Tepid real estate forecast signals investors to diversify, dig in

Investors should expect lower returns from their real estate portfolios and, at this late hour in the real estate cycle, should concentrate on defensive investments and portfolio diversification in 2017.

“We had a great run for the last five years in real estate, which recovered very well since the downturn,” said Allison Yager, a partner and global leader of real estate in the Atlanta office of Mercer's investments business.

“We're seeing a few indications that things are slowing down,” including less U.S. institutional investor capital flowing into core real estate, Ms. Yager said. “We are still seeing strong appetite from non-domestic investors, but they always take longer to invest.”

Returns will decline in 2017 for core stabilized properties as appreciation slows, she said.

The easing of capital into core real estate started earlier in 2016 as equity market volatility pushed investors to or over their target real estate allocations, she said. Hitting that ceiling meant less money to invest in real estate, so in some cases investors began withdrawing funds from open-end core funds.

All but the biggest name-brand real estate managers will have difficulty raising capital for core and core-plus strategies next year, she said: “There's not enough capital to support core and core-plus strategies unless (the manager has a) good brand.”

The bumpy fundraising market in 2017 will be the result of a combination of that slowdown in capital and expected political and economic changes.

“A lot of people will be on the sidelines to see what happens to the economy” in light of the U.S. election, Ms. Yager said.

David Paine, head of real estate in the Edinburgh office of money manager Standard Life Investments, said the main word for 2017 is “caution” in light of the nationalist votes in the U.K and U.S., and elections scheduled in various European countries.

“There are things that have happened and the prospect of others coming down the line that would have a material impact on strategies,” Mr. Paine said.

These events will tilt all investments in different directions depending on how these elections play out. This environment requires a higher degree of care in making real estate investment decisions, he said.

“Clearly real estate is cyclical anyway and different parts of the world are in different points of the real estate cycle,” Mr. Paine said.

Real estate in the U.S. has been offering good returns and should continue providing moderate returns, which is attractive relative to other countries around the globe, he said.

As for the United Kingdom, even before June's referendum to leave the European Union, the country was at the tail end of its real estate cycle, Mr. Paine said. “Returns are already moderating quite significantly and now there is uncertainty about the underlying economic drivers that will persist for a long time,” he noted. This makes the U.K. less attractive for real estate investment than other global markets.

Real estate across the Continent is performing well because the real estate market in Europe is lagging the U.K.

“There is a lot of money looking to find a home in continental Europe and there are attractive opportunities to be had,” he said.

The view for the Asia-Pacific region is more polarized, Mr. Paine said. Some markets such as Australia are doing relatively well, while Hong Kong and other areas in China are looking fairly weak.

Overall, investors will be more cautious in 2017, he said, and thus less interested in development.

“The bulk of investment volume will come from investors fundamentally drawn to the asset class because it offers attractive yield compared to bonds,” Mr. Paine said.

“Our investors are looking for us to dial down risk,” he said. “That could take the form of core real estate, which is keenly priced at the moment. People will be looking for a broader basket of assets with quality income for a long period of time. There are fewer of those opportunities than we might have seen a couple of years ago.”

Discipline is the watch word at consulting firm Willis Towers Watson PLC. Investors need to remain disciplined and concentrate on the role real estate is meant play in their portfolios, said Peter Rogers, Chicago-based senior investment consultant in the manager research group.

“We are cautiously optimistic regarding the real estate markets, however there is heightened uncertainty about the economy and political environment, which will lead to heightened capital market volatility,” Mr. Rogers said.

In terms of investing for 2017, Willis Towers Watson executives favor value-add strategies that are short in duration with low leverage, he said — for example, investing in income-producing properties, or properties with issues that can be solved in 12 to 24 months rather than three to four years.

“We're not trying to take on excessive risk in search of additional return or total return,” Mr. Rogers said.

Willis Towers Watson executives also favor property types that take advantage of certain demographic trends, such as aging baby boomers or the rise of millennials. Sectors including senior housing and student housing are less reliant on economic growth for returns, Mr. Rogers said.

At this point in a mature cycle, investors not only need to look at what is happening in the near term but also have to predict where the market could be in five to seven years when their fund managers are exiting those investments, he said.

“We think the problem of (real estate managers) underperforming target returns is higher. ... We are tilting toward certainty of income: debt-oriented vs. equity-oriented strategies,” Mr. Rogers said.

Babak Zenouzi, senior vice president and chief investment officer of real estate securities and income solutions in the Philadelphia office of Delaware Investments, also recommends investing in shorter duration real estate strategies in 2017.

Shorter duration strategies — such as self-storage properties, which can increase rates monthly; hotels, with their daily rate changes; and apartments, which typically can raise rents annually — tend to outperform in a rising interest rate environment, Mr. Zenouzi said.

By contrast, property types with longer leases are less desirable. These real estate sectors include industrial properties and health care. Health care properties in particular can have leases as long as 12 to 15 years, he said.

“Capital is the raw material in this industry,” Mr. Zenouzi said. “Clearly we can observe higher capital costs today, but we have to forecast whether there will be commensurate economic growth. If so, real estate does very well.” Little economic growth will be tougher for real estate investors, he said.

Jason Yablon, senior vice president and portfolio manager of New York-based REIT manager Cohen & Steers Inc. is optimistic about the new year.

“We see a potential buying opportunity shaping up in U.S. (real estate investment trusts), as valuations have improved and Donald Trump's election has primed the pump on growth and inflation expectations,” Mr. Yablon wrote in an e-mail. “While much is still unknown, we believe there may be potential for the kind of policy upheaval that could change the shape of real estate fundamentals and values for the better through stronger demand and slower new supply.”