. Data centre growth prospects remain attractive, in our view, due to the structural growth in e-commerce and cloud computing, coupled with the high costs and technical requirements of building new space.
Property markets on the continent are likely to continue to benefit from strong economic activity in the region. We favour residential property owners in most markets—Spain and Germany in particular. Economic growth is likely to remain robust in Spain, with office landlords being a primary beneficiary. Offices in France also appear attractive given the sector’s strong fundamentals.
In light of our relatively negative view of economic prospects for UK, we favour companies that we believe feature more defensive or structural growth characteristics and that will likely remain relatively insulated from an economic deceleration. These include logistics warehouses, student housing and health care landlords. While these sectors remain our focus in UK, certain office landlords appear attractive based on improving valuations.
Japan and Australia offer select areas of opportunity. In Japan, we remain positive on developers given attractive valuations and solid fundamentals. We maintain our preference for certain J-REITs that offer the ability to deliver relatively stronger dividend yields and/or earnings growth. In Australia, the Sydney office market is expected to experience net demand growth, boosting property occupancy and rental rates. We also favour logistics landlords, which are experiencing strong demand from the growth in e-commerce.
Approaching with caution
We remain moderately underweight in US due to what we believe are more attractive opportunities elsewhere. We are most notably underweight retail in light of the secular headwinds facing the sector. Secondary and some prime retail malls and shopping centres remain under pressure from the secular growth of e-commerce. We expect shopper traffic and ultimately tenant demand to steadily decline at poorly positioned locations, while the most-attractive shopping destinations in each market will survive and perhaps even gain market share as others close. We are also underweight health care, where we believe government reimbursement rate cuts, supply growth, operator pressures, and generally higher interest rates will continue to depress the sector. Additionally, we remain underweight industrial properties because their valuations have become excessive relative to growth, in our opinion.
We remain negative towards UK retail sector due to the damaging effects of Brexit, e-commerce, and our negative macroeconomic outlook for the country. High occupancy costs may also prove to be a headwind for the profitability of retailers and department stores.
Singapore and Australian retail. While the Singapore economy is improving, with global trade boosting exports, valuations have become stretched and offer little upside. Suburban malls face growth challenges with supply accelerating and e-commerce penetration still low. We expect pressure on capital values over time, especially if the monetary backdrop tightens. In Australia, retail spending trends at traditional shopping centres are weakening following the arrival of Amazon, which is disrupting the Australian market in the same way it has in the U.S.
Hong Kong interest rates are primarily influenced by US, so a tighter Federal Reserve policy could weigh on real estate securities there. However, the flow-through of higher rates to residential mortgages is limited, as southbound capital inflows from mainland China are largely offsetting the outflow from global tightening concerns, and the economy is growing at what we believe is a healthy pace, aided by stable domestic consumption and better external trade. The net effect is that consumption demand remains strong, and office fundamentals are supported by low vacancies and demand from Chinese companies, driving healthy development and leasing activity for landlords.
Jon Cheigh, executive vice president and head of Global Real Estate at Cohen and Steers