In 2024 to date, European markets have pivoted through inflection points on interest rates, economic growth, and property capital markets – which we graph and unpeel in our latest LaSalle European Market View chartbook.

Cyclical shifts are interacting with geopolitical risks in 2024 – from trade headwinds to energy and migration demographics – to create volatility and to shape changes in Europe’s occupier demand and investor risk appetite, all as the region stands on the cusp of an unexpectedly active summer election season.

We cover the latest real estate market trends in 2024 to date. Particularly notable is how a combination of moderating inflation and resilient fundamentals has led to an improvement in real – after inflation – market rent growth, even as nominal rent change has come off the boil.

The state of the market year-to-date: Capital markets digest repricing, as tenant demand stays resilient and energy markets deliver a positive surprise.

Our latest LaSalle European Market View shows how Europe’s economies and real estate markets are being impacted by, and adapting to, the current period of unusual uncertainty.

This update highlights recently released data on how Europe’s energy market has coped with shutoffs and surging prices in the winter following Russia’s invasion of Ukraine. It did so through a combination of reduced consumption (p. 6), more electricity generation from renewables (p. 7), and shifting to imports from new sources (p. 8). In Q1, the EU’s natural gas consumption was tracking 18% below average. This owes some thanks to mild winter temperatures, but also to conscious conservation efforts.

 Natural gas consumption in Europe (EU27)

Source: LaSalle analysis of Eurostat data to March 2023. Note that the UK is excluded from all time series data above.

Falling energy prices have led to recent steep headline inflation declines (p. 11)  and kept Europe’s largest economies from entering recession to date (p. 9). Yet core inflation – excluding volatile food and energy – is higher today than in 2022 – and GDP growth is at stall speed. European banks have weathered the aftershocks of SVB’s failure and the Swiss National Bank’s forced resolution of Credit Suisse. However, some pullback in bank risk appetite is evident in debt markets (see p. 29 and our April ISA Briefing). 

Even as the ECB and Bank of England’s rate hikes have continued, long-term swap rates today are similar to where they started the year (p. 28). This has given private real estate and yields some time to digest the new repricing math. The UK’s repricing stands out for its speed, with monthly UK index data swinging to a positive return in March after eight months of deep negative returns (p. 34).

European real estate transaction volume declined to an 11-year low in Q1. This is a lagging rather than concurrent indicator, however, and reflects the high uncertainty and bid-ask spreads that existed near the end of 2022. At the same time, the most recent Q1 data on occupier trends shows hardy demand fundamentals, albeit with some cooling. In Q1, prime logistics rents continued to grow at a double-digit annualized pace and UK residential sector kept pace with high inflation across many markets, even as office rents cooled and retail rents were flat. As we look ahead, we believe the relationship between current vacancy and its historic levels (p. 18, 20, 21) points to the European property types and markets where rent momentum is most likely to continue.

Quarter-over-quarter rental growth in Europe

*Average rent and Q1 2023 residential data currently unavailable. UK residential rent data is based on new listings (rather than in-place rents).
Source: JLL, HomeLet data to Q1 2023. Latest as of May 2023.

US private real estate returns went negative in Q4 2022 as the impact of higher interest rates continued to ripple through to market pricing and appraised values. This trend is expected to continue through the first half of 2023 with stability projected to return later in the year.

Returns in the fourth quarter showed negative appreciation and income returns in line with previous quarters, resulting in negative total returns for both the NPI and ODCE. The slowdown in returns was most significant for industrial, with retail delivering the highest returns of the major sectors (this is a notable shift from trends of the last 5+ years). Looking ahead, the dominant theme in sector performance is expected to be the under-performance of offices.

This note provides details on the fourth quarter performance of the NPI and ODCE indices, summarizes the outlook for future returns, and provides some information regarding insights from the first release of data related to the new NCREIF subtypes.

Highlights from the Q4 data releases include:

• The quarterly total NPI return declined 410 bps from Q3 to -3.5%. The Q4 return comprised a 0.95% income return and -4.45% appreciation return.
• The trailing-year return declined more than 1,000 bps quarter-over-quarter to 5.53%.
• Returns for all property types were down from the previous quarter and in negative territory, with industrial seeing the greatest decline for the second consecutive quarter. Retail was the highest-returning property type for the first time since Q1 2016.
• The ODCE value-weighted quarterly gross total return of -4.97% was down 440 bps from the third quarter. Appreciation remained negative at an index level and the income return was flat at 0.80%, an all-time low. Mark to market on leverage was a positive as interest rates rose, but negative appreciation caused leverage to be an overall negative to returns.

• The reopening is expected to boost occupier and investor demand for commercial real estate in China. Improving real estate fundamentals and domestic investor sentiment, along with low domestic interest rates and the rapid growth of the domestic public REIT market, points to increasing capital market liquidity among domestic investors for Chinese commercial real estate assets in the near term. The logistics and multifamily rental sectors are expected to benefit from this trend the most due to their relatively sound fundamentals, their qualification for domestic public REIT structures and other supportive government policy measures.⁶
• In the Chinese culture, the Year of the Rabbit signifies prosperity, peace and longevity. While the world is still facing many challenges including elevated inflation, higher interest rates, the risk of recession and the Russia-Ukraine war, the reopening in China in the Year of the Rabbit brings clear positives to the Chinese economy and its real estate markets, though the risk of a renewed rise in global inflation should be watched carefully.

⁶ Among the major commercial real estate sectors, currently only industrial and multifamily rental assets are qualified underlying assets for ownership by domestic public REITs.

Europe’s cold, dark winter turns brighter

One year on from Russia’s invasion of Ukraine in February 2022, European energy markets have proven adaptable, facing down a unique degree of energy disruption owing to the region’s dependence on pipeline links from Russia. After initially skyrocketing—European natural gas price at their peak were twelve-times higher relative to the ten-year, pre-conflict average—by mid-February 2023 prices it had fallen to a level only around two and a half times that long-term average.³ Government schemes to partially socialize the cost of higher energy, at the expected expense of massive government deficits and higher borrowing costs, now look a lot less extreme.

¹ R₀ is the basic reproduction number, which describes the expected number of cases of an infectious disease directly generated by a single case, in a population where all individuals are susceptible to infection.
² 1 therm = 100,000 British thermal units (BTUs), a measure used in UK natural gas pricing. 1 MMBTU = 1,000,000 BTUs, which is used in US gas pricing. 1 MWh = 1,000,000 watts of electricity over one hour, used in European pricing of natural gas.
³ Refinitiv, Natural Gas TTF (Title Transfer Facility) historical front month futures as of 13 February 2023

US private real estate returns weakened considerably in 3Q 2022 as higher interest rates continued to have a major impact on market pricing and appraised values. This trend is expected to continue in the remainder of 2022 and into the opening quarters of 2023. This is leading to a dramatic slowdown in returns from the record levels seen less than a year ago.    

Returns in the third quarter showed negative appreciation, with total returns remaining positive for both the NPI and ODCE. The slowdown in returns was most significant for industrial, with apartments delivering the highest returns. Looking ahead, the dominant theme in sector performance is expected to be the under-performance of offices.  

This note provides details on the third quarter performance of the NPI and ODCE indices, summarizes the outlook for future returns, and provides some information regarding insights from the first release of data related to the new NCREIF subtypes.

Highlights from the 3Q data releases include:   

• The quarterly total NPI return declined 260 bps from 2Q to 0.6%. The 3Q return was a 0.93% income return (an all-time low), and the appreciation return went negative for the first time since 3Q 2020 at -0.37%.
• The trailing-year return declined more than 500 bps quarter-over-quarter to 16.08%, which is still high relative to history.
• Returns for all property types were down from the previous quarter, with industrial seeing the greatest decline. For the first time since 1Q 2016, industrial was not the highest-returning property type.
• The ODCE value-weighted quarterly gross total return of 0.52% was down 430 bps from the second quarter. Appreciation turned negative at an index level and the income return continued to fall to 0.81%, an all-time low. Mark to market on leverage was a positive as interest rates rose, but negative appreciation caused leverage to be an overall negative to returns.

The global economy in general – and real estate markets in particular – are currently in the throes of an acute episode with pressure coming from every direction.

Eventually, we expect post-COVID-19 pressures such as inflation, supply chain issues and large fiscal stimulus to settle and a new normal to emerge. It’s just a question of “when?”

In this year’s edition, we seek to look through the current acute period of volatility and uncertainty, to discuss our view of likely outcomes and scenarios to consider, key themes for investing and real estate strategy recommendations that we expect to be resilient across the range of conceivable macro environments.

Inflation, energy and real estate

Inflation has moved rapidly from overlooked to top-of-mind this year. For the past eight months, many different types of price movements have received significant attention among economists, central bankers and real estate owners and occupiers. Global supply chain bottlenecks and pandemic-related fiscal and monetary stimulus have all contributed to price instability. More recently, Russia’s invasion of Ukraine has been a particularly troubling cause of energy price volatility, especially in Europe.

Many countries are transitioning their energy grids to more renewable sources, but a full transition could take several decades. Fossil fuels supply about 77% of the world’s energy, according to the Environmental and Energy Study Institute (see p. 7). The chaotic collision of inflation and energy shortages – particularly in Europe – has decision-makers scrambling as winter approaches.

The disruption of Russian natural gas flows to Europe prompted delegates of the European Union to discuss solutions and to wean itself from Russian gas. Some are promoting a common price cap on all gas imports, while others believe this will limit supply, further stressing consumers and businesses. As winter approaches, strategic reserves in Europe are at full storage capacity (see p. 45 Gas Storage), so an immediate crisis has likely been averted. However, it remains unclear how these reserves will be replenished once they are depleted. Our analysis of this rapidly-changing situation in Europe can be found on p. 9 of this month’s deck.

Energy inflation is also impacting lease agreements between real estate owners and occupiers. Green Street Advisors recently noted that on average, energy costs to either the owner or tenant equals roughly 6% of total rent or USD ~$2.00 psf in both the US and EU. But with energy costs having risen sharply, the question becomes: who bears the cost?

In North America, most commercial leases are triple net, with tenants responsible for utilities, taxes, maintenance, and insurance. Triple net leases are also prevalent among retail properties in the US and Canada, but Canada also has gross, semi-gross or base-year leases which are indexed to CPI inflation. While tenants pay directly for their energy usage, owners are not fully off the hook as they bear responsibility for vacant spaces. Owners can also mitigate cost risk through guaranteed maximum price contracts for certain utilities.

Leases in the UK are also generally on a net basis. However, to counter rising prices, tenants have been renegotiating rents based on total occupancy cost, thus the property owner becomes responsible for any costs that exceed a threshold. In this regard, UK tenants have been increasingly seeking different lease structures that are effectively gross in nature, with shorter lease terms (see p. 10).

On the European continent, most commercial leases are fully indexed to inflation annually. Larger retail tenancies such as grocers often have bargaining power and can negotiate an index cap or lower indexation levels. But even with indexation, tenants are becoming more sensitive to utility costs and are negotiating for increases to be capped. In Japan and China, fixed-term leases typically put the burden of paying higher utility costs on the tenant, but landlords must be careful to keep total occupancy costs under control or a downward reset to the base rent could be the only way to get a tenant to renew.

Despite progress in transitioning energy grids to renewables in many countries, the world remains largely dependent on fossil fuels to provide the power to heat and cool buildings. Rising energy prices are testing the tenant-landlord relationship and the balance of power is rapidly shifting in favor of tenants, especially in weaker sectors like mall retail and offices.

Climate risks: Too big to ignore

The last day of summer in the Northern Hemisphere was September 22nd, and cooler temperatures will surely be welcomed by many. Europe and China recorded their hottest-ever summers since recordkeeping began in 1880, according to NOAA’s National Centers for Environmental Information. Meanwhile, the US recorded its third-hottest summer by the same metric.

Economic impacts extended across the world. Transport throughout the UK ground to a halt for part of July as temperatures reached levels never imagined by the Victorian engineers who designed its railway network. A lack of rainfall left crops parched and caused key rivers such as the Rhine to reach levels so shallow that they were not navigable by the barges that have become a key part of Central Europe’s supply chains. In some areas of the US, the key problem was too much precipitation, with extreme rain causing severe disruption in Kentucky and Saint Louis; flooding contributed to a drinking water crisis in Jackson, Mississippi. In China, precipitation in Jiangxi and Anhui provinces in July and August was 60% less than a year ago. Record heat and drought across China, including parts of the Yangtze River, caused a shortage of hydro-power and halted shipping. Relief from this year’s extreme temperatures is coming at the same time as what looks to be another severe season for hurricanes and wildfires takes shape. Hurricane Fiona left all of Puerto Rico without power before making a rare assault on Canada’s maritime provinces, and Hurricane Ian is likely to be the worst hurricane to hit the west coast of Florida since 1921.

The summer has also been a reminder to consider both the physical and transition risks associated with climate change. Reducing carbon emissions, which is key to preventing further long-term escalation in events such as these, has come under renewed urgency given recent geopolitical tensions. Most European countries face a severe energy crisis triggered by Russia’s war in Ukraine and the cessation of natural gas flows through key pipelines. Renewables like solar power have the dual benefit of aiding decarbonization and reducing dependence on Russian fossil fuels.

As real estate investors, we are concerned about the impacts that climate change will have on our investments. On the physical risk side, it is critical that we become aware of the extent to which climate risk hazards may directly impact our portfolios and prepare our buildings to be resilient to climate change. The first step is to identify the physical climate hazards that will impact specific buildings, measure the exposure to those hazards in aggregate within the portfolio, and then get to work managing, mitigating, and strategizing around these risks.

To get the data, we have a plethora of climate data providers and forecasters to choose from, but it can be overwhelming to narrow the field down. When we reviewed multiple data providers, we found considerable inconsistency in how metrics are defined, and wide variation in risk scores for the same hazard at the same property.

Our recent report, “How to Choose, Use and Better Understand Climate Risk Analytics”, researched and written in partnership with the Urban Land Institute (ULI), is an excellent overview of the challenges faced by first-time consumers of climate data. The paper outlines physical climate risk basics, identifies differences between data providers to be aware of, and raises a call to action to standardize the outputs in ways that are most meaningful and useful for real estate, with transparency that enables apples‑to‑apples comparisons across models.

Once the data is in hand, the next step is to manage the risks at two levels: at the property level, through evaluating both existing and potential new hardening strategies to be more resilient against particular hazards; and at the portfolio level, through assessment of exposure concentrations and consideration of how climate risk informs overall portfolio construction strategies. And lastly, we must continue to monitor these risks on a regular basis, because one thing we know for sure is that our climate will continue to change, and more disruptive and damaging seasons like the hot summer of 2022 are likely to recur.

Does the inception year for a fund matter in the same way a vintage year matters for wine? Our analysis of data from Preqin highlights that both the vintage year and risk style of a fund have been important determinants of performance over the last 30 years (Page 5).

A wine vintage is shaped by external conditions like the weather. Stressful conditions like droughts can produce great wine. Likewise, macroeconomic conditions influence a fund’s risk and return characteristics. In the Mid-Year 2022 ISA, we noted how capital markets are experiencing a major regime shift. The macroeconomic environment has quickly moved from lower-for-longer to weaker growth (Page 33), high inflation (Page 14), and higher interest rates (Page 9), all of which affect real estate performance.

Vintage years characterized by major disruptions in macroeconomic conditions – like the dot-com crash or the global financial crisis – have been associated with modestly higher median returns compared to the prior period, but also a significantly higher dispersion of returns (Page 6). So, a stressful macro environment simultaneously creates higher volatility while it also slightly raises the odds of a stronger entry point for investing. Put differently, choosing a wine from a good vintage year is no guarantee that it will turn out to be a memorable bottle!

In wine-growing countries across the world, the summer has been dry and hot. Decades of historic data allow oenologists to draw inferences about the likely quality of the 2022 wine vintage. However, vintage year analysis for real estate funds is trickier. For one thing, the combination of macroeconomic conditions that the 2022 real estate fund vintage faces–weak growth, high inflation and rising interest rates–have not been seen in conjunction since the 1970s.

In addition, the repricing implied by public real estate markets (page 31) has not yet fully worked its way through private markets. On the one hand, capital that has been invested early in 2022 already might face valuation declines if the repricing continues. On the other hand, any private equity repricing in late 2022 offers an interesting entry point for funds with dry powder.

Even with plenty of data to review, it takes the passage of time to confirm the final quality of a wine vintage. We also expect that it will take several years for the true quality of the 2022 real estate fund vintage to be known. Nevertheless, the wine analogy (and our own research) shows that stress can still produce a strong vintage, for wine or for real estate.

Yet August, with its summer festivals and family holidays for many, is a good month to put the frenetic pace of change into perspective. Many of the indices, prices, and events summarized in our macro indicators deck reveal just the tip of the iceberg, with a deeper, complex story hidden from view.  Often only a longer form, like a book, can do justice to these stories. 

Recently published books that we’re reading – and recommending – this summer delve into energy geopolitics, climate change impacts, and the history of real estate and investments. Helen Thompson’s Disorder: Hard Times in the 21^st Century (Feb. 2022) traces how historic energy policy contributed to today’s geopolitical fractures, in Europe and beyond.In asimilar vein, Ian Bremmer’s Power of Crisis (May 2022) looks at how leaders are responding to three big crises facing the world:  health emergencies, climate change, and the rise of artificial intelligence (AI). The UK, Central China, and Texas have sweltered through record temperatures over the last month and the continued backdrop of virulent COVID strains, like BA.5, continue to show how these crises are not mere abstractions but are a recurring part of modern life. 

Concrete examples of climate impacts, like how reptiles are trying to cope with more frequent Caribbean storms, abound in Thor Hanson’s excellent book, Hurricane Lizards and Plastic Squid (Sept. 2021). Hansen delves into a new field of climate change biology. He describes the long sweep of natural time as one of “punctuated equilibrium.”  This consists of “bursts of rapid activity (punctuations) followed by long periods of stability.” This pattern also aptly describes economic and real estate cycles, with current turmoil upsetting the post-GFC equilibrium. 

Turning to real estate – and some quite recent history – The Cult of We (July 2021) by Eliot Brown and Maureen Farrell – lifts the curtain on the madcap history of WeWork’s founding by Adam Neumann. The writers focus on the hubris that led to the downfall of “We”, although the recent reset and rebound of many shared office concepts is beyond their scope. Alexandra Lange’s Meet Me by the Fountain focuses on the shopping mall – and how it “has changed and changed again” from futuristic, to ubiquitous, to pandemic-induced redevelopments (June 2022). In Land (Jan. 2021), Simon Winchester links a variety of tales on a theme of land as “the only thing on earth
that lasts.” 

And, in a book tailored for investors, In Pursuit of the Perfect Portfolio (Aug. 2021), Lo and Foerster describe how the ideas of Markowitz, Bogle, Shiller, Siegel, and six other investment visionaries developed the frameworks that have taught us to build better portfolios. 

We also invite you to read our Mid-Year ISA, released last month, laying out our global real estate investment recommendations at this inflection point, with a particular focus on inflation protection, strategies to weather shifting monetary policy, and the ESG revolution in real estate. In addition, we have published a new white paper this month on the Demographics of Aging and its impact on real estate.

Shelter from the storm

More economic and geopolitical history unfolded in the first half of 2022 than typically occurs during the span of several “normal” years.  The quaint concept of “normality” may itself prove to be an artifact of history. Yet, the mid-year ISA describes how real estate held up well despite all the tumult.  Strategies we set out in 2021, performed as expected, or sometimes even better than expected.   Strategy shifts recommended by LaSalle for the second half of the year are modest, despite a renewed focus on the changing macro environment. 

Real estate generally provided shelter during the waves of volatility that swept through the securities markets in the first half of the year.  In the second half, we foresee different dynamics unfolding as described in Chapter 1, and in the specific strategy shifts recommended in Chapter 2.  The big change has been the end of ultra-low interest rates in Western countries.  Finally, we revisit the role of real estate in a portfolio in Chapter 3, based on new research done with JLL for the bi-annual Transparency Index, as well as the most recent updates to the correlations with other asset classes.  

The most important change in the macroeconomic outlook has been the regime shift from highly accommodative to tightening monetary policies by Western central banks. Many world events simultaneously contributed to this inflection point including:  the re-opening of economies after COVID-19, Russia’s invasion of Ukraine, trade wars, and government stimulus spending.  Although these pressures were building in 2021, there is no escaping the fact that the financial and commodity markets shifted sharply in the first half of 2022.  

In this mid-year update, we focus on the ways that assets and portfolios can be positioned to weather a sustained period of high inflation.   We acknowledge that each country is in a slightly different position in the transition from low to higher inflation and that each central bank will react differently to the mix of cost-push and demand-pull inflationary forces. 

Other highlighted trends include the continuing competition and complementarity between virtual and physical space.  Patterns that affect both asset and sector selection are now coming more clearly into view.  Also, we point to the continued momentum of the ESG revolution as investment managers commit to reducing the carbon footprint of their portfolios, while also grappling with climate risk forecast challenges, transition risks from new regulations, and social issues like housing affordability or health and well-being factors that affect tenants.

Stellar private real estate returns continue; but poised to decelerate

US private real estate returns remained very strong in the first quarter of 2022, which brought trailing-year returns to levels not seen in 40 years. Industrial and apartment sectors continued to lead, while office and retail continued to lag. The 1Q returns do not reflect the rapid changes in the US macro-economic environment that started in the first half of 2022. It is almost certain returns will slow dramatically in the coming quarters, but the timing and magnitude of the shift to lower returns is highly uncertain.

This note provides some details on the performance of the NPI and ODCE indices, along with views on the outlook for US private real estate returns informed by LaSalle’s market activity, valuations, and the PREA Consensus forecast.

Highlights from the 1Q data releases include:

• Quarterly total returns appear to have peaked at the end of 2021.  The NPI total return of 5.3% in the first quarter was down from 6.1% in the fourth quarter, but still the third consecutive quarter with a quarterly return over 5%.  The trailing-year return is up to 21.9%, the highest since the first quarter of 1980 (another time when inflation was elevated).
• The quarterly income return of 0.99% was below 1% for the first time ever, bringing the trailing-year income return to 4.18%.  Appreciation returns of 4.34% brought the trailing-year appreciation to 17.2%, the highest in the history of the NPI (dating to 1978).
• Property type trends remained consistent with past quarters, with industrial leading by a wide margin, apartments also delivering strong performance, while office and retail lagged significantly.  This continues to highlight the importance of sector selection in driving relative performance.
• The ODCE quarterly gross total return of 7.37% was down 60 bps from the record level in the fourth quarter.  This was comprised of a 0.93%income return and a 6.44% appreciation return.  The trailing-year gross ODCE return is up to 28.5%; 27.3% on a net basis, both all-time highs.
• 1Q returns are based on income earned in the first quarter and appraisals completed over the course of the quarter.  These returns do not reflect the negative macro news that started to emerge in the first half of 2022.

The trade links between the world and the conflict zone in Ukraine are relatively small in aggregate terms. However, when combined with COVID-related snags and new sanctions on Russian exports, these blockages become severe all across Europe and beyond. Critical commodities such as energy, grains, and specific materials with direct implications for real estate (such as sheet metal and sprinklers used in warehouse buildings) are all affected. This contributes to higher levels of inflation in Europe and around the world. The macro deck shows that medium- and long-term inflation expectations remain subdued (pages 7,8,10). But, this comforting view does not alleviate the stress on major economies and construction pipelines in the short term.

Chronic inflation risk will likely be mitigated by real estate’s ability to work as a partial inflation hedge, although this ability is uneven across markets and sectors. This is because real estate has performed best as an inflation hedge when landlords have pricing power to push market rents. Today, this pricing power is in place for many property types favoured by investors. Moreover, this inflation hedging performs best when rising utility costs can be passed through to tenants via “triple net” leases, rental indexation and shorter lease terms. Inflation also contributes to higher construction costs, which means higher replacement costs, extended construction periods and slowdown of development pipelines. In the past, this has supported resilient values for standing assets during periods of elevated inflation. There are no guarantees that this resilience will occur, but the pieces are in place for a strong inflation hedge effect again.

From an investor’s perspective, geo-political tensions would appear to represent a chronic malady of the post-globalization era. Examples of authoritarianism, geopolitical disputes, populism, and nationalism can be found across the world. Important measures to watch are: geopolitical risk (page 3), the health of democracy (page 13) and real estate transparency. According to EIU’s Democracy Index 2022, the scores have been falling in many countries, due to pandemic restrictions that meant many countries struggled to balance public health with personal freedom. On the bright side, JLL and LaSalle’s soon-to-be released Global Real Estate Transparency Index shows marked improvements in three categories: sustainability reporting, proptech adoption, and data tracking of alternative property types. Rising transparency may not counter all the negative effects of falling democracy; but data availability and strong property rights have historically underpinned the free movement of capital to real estate.

The progression from acute to chronic has another positive aspect. The transition allows investors to underwrite assets with the new risks accounted for. During the acute stage, investment decision-making can become paralyzed. In the chronic stage, investors can begin to make longer-term risk adjustments that anticipate the long-term trajectory of the situation.

Similarly, many countries in the Asia Pacific region are also transitioning to living with COVID-19. The Asia Pacific region has been relatively successful in keeping the coronavirus at bay over the last two years. As a result, some countries in the region, like China, were able to restart their economies relatively quickly and limit the economic impact of the pandemic. However, the emergence of the highly contagious Omicron variant has pushed governments in the region to re-impose strict measures to give their healthcare system time to recalibrate and set the stage for living with COVID-19. While many countries in the Asia Pacific region are moving towards living with COVID-19, China has maintained a zero-COVID policy. Since March 2022, the Chinese government re-introduced mass PCR testing and lockdowns in “high risk” neighborhoods of several Chinese cities to curb the Omicron variant outbreak. In April 2022, the IMF and other economists gave China a modest downgrade on its growth outlook, although these revised estimates remain higher than any major European or North American economy. On April 28th, President Xi made a solid commitment to increase infrastructure spending to counter slowing growth. In addition, the People’s Bank of China’s has re-committed to easing monetary policies. These efforts are expected to offset some negative impacts from the zero-COVID policy. We expect the recovery of occupier markets in China to be delayed, but not detoured.

Australia, Singapore, and South Korea are among the leading countries in the Asia Pacific region that are making the transition to living with COVID-19, helped by their stabilizing infection rates, and rapid vaccination/booster rollout. As of the end of April 2022, Australia, Singapore, and South Korea have eased nearly all COVID-19 safety measures and re-opened their borders to fully-vaccinated foreign visitors without the need for quarantine. Japan is also moving toward living with COVID-19, albeit at a slower pace than Australia, Singapore, and South Korea, after its quasi-state of emergency was lifted on March 21, 2022.

The relaxation of public health measures and the transition to living with COVID-19 have been highly beneficial for real estate demand. In the Asia Pacific region, the relaxation of social distancing measures and the strong willingness to return to offices has supported the recovery of office demand, especially in countries leading the transition from pandemic to endemic. In this month’s deck we track work from home expectations around the world (see p.3). Office markets like the Sydney CBD and Seoul saw vacancy rate improvements since the height of the pandemic, while other office markets, such as the Singapore CBD, had a positive net effective rent growth. Although rents in the Tokyo Central office market continued to decline in the first quarter of 2022 due to the quasi-state of emergency, the average vacancy rate in the Tokyo Central office market remained the lowest among major office markets in the Asia Pacific region. Major office markets across Europe show a similar recovery, although North American office markets still lag and the recovery in the largest US office markets is tepid at best.

Looking ahead, the transition from the pandemic to the endemic stage is expected to continue to support the recovery in real estate demand. However, other macro forces are now taking center stage as Covid retreats. Russia’s invasion of Ukraine, rising inflation, and interest rate hikes could cast a shadow on the recovery. Therefore, as shown in this month’s deck, the pace of improving real estate fundamentals varies greatly in cities around the world. Investors will need to pay close attention to these cross currents when underwriting new investments and adjusting portfolios.

The impact of market volatility on real estate

The news from Ukraine is disturbing and relentless. Lurking under the headlines are dramatic economic gyrations — higher interest rates, higher inflation, successive waves of “risk-off” and “risk-on” market sentiment, yield curve changes, and rising commodity prices. This volatility should not go unnoticed; it is the focus of our April Macro Deck.

In March, interest rates generally moved higher after an initial “safe haven” effect as sovereign yields fell following the invasion of Ukraine (see pages 3, 6). Stock markets also fell, then rebounded and ended the month up as the month progressed (see pages 7-8). Elevated inflation indicators continued to be reported from around the world (see pages 11-16), and the concern that higher inflation will remain persistent became widespread. The US Federal Reserve became the 11th G20 Central Bank to raise interest rates since the COVID pandemic (see page 4-5). The US Fed has taken the approach of communicating direction well ahead of action, and the signal is the March rate hike will be the first of several in the coming months (see page 17, 24).

Higher interest rates are a concern to real estate investors because real estate is very dependent on borrowing. In 2020, economic distress was accompanied by falling interest rates, and the net result was higher real estate values. The question now is if higher interest rates will lead to lower real estate values. There is no global answer to this question. The outlook for each market, sector, and property is impacted by secular trends, economic growth, ability to raise rents, and buyers’ access to leverage. Consideration of all these factors, alongside interest rates, determines the value outlook. In some cases, accelerating NOI growth will outweigh any negative impact from higher rates; while in other cases, the balance will go the other way.

Inflation’s impact on real estate is similarly nuanced. It has been decades since developed economies have seen a higher inflation regime. Yet, the case for including real estate in a diversified portfolio has included its inflation hedging ability. The increase in real estate allocations over the last two decades may have been more about risk-adjusted returns than inflation hedging. Now that we actually have elevated levels of inflation, will real estate’s hedging power hold up?

One challenge of demonstrating if real estate is an inflation hedge is that real estate data from the last period of elevated inflation in the late 1970s and early 1980s is limited (see page 18). The year 2021 had elevated inflation — how much of an inflation hedge was real estate last year? The answer–based on 2021–seems to be “it depends”. The first critical element for real estate to be an inflation hedge is an ability to raise rents. This depends on landlord-favorable market conditions, which was the case in some investment segments, but not others.

In 2021, there were great-to-amazing returns for residential and industrial properties in many markets, while office and retail returns were often mediocre at best (see page 45). This corresponds with the sectors where landlords had pricing power and where they didn’t. The conclusion to date is that while lease terms and expense burdens are useful to guide the ability of a property to hedge inflation (see page 46), the most important element is the market power to raise rents.

The impact of the Ukraine crisis for real estate investors

Russia’s incursion into Ukraine began in the early hours of February 24th and has progressed rapidly and violently every day since. After over seven decades of cold war machinations, a hot war has broken out in Eastern Europe. The gravity of the situation for Ukraine’s people and seriousness of the risks to the post-Cold War geopolitical order cannot be overlooked. The geopolitical tremors of Russia’s action and the West’s sanctions are likely to be felt across the world for years to come. But direct implications for institutional real estate portfolios are relatively limited. Rather, the key channels of influence on property markets are likely to be indirect and macroeconomic in nature. These include higher inflation, “risk-off” market sentiment, and accelerated changes in the European energy mix.

Ukrainian and Russian properties will clearly feel the most direct effects from the conflict — the former due to the likelihood of physical damage, and the latter driven by economic sanctions. The 2014 annexation of Crimea triggered a steep decline in Ukrainian real estate investment volumes and a more muted softening in Russian volumes (see deck page 6). But these two countries have never really featured as targets for cross-border property investors. According to LaSalle’s Investable Universe estimates (see deck page 5), Ukraine and Russia account for just 0.3% and 2.7% of Europe’s total invested institutional real estate stock by value, respectively.

The more transparent former-communist EU member states, such as Poland and the Czech Republic, are more relevant for real estate investors in 2022. Many pan-European portfolios have exposure to these key Central and Eastern European (CEE) markets, which have boomed as consumer economies and as sites for near-shored services and manufacturing. All of the EU-member CEE countries, including the Baltic states, are also members of NATO, which should shield them from Russia’s territorial ambitions. When shelling is within earshot of the NATO border and refugees pour into CEE, nerves are understandably on edge. However, unlike the days of the Soviet Republic, the likes of the Baltics, Poland, Slovakia, Hungary and Romania are all strong economically and they are protected by a rapidly deployed NATO shield. So, “domino effect” risks are remote.

Although direct impacts on investable property are limited, indirect macro risks from the conflict are substantial. Aggregate trade flows between major developed economies and Russia or Ukraine suggest a very limited drag on growth, but the concentration of exports in certain key commodities will probably drive inflation higher at an unwelcome time. Russia is one of the world’s largest oil producers and a supplier of metals such as nickel, aluminum and palladium. Major natural gas pipelines run to Europe from Russia via Ukraine. The geography of gas infrastructure and the energy mix of various EU states mean that several large EU countries, notably Germany and Italy, are heavily reliant on imports of Russian gas (see chart on page 4). While ample gas storage levels mean that a slowdown or shutoff of gas flows would not create a shortage during this heating season, it would have knock-on effects on supply levels later in the year.

How much could this boost inflation? If the gas and oil price jumps seen in the early days of the invasion are sustained, Capital Economics estimates that this would increase eurozone headline inflation by a percentage point by mid-2022. That said, a possible new Iran nuclear deal could have an offsetting effect on energy prices. Meanwhile, both Russia and Ukraine are both major wheat producers, and Russia makes potash (a fertiliser ingredient), suggesting possible additional implications for food prices (see deck page 9).

It is tempting to assume that higher inflation means higher interest rates, but the Ukraine crisis may or may not lead to increases in borrowing rates for real estate. As is common in geopolitical crises, long bond rates in major developed economies have come under downward pressure as investors seek safe-haven assets. Central banks will be torn between addressing heightened inflation and the risks to growth. On balance, the pace of monetary tightening may be a little slower and later than previously forecast. The direction of borrowing costs therefore depends on changes in risk premia. The longer and broader the scope of the conflict, the more deeply “risk off” market sentiment will get priced in the capital markets. Taking the long view, the conflict is causing Europe to reflect on how it can improve its resilience to geopolitical risks, and especially how it came to be so dependent on Russian gas in the first place. The Nord Stream 2 pipeline, which would increase Western Europe’s reliance on Russian gas, is now very unlikely to ever be built, and new liquified natural gas (LNG) regasification infrastructure may be constructed to facilitate imports from elsewhere in the world.

At the level of real estate, the existing movement away from buildings’ use of gas, driven by sustainability objectives, is likely to be accelerated by energy security worries. Additionally, given that Russian attacks on NATO members are more probable in cyberspace than physical space, the cybersecurity defences of building systems may also need to be fortified. Both these factors could drive up capital expenditure for real estate.

One of Europe’s frozen conflicts has suddenly started to run hot. Real estate investors are wise to anticipate incrementally higher inflation, particularly in construction materials and energy costs, while evaluating the relative magnitudes of the upward and downward pressures on the cost of debt. The March Macro Deck contains a summary of the rapidly evolving situation in Ukraine as well as other trends around the world.

Over one-fifth of the world’s population celebrates Lunar New Year on February 1st

It’s the most important holiday on the calendar for many Asian cultures, particularly the Chinese. We are heading into a year of the Water Tiger, which occurs every 60 years. In China, the tiger is considered the king of all beasts, symbolizing strength and bravery.

China’s Central Bank (PBOC) is certainly making a strong and brave move at a time when many central banks around the world are taking an increasingly aggressive stance to counter rising inflation. With the U.S. inflation rate reaching a 40-year high, the Federal Reserve (Fed) communicated a hawkish move toward policy normalization in January. By contrast, the PBOC is on a different path and has been easing monetary policies to counter slowing economic growth in the fourth quarter. China achieved 8.1% GDP growth in 2021, despite the headwinds from its COVID-zero policy and the slowing for-sale residential sector. Yet, inflation has remained subdued in China, and so the PBOC can be accommodative at a time when other central banks have signaled tightening. Historically, most central banks in Asia Pacific followed the path of the Fed. However, this time around, each monetary authority is responding to different circumstances. We are heading into rare territory of diverging global monetary policies.

At one end of the spectrum, ahead of the Fed, central banks in South Korea and the U.K. have been raising benchmark rates to rein in rising inflation pressures. Most notably, South Korea’s benchmark rate is now back to the pre-pandemic level. The Monetary Authority of Singapore has also turned to gradual tightening of its local currency since October 2021. At the other end of the spectrum, inflation rates in China, Japan and Australia have also increased, but to a lesser extent than countries such as the U.S., the U.K., South Korea, and Singapore. The relatively lower inflation rates in these Asian countries are supported by country-specific measures that influence their domestic price trends; for instance, raising export tariffs on some steel products to shore up demand domestically in China and subsidizing fuel prices in Japan. The Bank of Japan continues to commit to an ultra-accommodative monetary policy, despite raising its inflation forecasts at the January meeting. The European Central Bank is also unlikely to hike rates soon, as it follows the sequence of tapering QE first, ending zero and negative interest rates, and finally raising rates. Positioning between the two ends of the spectrum, the Reserve Bank of Australia with a triple mandate – a stable currency, full employment, and economic growth – has an intention to lag other central banks in normalizing monetary policy, while watching the inflation risk and other central banks’ moves closely.

As some of these diverging capital market trends play out, currency movements are likely to be reshuffled in multi-asset portfolios. As we look forward to the Year of the Tiger in an environment of rising inflation and the potential end of the easy money era in several countries, the good news is that the growth momentum is generally trending up globally. Investors will likely pivot towards assets that can do well in this environment. Real estate rental income tends to rise when inflation rises and demand drivers improve, which makes real estate an attractive asset class for inflation hedge. The favorable investor appetite has been evidenced by the record-high global real estate transaction volume last year¹, despite the headwinds from the pandemic.

¹ Source: MSCI/Real Capital Analytics, Inc. The global real estate transaction volume of $1.7 trillion in 2021 was the highest on record since MSCI/RCA started tracking the data in 2001.

• Prepare for the Endemic Economy. Despite Omicron, we still foresee a global growth cycle that acts as a tailwind for real estate recovery. The ride won’t always be smooth and the exact timing of the transition from “pandemic” to “endemic” is not known. Nevertheless, we are getting closer as vaccination rollouts continue to get traction around the world: 4.6 billion people (58% of the global population) received at least one COVID vaccine dose in 2021. Last year also became a very unwelcome crash course on the challenges of adopting rapid changes in public health practices and understanding the microbiology of a rapidly mutating coronavirus. In the wake of COVID-19, countries must rebuild economic productivity, relink supply chains, realign social patterns, and recharge spending power. Buildings must adapt to serve an economy that relies on physical and virtual space to grow in ways unlike the past.
• Anticipate Higher Standards. Investors will ask more of real estate in several different directions all at once. Sustainability (ESG) goals and rising tenant expectations are among the “asks” that investors must respond to. This raises the bar for putting societal and environmental goals alongside traditional financial objectives. Strong financial returns in 2021 (summarized in the January Macro Deck) also lead investors to expect “more of the same.” Yet, rising values will make this challenging, unless leverage or carefully considered risk taking rise too.
• Plan for Climate Change. The attention given to climate risk is accelerating around the world as more evidence of climate change becomes recognized. The impacts of more volatile weather patterns, rising temperatures and new regulations will be integrated into investment analyses. There was no letup from climate change’s impact in 2021, including punishing heat in North America, record-breaking floods in Europe and Asia, right through to wildfires in suburban Denver on December 31st.
• Expect Rising Liquidity and Inflation. Real estate has shifted from capital-starved to capital-rich several times already in this century. Recently, the supply of capital has more than kept pace with the rebound in deal flow. This creates challenges for the deployment of money, even as it boosts the performance of assets already in a portfolio. Rising inflation also raises issues—favoring some property types and lease structures more than others. Not all countries are experiencing inflation or rising interest rates, so country-specific strategies are required.
• Take the Long View. Four secular demand drivers–demographics, technology, urbanization, and environmental factors–will continue to shape real estate markets in the years ahead. The progression and shape of these forces evolve as societies get older and markets react to the global themes. These changes are explored in a series of “Insight Reports” that are summarized in this month’s deck.

High expectations for real estate are tempered by realism and resilience born from a rare combination of uncertainty and extremes in 2021: wildly exceeding expectations in some areas (rebounding spending and asset returns) and deeply disappointing in others (pandemic disruption, bottlenecks, and inflation).

Many real estate investors experienced a year of outcomes better than last year’s consensus expectations. Rent and NOI growth for residential, logistics, and several niche property types set new records in many countries as a rapid demand rebound blew past the supply of space available. Asset returns surged. Global stock markets gained 20% in 2021. Core, unleveraged property indices in the U.S. and U.K. show gross total returns on pace to exceed 15% for the year.

The macro themes in the 2022 edition of LaSalle’s Investment Strategy Annual provide a road map for navigating real estate markets around the world in the years ahead. We focus on several major trends, which when taken together, lead to our recommendations.

Eventually, we expect post-COVID-19 pressures such as inflation, supply chain issues and large fiscal stimulus to settle and a new normal to emerge. It’s just a question of “when?”

In this year’s edition, we seek to look through the current acute period of volatility and uncertainty, to discuss our view of likely outcomes and scenarios to consider, key themes for investing and real estate strategy recommendations that we expect to be resilient across the range of conceivable macro environments.

Thoughts on COP26

The 2021 United Nations Climate Change Conference, COP26, commenced this weekend with 25,000 delegates from over 100 nations converging on Glasgow. The conference is a major landmark in international climate policy. Progress reports and revisions to previously-pledged goals for reducing greenhouse gas emissions are now due. In recognition of the ever-increasing ambition expected of these commitments, this process is referred to as the “ratchet mechanism.” The conference takes place against the backdrop of European natural gas prices, which have risen almost sixfold in a year, and amidst logistical challenges of moving delegates around during a transport workers’ strike in Scotland.

Much of the recent spike in European natural gas prices (p.10) is the result of supply-side factors. As economies reopen and consumers return to pre-pandemic levels of activity, energy producers have not found it so easy to rapidly scale up output, especially for infrastructure mothballed as industrial demand collapsed during 2020. Competition for the supply that is available, combined with the imperfect substitutability of renewables, has resulted in spot prices increasing as much as 25 times during periods of peak demand. It is not only heating homes and generating electricity that will become more difficult and costly if natural gas prices remain high – knock on effects will be felt in in many kinds of consumer staples.

The short-term supply factors driving energy prices will likely fade as extraction capacity returns to pre-pandemic levels. In the longer term, the broader agenda to move away from fossil fuels suggests structural declines in the demand for natural gas. The U.K. government has moved to restrict future domestic use of gas for heating, banning the sale of new domestic gas boiler systems from 2035. The EU, where natural gas accounts for some 32% of final household energy consumption–-against just 12% for petroleum–-has proposed a second Emissions Trading System (“ETS”) covering the buildings and transport sector to start operating in 2025, alongside the existing ETS covering the electricity and industrial sectors¹.

Apart from the EU, the three largest economies in the world are all making plans to ramp up their own transition from fossil fuels to renewables. Under President Biden, the U.S. has re-joined the Paris Agreement, and committed to net-zero emissions by 2050. China has pledged to be carbon neutral by 2060, even though it relies on coal for more than half of its power today. Japan has pledged to reach net zero by 2050, and 40% of the 225 companies in the Nikkei stock index have made similar pledges.

In the medium term, growing populations as well as increasing dependence on data centres, electronic devices, networking infrastructure and electric vehicles will likely drive electricity demand higher rather than lower. The major mechanism by which countries will aim to meet the ambitious goals set out at COP26 is known as ‘greening the grid’. As the renewable infrastructure to accomplish this goal is constructed, it is possible that reliance on natural gas will increase, rather than fall, as coal is phased out. Ultimately, the replacement of coal, natural gas, petrol and diesel with sustainable electricity generation will become the primary channel for reducing emissions.

As national governments increasingly accept the necessity of expensive interventions to meet ambitious climate goals (p.6), a key challenge for asset allocators will be to adapt to all these fast-moving changes. State spending will likely aim to ‘prime the pump’ of private investment, and with some 80% of global energy demand interacting with the built environment², real estate investors have both a vital role to play and a considerable opportunity.

The World Resource Institute considers buildings “by far the largest source of low-cost [carbon] reductions.” By acting ahead of the curve, landlords may be able to achieve higher occupancy, stronger tenant demand, lower ongoing expenses, and resulting higher net operating income from refurbished Net Zero Carbon buildings.

Investors are increasingly looking to broader real asset types to transition to Net Zero Carbon. This new generation of investors and their managers will be advancing their ESG and Sustainability programs to minimize climate-related risks while identifying new opportunities. Investment managers with Net Zero Carbon commitments, such as LaSalle’s alignment with ULI’s “Net Zero by 2050” commitment, as well as our participation in the Net Zero Asset Managers Initiative, signal the commitments that our firm has made to transition to Green Energy.

1. climateactiontracker.org

2. iea.org/data-and-statistics/data-product/world-energy-balances-highlights

From pandemic to endemic

As the Delta variant becomes dominant worldwide and forces some countries to reimpose restrictions, we ask a crucial question: What impact on consumer and investor behaviour will COVID-19, and its existing and future variants, have in the long run?

The good news is most experts agree that current vaccines are highly effective against severe disease caused by all known variants of the virus that causes COVID-19. The links between cases, hospitalisations and mortality have weakened in places with the highest level of vaccinations—Singapore, Canada, the U.K., Germany, and France are among the leaders in their rates of fully vaccinated individuals.

However, the links between Delta spread, severe illness, and mortality are still in place at the global level. When considering recent rises in cases and mortality, we can differentiate between countries that are highly vaccinated and those with limited vaccine supply (e.g., much of the developing world) or hesitancy issues impeding vaccine take-up among some population segments (as in the US).

In the U.K., which had the first experience of Delta outside India, cases surged sharply after football’s European Cup in July. The situation has stabilized quickly in a country where close to two-thirds of the population has been fully vaccinated. The ratio of deaths to cases was about one in 50 during the winter wave; it has fallen to one in 750 in mid-summer. Elsewhere in Europe, the Netherlands has broadly followed the U.K.’s trajectory, even though some light restrictions needed to be re-implemented in August. Similarly, Canada has opened its borders to vaccinated people this summer for the first time since March 2020.

Whilst Europe and Canada have successfully started to reopen, in some parts of the world, the worst phase of the pandemic is occurring now. The exponential growth in cases affects countries the most where vaccination levels are insufficient to prevent new waves of deaths, especially the southeast US, Latin America, and Southeast Asia. For instance, Peru, with less than 4% of the country fully vaccinated, is recording over 600 deaths per 1 million people—the highest in the world currently, and far above peak levels recorded in the U.K..

In the rich world, “zero COVID” countries such as China, New Zealand, and Australia, which have coped so well in earlier COVID waves, are seeing renewed restrictions due to relatively small outbreaks. In our view, these countries face a transition. They will have to remain closed to inbound visitors until vaccinations are high enough, and then must inevitably accept some low level of cases accompanying the reopening of borders. Singapore and Australia have recently laid out plans to reopen borders once vaccination rates are high enough, and shift the focus of concern from cases to hospitalisations. That said, political reputations had been staked on “zero cases”, so the accompanying shift in mindset may not be easy or immediate.

Because the Delta variant is more infectious than the original virus, it managed to breach these countries’ once air-tight pandemic defences, making it clear that we likely will not be able to eliminate the virus worldwide. This does not mean that the pandemic will go on forever; rather, the virus will become endemic, meaning widespread within the population, but manageable with a four-fold combination of vaccinations, contract-tracing, treatments, and occasional rounds of social distancing.

But as we approach the endemic state globally, waves of the virus will ebb and recede, likely with declining amplitude. “In the endemic scenario, where many people have some immunity, the coronavirus will not be able to infect as many people or replicate as many times in each person it infects,” says Sarah Cobey, an evolutionary biologist at the University of Chicago.

What does this mean for economies and for real estate? A more gradual end to the pandemic, characterised by attenuating waves, may result in more of our new habits—the “new normal”—being retained for longer. Modest control measures, like mask mandates and travel testing, should persist for the foreseeable future. The return to the office will also be slowed in countries where it has not already occurred. According to JLL’s Pulse Survey compiled in April, most firms targeted September for return to offices; however, several high-profile companies have announced they are delaying their plans by at least a few months.

The transition to endemicity will also impact the data we track as followers of economies and markets. Vaccination rates and hospitalisation rates should take over from case rates to become the key metrics in predicting a return to normality.

From the point of view of long-term investors, waves of the virus will diminish as the outlines of the post-pandemic world become clearer. Nevertheless, the Delta variant represents a major setback for a speedy return to pre-pandemic “normalcy”. This reinforces our view that some aspects of economic and social behaviour are likely to take longer to recover than many imagined six months ago.

In recent weeks, many records have been broken.

We aren’t referring to the Tokyo Olympics but to record-setting heat, floods and fires in many parts of the world. Record heat in western North America, record rainfall in Germany and the Benelux countries, and near-record rainfall in Henan Province, China remind us that, as many scientists had predicted, extreme weather events are becoming more intense due to climate change.

The extreme weather events align with the contention by many scientists that the “Greenhouse Effect” of trapped CO2 in the atmosphere is the root cause of rising weather volatility. A recent UN report, Human Cost of Disasters, notes that improved reporting and recording in recent years partly explains an increase in disasters over the last 20 years (2000-2019) compared to the previous 20-year (1980-1999) period. However, most of the increase is due to a sharp “rise in the number of climate-related disasters” categorized as meteorological, climatological, or hydrological.

The extreme heat has led to dry conditions, making vast areas of western North America, Australia, South America, and Southern Europe more prone to wildfires that occur more frequently and earlier in the season. While the fires cause significant haze and poor air quality in nearby urban areas, in recent weeks smoke from over 80 large, active forest fires in the western North America have reached the Atlantic coast, some 2,800 miles away.

As noted in our May 2021 ESG Themes Take Center Stage report, extreme temperatures “are forcing buildings and infrastructure to face conditions well outside their design parameters.” During the recent heat wave in western North America, roads cracked and buckled in some areas, unable to withstand several days of record-breaking heat. While roads can be built to withstand extreme temperatures or other variants of a local climate, building for extreme heat was never considered in areas that rarely experience it. Similarly, the death toll from the heat wave in western North America was due in large part to the fact that many households in British Columbia and the Pacific Northwest do not have air conditioning, as temperatures rarely hit a point where air conditioning is needed.

Residents of coastal cities have long been aware that flooding is the most pressing manifestation of changing climate patterns and are thinking about ways to minimize flood risk. The Dutch and Danish governments have devised elaborate systems of barriers and water management to protect coastal cities from rising sea levels and storm surges.

The pandemic continues to be front-of-mind around the world as COVID-19 variants remain ever-present, in most countries. Rising vaccination levels could allow a phased re-opening of economies and a palpable sense that a return to normal is imminent. At the same time, extreme weather events in recent weeks remind us that the post-COVID world will not be the same as the pre-pandemic one.

This will not be the last time that our research team will be reporting on extreme weather and its impact on real estate. We believe that the events of the last two months represent the beginning of a long journey. At LaSalle, we are integrating climate risk analysis into our underwriting and portfolio reviews of managed assets. The research, risk management, and ESG teams at LaSalle have joined forces to bring the latest scientific analysis and projections for future climate change directly to our investment teams. This journey requires an understanding of which risks are covered by insurance or mitigated through physical improvements, and which cannot. This is a journey that all real estate investors must eventually take.

The great re-opening gains momentum

The pandemic gave us time to reconsider our lives, our work, our relationships with families, friends, neighbors, and co-workers. It also fundamentally changed how we interact with technology and with our surroundings – in both the natural and built environments. For real estate investors, the pandemic rocked the foundation of the asset class. Yet, as our Mid-Year Update reveals, real estate has generally survived intact, and many markets are thriving in novel ways. Finally, the pandemic raised awareness for the possibilities for creating societal benefits through investment in low-carbon assets and in healthy, diverse communities.

In the second chapter of the Mid-Year Update, we review the huge sectoral shifts we first reported in “The Future of…” series six months ago. Then, we revise and update this analysis with insights from the last several months of “The Great Re-opening” and add our forward-looking views for the rest of the year and beyond.

In the third chapter, we trace how “The Great Re-opening” continues to play out in each region. Overall, the re-emergence of leasing activity, and a sharp upturn in capital market transactions have brought a strong sense of optimism to real estate investors at the midway point in 2021. Values are reaching new highs in the favored sectors. Transaction activity in out-of-favor sectors is beginning to show solid support for values reasonably close to pre-pandemic levels, wherever asset-level and market occupancy have both held up. In fact, the biggest challenge for deploying capital is that so much other money is trying to find a home in real estate – in effect picking up the plot from the pre-pandemic years. The fourth chapter summarizes the asset-class perspective and looks at the question of how real estate performs in a rising inflation or rising interest rate environment, even though inflationary conditions are far from universal in the markets where we are most active. Finally, we highlight the importance of real-time data analytics to track the re-opening process around the world.

Last December, we foresaw surging demand for warehouse and residential space, a record amount of capital unleashed, and an acceleration of investor interest in alternative sectors once COVID was contained. All three of these predicted trends have kicked into high gear, especially in countries where vaccine deployment or “return to office” levels have been high.

Nevertheless, just as some people survived the pandemic, but continue to experience lingering symptoms, parts of the real estate universe will continue to suffer from long-COVID. For every property sector or specific location with robust demand, there is another sector facing serious headwinds and existential questions. The pandemic accelerated technology trends in virtually every aspect of our lives—remote working, virtual meetings, tele-health, distance learning, and the deepening of e-commerce. Finally, the pandemic accelerated the adoption of ESG policies by investors and by occupiers of real estate, a move that has many implications for how LaSalle invests in and operates its real estate holdings going forward.

Inflationary pressure is building

Real estate’s reputation for inflation protection will be tested in the months to come. Several different types of inflation have already climbed into view: Asset price inflation came first, followed by a spike in building material and energy costs. Next in line are labour and housing costs, and a broad range of consumer and producer prices that are all experiencing inflationary pressures in 2021 (pp. 6-13). At this stage in the re-opening of economies, inflation is still a good news story as a wide range of markets are responding to surging demand. The risks and opportunities associated with inflation are more subtle, as we describe below.

Even before it became clear that vaccines could play a prominent role in re-opening economies, asset price appreciation accelerated last year. Stocks, bonds, and the for-sale housing markets all responded quickly. The early lift-off also included specific kinds of real estate (warehouses, data centres, life science labs, self-storage, most residential). Sectors that experienced more difficulty during the pandemic (hotels, offices, and shopping centres) are much earlier in this value recovery process. Yet, the listed sector previews strong signs of recovery in these out-of-favour sectors also [as evidenced by recent stock market performance].

The inflation protection question is timely because headline measures of price changes have been trending higher across most large economies (p. 7). One reason this trend is critical is that many Central Banks set short-term rates to meet an inflation target. Through QE bond purchase programs, they also influence long-term rates. (p. 22). Yield curves currently point to modestly higher interest rates in the not-too-distant future (p. 21).

Policymakers focus on permanent, rather than transitory, increases in inflation. The recent upturn in price pressures reflects a recovery from the massive drop in economic activity during the depths of the pandemic. Prices for a wide range of goods and services are back to par, or slightly above their pre-pandemic levels in most major economies (p. 7). As shoppers return to stores (p. 17) and restaurants (p. 16), and travellers board more flights (p. 15), prices have moved up sharply from depressed levels of a year ago. Mild inflation could persist in the short term, since it takes some time for the supply side of the economy to gear up and meet the resurgent demand. Once supply chains are operating again and bottlenecks are resolved, relative movements in producer prices and consumer prices are expected to moderate over the next few years (p. 8).

Although a few inflation measures (most notably commodities) have been trending up across the globe, price trends are highly localised. For example, labour availability in major economies varies almost as widely as vaccine rollouts, degree of economic re-opening, and measures of consumer mobility (pp. 3, 18). Similarly, metro level data shows wide variations in the intensity of house price appreciation within the same country (p. 45). The diversity of inflation pressures on labour costs and housing highlights the interplay of international, national, and local forces.

For real estate investors, another consequential pocket of rising price pressures lies in the construction industry. In the US, input material costs have risen by a quarter over the last twelve months (pp. 11-12). The data points available from Europe suggest that construction costs are also beginning to increase, albeit at a more modest pace (p. 11). For real estate investors, the rising cost of borrowing also looms as a significant factor.

Real estate’s current supply-demand and financial characteristics can mitigate rising inflation. The balance of power between landlords and tenants determines whether real estate cash flows can keep up with, or exceed, inflation. The indexation of leases (particularly common in Europe) can offset some of the impact of rising prices. Triple net leases, where tenants bear the risk for higher operating costs, also offset the risk of eroding NOI. Meanwhile, shorter leases in some property types, like residential properties, allow cashflows to adjust more rapidly to rising price levels than leases that are marked to market less frequently. Rising borrowing costs are harder to avoid. Shifting to shorter duration debt creates significant savings that must be weighed against future refinancing risks and the costs of hedging.

In sum, inflation has not been a major issue for many decades. Almost no forecasters see broad-based, double-digit inflation on the horizon. True, sharply rising construction costs pose challenges for 2021 vintage development deals. But, unlike other fixed-income assets, real estate income streams typically keep up with inflation when rising prices are associated with a healthy, growing economy and real estate’s supply-side does not get too far ahead of demand.

Local issues with global impacts

Taxation is typically a national or local issue, not a global one. However, the runaway success of technology companies and, in recent years, online retailers has elevated the topic to the international arena. The pandemic has increased tech companies’ market-leading positions, as locked-down households and businesses availed themselves of on-line products and services. Many of these companies have a vast store of highly scalable intellectual capital, which can be “relocated” to whichever jurisdiction taxes it the least. Or to put it another way, when most of a business lives in “the cloud” how do you tax it?

In response, there has been growing support, particularly from European countries, for a so-called “digital tax”. The recent counterproposal from the US for a global minimum corporate tax rate further acknowledges that national taxation policies need to be harmonized and overhauled. Tax avoidance through “jurisdiction-shopping” can be as damaging to national economies as another tariff war.

Corporate and asset tax changes are maddeningly complex and difficult to predict. Each country employs a vast arsenal of tax instruments targeting income, capital gains, transfer taxes, user fees. Real estate, because it is readily identifiable and immovable, has long been a favorite taxation target. But, so have corporations, households, financial transactions, travel, and trade. And all countries make extensive use of “tax expenditures” (aka exemptions and loopholes). Many countries such as Ireland and Singapore use low corporate tax rates to attract investment, while others such as Hong Kong offer incentives to dissuade companies from leaving. Still others, actively market their tax haven status and offer tax advantages for individual and corporate investors.

The long term trend across all countries has been to reduce corporate tax rates. In 1980 corporate tax rates averaged 40% around the world. In 2020, the average is now 23.8%^[1]. If a global minimum corporate tax is introduced, a likely repercussion is that low-tax countries might lose some of their competitive advantage. Occupier demand for office space in cities that rely heavily on tax policies to attract corporations could be negatively impacted. This comes at a time when many technology and financial services firms are likely to emerge from the pandemic with a more flexible working policy that results in a re-evaluation of office space requirements.

Yet, no nation is likely to relinquish their taxing power without a lot of vigorous debate; the law of unintended consequences is likely to apply. Some European countries could benefit from higher tax revenues paid by Amazon, Facebook and Google. Meanwhile, the Asia-Pacific triumvirate of Alibaba, JD.Com and Tencent have also caught the attention of government regulators from time to time. Both situations demonstrate a power struggle between nation states and giant technology companies. Any negative impact on office markets from tech companies downsizing their physical footprints would likely not be hugely detrimental to office districts in Europe, Canada, and Japan, where space availability is already low. In the US, vacant office space is plentiful, yet tech companies like Apple (North Carolina) and Amazon (Northern Virginia) continue to plan expansions of physical space in anticipation of a “hybrid” Work-From-Home/Creative-collaboration office model.

In sum, the COVID era has given impetus to a series of “big government” policies: Infrastructure spending, reduced Greenhouse Gas emissions, and a more equitable, healthier environment are among them. Yet, nearly all these programs come at a high cost, which taxation policies are designed to address. Many real estate investors, including LaSalle, are rapidly adopting voluntary “ESG” policies, including “Net Zero Carbon” pledges, to do our part to improve the world. We believe these ESG initiatives can often be accomplished by the private sector, without the need for huge increases in taxation—although 88 countries already have “carbon taxes” according to the World Bank and more are coming. Yet, as owners and managers of hard assets, we share the concern that the playing field is not level. Owners of IP and virtual networks often escape the scrutiny of tax authorities, in a way that is impossible for the owners of “brick and mortar”. Those days may be coming to an end.

^[1] Taxfoundation.org

Opening days

The April edition of the Macro report includes more optimistic signs than many of our previous statistical summaries of the past year. Perhaps this sense of optimism is in part driven by the fact many of the contributors to this Macro report live in Chicago, where flowers are emerging after a rough winter and vaccinations will reportedly soon be available to everyone later this month. Whatever the exact factors may be, the building optimism about the expected re-opening later this summer is palpable and exhilarating.

Before turning to the data that is changing for the better, we first acknowledge that the pandemic is not yet over and the global number of new COVID cases is on the rise again. There is a race between the spread of COVID variants and the deployment of vaccinations (believed to be closely linked to the pace of vaccine production). The coronavirus variants seem to be winning that race in many countries across Europe, the Americas, and South Asia. The variants may delay economic recovery, especially in developing countries, and hopefully suffering can be contained during that delay. Yet, the macro deck also shows that eventually most of the developed world will soon be able to move to a more normal way of life.

In many places signs of re-opening are becoming tangible. Some of the new data sources we used to measure the severity of the decline in economic activity a year ago are now tracking along a strong recovery trajectory. US air travel declined significantly a year ago. It started to recover in the summer, only to fall back as the winter surge hit, even with modest increases for holiday travel. Now air travel has climbed back to the highest levels since March of 2020. The same trends are seen in mobility (p. 13-14) and restaurant reservations (p. 12). This points to the pent-up demand ready to be unleashed as people feel safe traveling and eating out again. The recovery signals are also evident in a steepening yield curve in the US, UK, Canada and other countries where interest rates are trending higher (p. 19-20) and inflation expectations are rising (p. 21).

The big question for many real estate investors remains: Will people start going to their offices and to shopping centers again when they feel safe, and will tenants renew their leases when they come due? (see p. 26, 44-45). While Zoom dinners and concerts have been a distant second best to the real thing, the general functionality of Zoom meetings and avoiding commutes makes the outlook for office demand more uncertain.

Professional and amateur sports are also experiencing re-openings around the world. Sports revenues generate an estimated $500-$800 BN each year-equivalent to between the GDP of Sweden and the Netherlands. When the Pandemic slammed into Europe and North America in March of 2020, virtually all team sports shut down. By summer, many leagues were back to limited operation, often without fans, and even in contained “bubbles.” Places with greater COVID control, like New Zealand, had full stadiums, but most team sports were limited to domestic competition with highly restricted attendance. Major League Baseball in North America and Formula One are useful trackers of this cycle, because the start of their 2020 seasons coincided with the Pandemic—(see p. 7). The Summer Olympics will proceed in Japan, one year after originally scheduled, but in front of a much-reduced audience, as foreigner spectators will not be permitted to come. Many other international sporting events (e.g. Davis Cup, T20 Cricket World Cup, Ryder, Cup, Tour de France, Giro d’Italia, UEFA Euro 2020/1, Wimbledon) and many cultural events are planning to proceed cautiously. International travel will have to wait until projects like “CommonPass” or “Excelsior Pass”, the first digital vaccine passports, are widely embraced by airlines and, most importantly, immigration and border control ministries in each country.

Highly constrained sports venues and international travel restrictions are examples of how economic and social trends will still be far from normal in the coming summer months. They also illustrate the “long impact tail” that the pandemic is likely to have on our lives and on real estate markets.

The role of behavioral influences

As the world slowly emerges from the worst pandemic since 1918, two of the most frequent questions we hear from investors are: “Will people return to cities? What can we learn from the Asia-Pacific experience?”

Although there are significant differences in the circumstances facing employers, workers, and consumers in each country, we believe it is quite helpful to understand what is occurring in the major cities of the Asia Pacific region as a preview of what might occur in the West. Behavioral influences play a large role. The sooner people are willing to return to their offices, the lower the potential impact on investment performance. Culturally, face-to-face meetings in a formal office setting are often viewed as essential business rituals in countries like China, Japan, and South Korea. In Shanghai, where the re-opening has been the most advanced globally, office demand turned positive in the second quarter of 2020. In Singapore, office demand (net absorption) turned positive in the fourth quarter of 2020, despite the worst economic decline since 1965 and the government’s policy capping office capacity at 50%. Even in the retail sector, which was hit harder by the pandemic than other sectors, occupier demand in Shanghai was positive in 2020. Chinese consumers gradually returned to malls when the health risk largely declined in April (see page 43).

The behavioral approach suggests that human psychology plays an important role in the decisions we make. A rational, fact-based approach to risk assessments and decision-making does not fully explain how people react to dangerous situations and their lingering fears after the danger has passed. The Asian experience seems to demonstrate that “recency bias” can be overcome through confidence-building actions and communications taken by governments and businesses. Despite cautious optimism, uncertainty lingers in major cities like Melbourne and Tokyo (see page 7). Nevertheless, it helps that mask-wearing is fully accepted and ubiquitous across most of the region. During times of uncertainty, behavioral influences on decision making are especially important. For instance, core beliefs, cognitive biases, past experiences, or cultural differences can influence decision making, which could ultimately affect economic and investment outcomes.

We believe the pandemic is a perfect example of why the behavioral approach matters. Asia Pacific’s ability to contain the pandemic is evident in traffic congestion and mobility indices (see pages 7 and 27). Rising mobility is a sign of rising confidence that builds into a virtuous cycle, when it becomes clear that leaving home while wearing a mask and social distancing–does not cause a resurgence of COVID. The pandemic control policies followed in major Asia Pacific countries, even before vaccine rollout, have a positive correlation with the region’s economic resilience, particularly in China, South Korea, Australia, and Singapore. The return of social and economic activities and real estate demand in Asia Pacific show what the West may be able to look forward to, as rising immunity levels in Europe and North America are likely to enable the same virtuous cycle of mobility and activity.

The rollout of COVID-19 vaccines will first help restore domestic activities, particularly in countries that were not able to control the spread of the virus in 2020– a critical step to repair their economies. Ultimately, for the global economy to reach the “new normal”, most likely a significant portion of the world population will need to be vaccinated. However, for now, the reality is that international border controls are getting stricter even in countries where vaccine rollouts have been the most advanced (e.g., the United Kingdom, in part, due to new strains of COVID-19); and in parts of the world that have been the most successful in controlling COVID-19, quarantine and social distancing rules remain stringent (e.g., Australia and Singapore) to ensure the momentum of the domestic recovery continues.

Looking forward, each country has a different vaccination rollout schedule and it could take some time for immunity to rise to levels that vastly reduce the risk of getting infected (see pages 6, 50). In the meantime, the upcoming economic and real estate recovery in most countries will rely more heavily on domestic demand. The experience of Asia Pacific shows us that a return to cities is not only possible, but probable, when both the behavioral and the biological effects of the coronavirus are tamed.

And the Year of the Vax

February 12th marks the beginning of the Year of the Ox in the Lunar Calendar. In Chinese culture, Oxen are known for diligence, dependability, and determination. These are traits we will all need to rely on in the coming months while vaccine deployment proceeds at an ox-like pace. As we enter February, the depths of winter in the northern hemisphere, the pandemic shadow is once again darkening much of Europe and North America, and a weary populace may be forgiven a dream of spring.

In economics, dreams like this are referred to as “rational expectations” since current views of future conditions underpin human behaviour in markets and society at large. Rational expectations theory plays an important role in understanding many macro-economic situations. How might this approach apply to the pandemic and epidemiological data? Although we are not experts in virology, we would like to share our analysis of pandemic data that points toward connections to economies and property markets.

In those nations which have borne the heaviest disease burden, uncertainties regarding the extent and durability of immunity conferred by prior exposure to COVID-19 have clouded forecasts and hence also expectations. Some insight may be drawn from a recent UK study, the first that rigorously looked at this question, which found that that having been previously infected does indeed confer strong protection. This recovered population may help to slow the spread of the disease alongside the deployment of effective vaccines. However, estimating the size of these recovered-immune populations means looking beyond official case counts, which have been biased by testing capacity that has varied considerably over time and place. On page four of this month’s Macro Deck, we examine estimates of total infections—symptomatic or not, tested or not—developed by the Institute for Health Metrics & Evaluation (IHME) at the University of Washington. Their model suggests that nearly a quarter of the population of some countries has already been infected.

Two nations which have endured a horrible pandemic experience—the U.S. and U.K.—have also played important roles in vaccine development and have secured large numbers of vaccine doses (see page five). Benefiting from an early start, they have been able to ramp up their vaccine programmes swiftly and are now immunising hundreds of thousands of people per day. Combined with a relatively large number of COVID survivors with presumed immunity, the U.S. and U.K. may well be on the way to gaining widespread population resistance to the coronavirus.

Diligence and determination also describe the successful response of the major Asia-Pacific economies to the pandemic. Meticulous traveller quarantines, testing protocols, and contact tracing systems will remain in place while the vaccine rollout begins. Some Asian governments have announced ambitious vaccination programmes that, when realised, would put them on track to be commensurate with some European and North American countries later in the year. Specifically, a new U.S. administration is putting comprehensive federal COVID-control measures in place for (effectively) the first time; plans to fund these measures are also moving rapidly. Meanwhile, the European Union has taken a stand to ensure that it gets its promised share of vaccine doses. The World Health Organization and Biden administration have also made moves to make sure economically disadvantaged countries get the vaccines they need. Remaining challenges include dealing with new variants of Covid-19, gaining a deeper understanding of immunity-through-infection, and conducting analysis of vaccination efficacy.

This will be the second consecutive Lunar New Year for which this normally bustling cross-border travel period remains constrained by the pandemic. Domestic travel in Asia is showing signs of a gradual return to near-normal, and progress has been made in the region with bilateral arrangements, sometimes known as “travel bubbles”, which are helping to facilitate some business travel. However, a return to frictionless inter-regional travel across Asia-Pacific, Africa, Europe, and the Americas will have to wait until the vaccination push is completed and its impacts are assessed.

The worst-hit countries in the West, having proven incapable or unwilling to control the virus through public health measures, may at least enjoy a hopeful future as population immunity levels rise. But ox-like strength will be needed to pull economies out of this pandemic recession. Our analysis indicates that each region and country will follow a slightly different path to controlling COVID-19, but it is clear that the Year of the Ox will also be the Year of the Vax.

And a look forward to 2021

Historians have plenty of material now to try to put the events of 2020 into perspective. Even without a global pandemic to contend with, the past year of shared calamity included political upheaval, wildfires, climate risk, social unrest, disputed elections, as well as trade relationships broken and re-formed. 

Political shades around the world

Followers of both US and UK politics are accustomed to studying maps coloured in with either red or blue. While Europeans may find it odd that Americans use red to indicate states won by the party on the right—the rest of the world generally associates that colour with socialism—the use of only two hues suggests a kind of satisfying, binary conclusiveness. And in the context of a major global resurgence of COVID-19, many people undoubtedly look forward to closure on something, not least the seemingly never-ending US presidential campaign or the endless UK/EU trade negotiations. However, in this topsy-turvy year, a well-defined outcome for either is far from guaranteed. In the case of both the US election and Brexit, there is a likelihood that we must cope with an unclear result and extended uncertainty; in other words, with shades of grey.

In prior decks, we have shown how election results have only a modest impact on real estate markets. However, there is evidence that extended economic or policy uncertainty does seem to play a role. And with Trump and Johnson at the reins, uncertainty is not in short supply. Let’s take each of these events in turn.

Neither the opinion polls nor the betting spreads have covered themselves in glory these past years. Nonetheless, both place Biden comfortably ahead with just a few days to go before the US election. The electoral college and the disinformation campaign surrounding postal votes suggest that the result of the election could be closer than implied by polls, almost certainly leading to a legal challenge from the loser. A contested election in the US could become a concern to private equity real estate assets if the uncertainty becomes entrenched. This concern cannot be ruled out if resolution through the courts takes several months. In normal times, this could be a survivable period for real estate; but as it will coincide with the twin threats of a COVID-19 resurgence and a stalled recovery, this uncertainty has the potential to dislodge tenants and deter investors during Q1 2021.

Meanwhile in the UK, the preferred deadline for UK/EU trade negotiations was in October; the practical deadline is sometime in November. Sensing the public’s desire for clarity, “Get Brexit Done” became the slogan of Boris Johnson’s December 2019 winning election campaign. The Brexit saga returned to the fore during 2020’s summer months as negotiations with the EU stalled. We have long argued that the short-term negative impact of a No Deal Brexit will be relatively muted, particularly when compared to the havoc wreaked by COVID-19. However, not all possible no-deal Brexits are created equal; Capital Economics^[1] has argued that an “uncooperative no deal,” where talks break down in an environment of animosity, would be more damaging in the long run because it would lead to fewer agreements in the future and the expiry of temporary measures.

Moreover, uncertainty surrounding Brexit has clearly influenced the occupier and investment markets since the 2016 EU referendum. As it stands, UK real estate would most likely feel the effects of continued uncertainty to the end of 2020 or indeed beyond into 2021 should we see a short-term extension or bare-bones deal. As with the US, this Brexit-related uncertainty in the UK comes at a time when the country is struggling to get another wave of COVID-19 under control. There are many possible paths which the UK/EU relationship could take, and we may not see the full repercussions for several years to come.

The US and Europe are not alone in facing political transitions during the pandemic. Japanese Prime Minister Shinzo Abe was forced to step down in August due to health problems. At least his successor, former right-hand man Yoshihide Suga, was selected quickly and represents policy continuity. But the fizzling of Hong Kong’s pro-independence protests amid social-distancing regulations seems to come with a less definitive conclusion to the tensions there. The passage of the National Security Law comes with promises that it does not represent an end to “one country, two systems”—an outcome we believe requires appreciation for shades of grey.

Uncertainty in and of itself need not be negative for real estate. If it manifests in lower bond yields, then recent years have shown us that an income-producing asset class such as real estate could be a net beneficiary. Moreover, opportunistic investors may look to take advantage of weak currencies and cheap leverage, whilst long-term investors may move to secure prized assets at a discount. But there is nevertheless cause for caution. The UK and US are led by populist leaders who are failing to come to grips with the pandemic. They are both among the largest, most liquid, and transparent real estate markets in the world, top destinations for cross-border investment, and arguably the worst hit by the structural changes ongoing in the retail sector. We cannot predict the outturn of either the US election or the EU trade negotiations with any great certainty. Our strongest conviction: All this uncertainty is likely going to take time to sort out.

^[1] “Brexit: Deal or no deal is not the big issue” Capital Economics 1 October, 2020

If the levels of stock prices are any indication, global COVID-19 worries may be behind us.

Many of the world’s largest stock indices, including the NASDAQ, the S&P 500, the Nikkei, the Dax 30 and the Shanghai Stock Exchange Composite, have all recovered most of their COVID-19 losses or even topped their pre-pandemic levels. Traditional wisdom has it that share prices are one of the best predictors of the future. Hence, a rising stock market might reflect that everything is under control, and the economic crisis is drawing to a close. (p.5 of the macro deck)

Yet, the gulf between the real world and the global capital markets is wide. Moreover, there is another bit of wisdom we have quoted in the past: “The stock market has predicted 9 out of the last 5 recessions” (Attributed to Nobel Laureate, Paul Samuelson). Maybe the odds are the same on the way up as on the way down. While the unprecedented liquidity injections by Central Banks have helped stabilize the global capital markets, the economic wounds from the COVID-19 pandemic have not fully healed. (pp. 8-9) According to the World Bank, the global economy is expected to shrink by 5.2% in 2020 – the worst recession since World War II. The disruption of economic activities due to shutdown measures has severely impacted corporate and municipal financial health (pp. 11-12). As a result, solvency risks have increased, and liquidity alone cannot solve a solvency issue. Companies cannot survive on subsidies and low-cost debt forever; eventually they need more revenue.

In the face of revenue uncertainty, many companies are expected to cut labor costs to shore up their earnings outlook. This trend is evidenced by the growing number of redundancy announcements, especially in industries that focus on retail trade and services. The pressure on companies’ financial health is expected to increase as the emergency measures (e.g., wage subsidies, deferred loan payments, stimulus spending) taper off next year in many countries. This weakened business outlook is expected to drag on households’ forward view for employment and income, which could further reduce consumption. Any potential COVID-19 resurgence and growing geopolitical tensions around the world also could further cloud the recovery.

So, with all this seemingly bleak news, what is the stock market trying to tell property investors? There are at least six options to consider:

• The worst may be over. Vaccine and treatment trials today could result in record-breaking production and inoculation that may tame COVID as quickly as it burst on the scene.
• Headcount reductions today could slingshot into higher earnings growth next year during the coming economic recovery.
• When you peel back many stock indices, most of the uplift seems to be concentrated in a few sectors or stocks; the pandemic may have created a few big winners and many losers. This pattern is found in the US REIT universe also. (pp. 26-27)
• There is an excess of capital available in the capital markets. It needs to find a home, and stocks are generally an easy place to park cash. Private equity may need a longer runway to take off and a longer glide path to land. (p.3)
• Interest rates could stay low for much, much longer. More than any specific recovery scenario, these low rates could be raising asset prices. (pp. 17-18)
• The stock market signal could be a “false dawn” and might evaporate if a second wave of COVID 19 hits in the months ahead. (p.4)

For real estate investors, as weaker economic conditions filter through to occupier demand, the net operating income (e.g., rents and occupancy) for real estate could deteriorate further before we get an actual sunrise. It usually takes about six months for macroeconomic trends to filter through to real estate fundamentals. The wait for a property market recovery could be elongated by the expiration of various fiscal stimulus packages sometime next year.

In sum, real estate may be the caboose on a recovery train that has not yet left the station. While waiting to catch the early train, investors may seek to trade out of asset types that are a drag on future performance while reserving seats in the head cars where the ride could be smoother. To mix a metaphor, investors should beware of the “false dawn”, as it is premature to declare that COVID is under full control just yet. Yet, the sun will rise again someday, and so investors should be well-positioned to catch the early train, even if it means standing in the dark at the station.

Not back to normal

The start of September marks the “Back to School” season in much of the Northern Hemisphere, and as with nearly everything in 2020, education has been impacted by the Coronavirus Pandemic. Getting Back to School reflects the same safety and social distancing challenges as getting back to offices, back to shopping, back to travel, back to socializing, and basically back to “life as we knew it”. As school, work, shopping, and travel all adapt to social distancing requirements, the buildings that enable these activities are also affected. Real estate investors need to identify the winners and avoid the losers as they price assets, determine strategies, and manage through this uncertain period.

As long as COVID remains a major health risk factor, a return to pre-COVID patterns of real estate leasing and operations will be in our estimation, partial at best. Just as parents and teachers worry if school is safe, firms and workers wonder if their office is safe, shoppers worry if a store is safe, and travelers worry if planes, mass transit, dining, or lodging are safe. As this situation persists, more data becomes available on safety and risk factors, and we gradually gain clarity on the economic winners and losers in this pre-vaccine stage of the pandemic. This data often raises additional questions about what happens when COVID-19 is under control and when can we get back to the next normal? The performance of private and listed real estate investments will be driven by this still-unknown future. Just as 2020 is more different than anyone could have predicted in 2019, the next 12 months could also provide a range of surprises.

This macro deck contains a wealth of content about the state of the world today. Admittedly, readers won’t see nearly so much about the future. We know that the level of virus containment (pp. 6,36,43) correlates with mobility and spending (p. 9-12,42). Longer-term, the question is: “Will the economy rebound when the virus is contained, or will the scars of the Pandemic persist?” Low interest rates appear to be the norm around the world today (p. 18-20), but will that persist as life returns to normal, especially in markets like the US, UK, Continental Europe and Japan that have experienced sharp interest rate declines during the Pandemic? Fiscal and monetary stimulus continue (p. 17), but what will be the impact of unwinding this liquidity, and how will governments pay back what was borrowed? The REIT market points to the variety of impacts across sectors (p. 26,27), with investors making calls on long-term challenges for sectors like retail and lodging, and long-term gains for data centers and cell tower REITs. Will these short-term price movements be proven right or wrong? Low interest rates and a desire for more space is boosting demand for suburban housing in many countries, but will this boost in demand be sustained? The pandemic raises more questions than answers, yet we believe investment managers will need to take a view on all of these issues.

In keeping with the “Back to School” theme, we share some data on the re-opening status of schools and universities (p. 4,8). The impact of a University operating remotely for a semester or school year can be significant on the local businesses and the real estate that depend on student spending. One assumption underlying pre-COVID investment strategies was the stability of “Eds and Meds”. We believe this Pandemic is threatening the stability of the education or “Eds” sectors, while providing a boost for some of the “Meds.” The return of economies to normalcy and productivity also depends on primary schools being able to safely educate children in classrooms. The long-term questions for education are similar to the big questions for offices: When is it safe again? What will be the lasting changes from this period of working and learning virtually?

While negative shocks rightfully grab the headlines, we have spotted sectors like laptop computers, home improvement stores (p. 7), data storage, and suburban single-family home rentals, all of which are experiencing booming demand. Based on rising stock markets around the world (p. 3), equity investors appear to be taking the long view that aggregate demand will recover in the not-too-distant future. Recent news, perhaps, provides some reasons to be optimistic regarding the development of vaccines and treatments. While today we as parents, workers, consumers, and travelers struggle with the safety of getting back to “life as we knew it”, as real estate investors, we are optimistic that long-term investment performance will be driven more by pre-COVID patterns of business and household consumption than by this historic, but hopefully brief, period of time. Our research projects, previewed in the Mid-Year ISA, continue to focus on what that future world will look like.

Lessons from diseases of the past

Over the centuries, epidemics have impacted the way people interact with each other as well as the built environment. The 1854 map of London by John Snow helped identify sources of cholera and led to changes in how the water and waste systems of London were designed. The Haussmann plan for Paris, Olmsted’s Central Park in New York City, and the Shanghai Customs Harbour Quarantine Station were all 19th Century responses to infectious diseases. Even further back, British historian Mark Bailey explains that the sharp reduction in the labour force after the Black Death in the 1350s boosted survivors’ wage bargaining power and disposable incomes. These income gains were then spent on better quality ale and food in public houses[1], giving rise to the pub culture. Given pubs’ ubiquitous role in British life, this change has been consequential both culturally and from a real estate perspective. Even as hundreds of public houses across the UK begin to reopen in the summer of 2020, all are operating under severe capacity restrictions. With modern airline travel and intercontinental mobility, the world has graduated from epidemics to pandemics. The sobering result: the bars and pubs along Clarke Quay in Singapore, Lan Kwai Fong in Hong Kong, and Rush Street in Chicago are in a similar state of partial or complete closure.

From where we stand today, thinking about a post-COVID world may seem premature. Both the resurgence of infection rates in the US (pg. 6), as well as localised second-order shutdowns in places as far from each other as Barcelona, Dallas, or Melbourne exemplify the fluidity of the phases of the pandemic. Nonetheless, we do believe a “COVID under Control” phase will eventually arrive, as cautiously optimistic news on treatments and a potential vaccine revealed during July (pg. 22).

Once an effective vaccine is available, sorting out permanent versus temporary changes in culture or behaviour will take time. Interested readers should refer to Chapter 3 of the 2020 ISA Mid-Year Update as it delves into what the future of real estate sectors might look like post-pandemic, as well as the connections to other global threats such as climate change.

The second quarter data for the real economy paints a disturbing picture in most countries. Despite massive government support in parts of the world, the destruction of jobs brought on by this pandemic has undone a decade’s worth of unemployment decline in the OECD countries (pg. 3). Traditional sources of data take time to assemble, and by the time they are published they tend to reflect information that is already several months old. So, turning to high-frequency activity data helps paint a timely picture of economic activity. For instance, travel to workplaces and retail locations continue to rise; restaurant reservations (pg. 9) and airplane travel also seem to be trending modestly upwards in July (pg. 8), even as Q2 GDP are reported showing historic declines.

Real estate valuation data is also impacted from lags and timing issues. For instance, the latest available valuation-based indices reflect data only up to the end of Q1 in many countries. Few properties have been changing hands (pg. 25), providing less comparable transactions. Thus, it will take some time for new information to be incorporated into the wider index. Real estate trusts and companies traded on listed exchanges uncover important insights for private equity and real estate debt. Through real-time trading and pricing, these securities swiftly reflect changes in the underlying health of occupier markets and risk premia required to hold real estate assets. Global REIT valuations swung from trading at a healthy premium to private market valuations pre-pandemic to now trading at a discount (pg. 26). While this discount has narrowed over recent months, the pricing gap is wider than in recent decades. Given the importance of transactional evidence to private market valuations in times of high uncertainty, we believe this dislocation between public/private markets is likely to persist for some time. The disconnect opens a window for investors to exploit this discrepancy between public and private market pricing.

Public markets can give us a steer as to how investors are assessing the relative risks and opportunities across sectors. The sector hierarchy in REIT pricing broadly coincides with the uncertainty around each sector’s prospects alluded to in Chapter 3 of the Mid-year ISA. Retail and office REITs are trading at wider discount than they have typically done, and industrials and residential REITs are trading at a healthy premium (pg. 27).

We would love to exchange views with you on the future post-COVID world. You can send us an email to this address:[email protected]

[1] “How the Black Death Gave Rise to British Pub Culture” https://go.lasalle.com/e/579181/rticles-what-is-the-oldest-pub/

An unexpected way for a cycle to end

For the last three years, at LaSalle’s client seminars, we would try to envision the way that the current cycle might end. In the case of Australia, China and South Korea, this was a real stretch of the imagination, since the economic expansions in these countries were all longer than 25 years. In the US and Canada, as well as in much of Western Europe, an uninterrupted growth cycle lasted ten years, dating back to the Global Financial Crisis (GFC). A few European countries (Poland and Slovakia) survived the GFC without going into a recession at all, while other G-20 countries (including Japan, France, Italy and Spain) flirted with mild recessions several times over the last ten years. Nevertheless, our collective experiences through previous cycles in the prior 30 years conditioned us to be looking for the signs of the next downturn.

We came up with a series of fairy tale metaphors: The three bears who ended the Goldilocks slumber party and The Boy Who Cried Wolf. Grizzly Bears stood for geo-political crises. Polar Bears represented too-tight central bank policies. Honey Bears represented over-reliance on fiscal stimulus and unsustainable deficits. The shepherd boy in the “wolf” story reminded us that eventually a wolf shows up–you and your flock need to be prepared. Although these stories were amusing, the topic was serious. All expansions throughout human history eventually come to an end and investors need to be prepared. The economist Josef Schumpeter coined the phrase “creative destruction” to remind us that downturns also play a cleansing role that leaves an economy well-positioned for the next expansion. We firmly believe that this could happen with the COVID-19 crisis.

Now, in the year 2020, we have a live example of an unexpected and severe threat to human life, prosperity, and investment portfolios. When our offices shut and business travel halted, we all had a mass education in how pandemics work. Many of us have become daily consumers of COVID-19 case and mortality data. As real estate investment managers, our jobs have quickly pivoted. We must figure out the appropriate actions to take to defend the income-generating power of the properties we invest in. At the same time, we also have the fiduciary responsibility to look around the corner and to develop plans to go back on offense in the second half of 2020 or in 2021 on behalf of the clients whose assets we are entrusted with.

We have already begun this forward-looking task for the Mid-Year update to LaSalle’s ISA. This is not easy. It took noted economic historian Adam Tooze eight years to research and write Crashed, which documented “The First Crisis of a Global Age” – the 2008-2009 financial crisis. Now, just two years after Tooze’s book was published, we have the second crisis of the global age to contend with. Using the Tooze timeline, it could take until 2028 for academics to figure out exactly what COVID-19 means for the global economy. In the meantime, it is our intention to get started now, which is exactly what you will find in our mid-Year update.

We hope that readers will find our look into the future of retail, office and logistics properties to be helpful as we recalibrate what to expect from real estate portfolios in the years ahead. We welcome and encourage your responses and comments on our analysis.

How will real estate respond?

June marks the transition from spring to summer in the Northern Hemisphere and fall to winter in the Southern Hemisphere. The changing seasons help mark the passage of time when many familiar routines have been disrupted by the pandemic. These inconveniences pale in comparison to those who have paid a much higher price – in lost lives, lost livelihoods and separations from friends and family. Never in the post-war history of the modern world have so many endured so many months filled with such uncertainty and trepidation as the first two quarters of 2020. So, the gradual re-opening of economies and the coming of the Northern Hemisphere summer should represent a huge relief.

Yet, the second phase of the pandemic has the defining characteristic that we still must live with COVID-19. While some countries, led by China, South Korea and Germany, are already several weeks into re-opening, others are just starting. The concern among some epidemiologists is that certain jurisdictions may be re-opening segments of their economy before tracing and testing is fully in place. The total number of COVID-19 cases is still rising in many countries, even though the rate of growth has tapered. Recurring infection spikes could force countries to lock down segments of their economy again. Successful re-opening will depend, in part, on how well each country follows prescribed social distancing and safety measures, as well as whether their healthcare system has the capacity to handle a second wave.

The degree of containment success during Phase Two of the pandemic will have impacts on real estate performance. The speed of retail sales recovery at brick-and-mortar stores is uncertain, but this month’s deck shows how we can track rising mobility and footfall at properties as re-opening gets underway. Closure of physical stores led to double-digit and in some cases triple-digit ecommerce sales increases. Some of this shift could be permanent, especially for stores that cannot easily adapt to social distancing or run profitably at highly controlled density levels. On the other hand, retailers that can more easily adapt to click-and-collect models, are already seeing sales recover. Office workers are expected to face a different world when re-opening occurs, including physical distancing for everything from elevators and washrooms to floor plan layouts. In May, some prominent tech office users, including Twitter and Facebook, announced that their employees will be able to work from home for the remainder of 2020, or in some cases, permanently. This has the potential to significantly reduce aggregate office demand if other firms follow suit. On the other hand, other office users may require more space to enable social distancing. The tug of war between these two forces will play out differently for each tenant; but we will be watching aggregate patterns that will determine what happens to overall office demand.

These are issues investors must take a view on, long before the answers are known. To help guide our colleagues and clients, in this month’s deck we examine:

• A comparison of the TomTom Traffic Index congestion levels for two cities at different phases of re opening: Shanghai and Toronto (slide 4)
• A status update of different countries in terms of re-opening and transitioning to Phase Two (slide 6)
• Revised GDP forecasts from Oxford Economics, which now surpass IMF forecasts from April in terms of degree of decline in 2020 and a sharper recovery in 2021. Global growth of -4.8% in 2020 is forecast, while several countries’ 2020 forecasts have declined by three to seven percentage points compared to Oxford’s forecasts in March and April. (slide 8)
• A forecast decline in global trade which is expected to surpass the sharp decline seen in the 2008-09 downturn (slide 9)
• The latest monthly readings of CPI Inflation moved negative in Canada, Sweden, Spain, Switzerland and Ireland, and has plunged in other countries as consumer prices fall amid the pandemic (slide 15)
• In May, the U.K. joined Japan, Germany and other European countries in selling negative yielding debt, reflecting the investor view that paying a modest amount to own bonds is safer than other investments in the midst of a global recession. It also indicates how central banks are using their QE powers to keep bond rates low or slightly negative. (slide 27)

But a long journey lies ahead before this disease is contained.

Four months after the first diagnosis of the deadly COVID-19 virus, the headlines and images of its devastating effects are wearing on us all. A long journey lies ahead before this disease is contained. Yet, plans to develop effective treatments and vaccines are moving into high gear. As April turns to May, it is fitting that we look ahead to the second phase of the crisis, when partial and cautious re-opening of economies gets underway. Images of Chinese Peach Blossoms and a German Maibaum (maypole) symbolize a welcome change as LaSalle gradually re-opens offices in China, in Korea, and in Germany. Other countries will follow, but we can learn a great deal from the experiences of the cities that come back online first.

This month’s macro deck lays out the three phases of this journey: 1) The Lockdown; 2) Partial Re-opening, or “Living with COVID”; and 3) The New Normal, when the virus is under control. It also charts the first leg of the journey and how real estate is reacting with a shorter lag time than is usually the case for the transmission of macro-economic forces into property’s financial performance. Highlights of the deck are as follows:

The steepest economic contraction in living memory: The International Monetary Fund (IMF) cut its 2020 global GDP growth forecast to negative 3% in 2020, before projecting a return to growth in 2021. These forecasts are the most severe re-rating of country-level, regional, and global GDP in the history of the IMF. The International Labour Organization estimates in April that nearly 1.25 billion people globally are at risk of being unemployed or furloughed. The collapse of oil prices is another indicator of the severity of the downturn.

Government policy responses: The amount of fiscal stimulus planned across the US and Europe exceeds that of the GFC. More fiscal stimulus is expected, given that countries accounting for half of the world’s GDP are in some form of lockdown. We believe the pandemic will leave developed nations deep in debt and force hard choices. For instance, Italy’s national debt is approaching unsustainable levels, putting pressure on the European Union to arrange a bailout. Some countries may try to carry enormous quantities of debt with a combination of higher taxes and inflation.

China’s response offers lessons for investors and occupiers: The COVID-19 outbreak has had a severe short-term impact on the Chinese economy and property market. However, headline indicators of business activity largely returned to pre-outbreak levels by the end of April. The Chinese government’s “coordinated approach” appears to have shielded the economy from a deep and prolonged downturn, while a range of measures introduced by owners and tenants have provided a foundation for a gradual property market revival.

Logistics as a net beneficiary in the long-run: Migration to online retail and fast-forwarded consolidation in the retail world accelerates demand in the logistics sector. Supply chain diversification has become a priority, and re-shoring of some manufacturing may start to happen in Europe and North America.

Pricing disconnect: Going into the crisis, investment activity in Europe and the US was holding up well in Q1 2020 compared to the same period one year ago. By contrast, investment activity in Asia Pacific dropped by 58% in Q1, as the lockdown affected the completion of transactions. This same interruption in transaction volume has now hit the West, even as it begins to ease in East Asia.

Public health response: In our view the pandemic demonstrated the ability of some countries to take drastic action when risks to public health become urgent and pressing. And it also showed the inability of others to respond as quickly and effectively. We believe these responses likely presage the willingness and ability of countries to engage in the collective action needed to address future challenges including a second wave of infections, global warming, a move to a carbon neutral society, and climate risk.

In the 27th edition of the Investment Strategy Annual, we address the themes that will shape the real estate investment environment for at least the next three years and likely longer.

The pandemic has simultaneously accelerated and interrupted these trends. Some assets and strategies amplify the effects of COVID-19, while others are much more insulated. In the coming year, investors should prepare for the COVID endgame.

Mastering the simultaneous need for fast/intuitive and slow/careful thinking becomes an important skill to develop in the speeding-up world of real estate. We review techniques to help investors determine portfolio objectives. We present our outlook for the property types and countries that are the most attractive. We share our best investment ideas.

Speeding up and slowing down all at once

Time has simultaneously sped up and slowed down in a surreal way as we all work from home. Economic forecasts issued last week are now woefully out of date. A recurring comment we hear: “Just three or four weeks ago, this would have been unimaginable.” Where “this” applies to COVID case counts, unemployment claims, counting the number of tenants NOT paying rent, or fiscal packages and central bank backstops worth 10% or more of a country’s GDP.

A new challenge is getting access to reliable data and forecasts. The digital transformation of our industry, currently well underway, should help us figure out what is going on. But it may not be as helpful in telling us where we will be a year or two from now. Sorting fact from fiction and spin is also getting harder. The public markets illustrate the spasms of fear and relief that wash through portfolios on a daily basis. In the words of author Max Brooks, “Panic can spread even faster than a virus.” Brooks teaches at West Point (The Modern War Institute) and is a consultant to government agencies and NGOs on disaster preparedness around the world. He says, “During any pandemic, we must practice excellent fact hygiene.” In that spirit, this month’s macro deck highlights both facts and fact-based opinions, but we are careful to distinguish between the two.

A sharp global recession is underway. Half of the world’s GDP is now under some kind of “stay at home” directive. As a result, the major economies of the world are undergoing a near-simultaneous demand-side shock, with supply-side and financial shocks also underway. Consumers and businesses have stopped spending on non-essential items. Transportation, leisure and construction have come to a standstill unprecedented in peacetime. Manufacturing was among the first industrial sectors hit as factories closed, but with robotics now prevalent and China getting back to work, interrupted supply chains may be able to get repaired. Goods and containers can move across borders, even if people cannot. By contrast, the services sector – especially hospitality and retail services – has been hit especially hard and is still in the early stages of coping with a demand shock that is existential for many small and large businesses.

The financial system is also now under enormous stress—both credit and equity flows. Unprecedented policy responses by governments will try to reduce the ripple effects. Monetary and fiscal actions of historic proportions are being rolled out. Ultimately, credit creation relies on trust, not governments alone. And trust is in short supply right now. Despite historic efforts, credit markets are tightening and investors have become excessively risk averse. Lenders now have record-low base rates provided by Central Banks; but borrowers may not get access to incredibly cheap debt, as spreads widen out. In short, we expect huge differences among property types and markets in terms of risk, resilience and liquidity to manifest themselves.

We first circulated a list of property types at risk six weeks ago, when it became clear that this coronavirus was jumping across borders. The ranking is based on REIT data and feedback from our portfolio and asset managers. (p.9) These lists are intended to give colleagues and clients a sense of where to expect trouble. A contrarian investor may be able to take advantage of overly pessimistic reactions to such lists in the years ahead. But, for now, these are also the sectors that are most likely to experience interrupted income streams and borrower defaults. The “best-insulated sectors” will not be immune and all property types will feel the impact of global recession.

As far as the timing and duration of this downturn, there is still so much we do not know. We do not know exactly what it will take to contain an outbreak, especially where containment measures were delayed or when testing has not been widely available. So, none of us knows exactly when “return to work” policies will be promulgated in each country or metropolitan area — although China is leading the way and could provide the world with an example to follow. We still need to find out what, if any, re-infection risk is associated with “return to work” and how quickly risk-taking, investment, trade and travel will resume to the point where the financial system can recover and function without government support. Underpinning our scenarios are multiple assumptions about when effective vaccines, treatment and testing will be widely available (p. 3 & 7). These “unknowables” lie at the heart of our assumptions and plans. Finally, we may all need to learn the skill of “time bending” to cope with the fast and slow pace of social and economic life in the months ahead.

The COVID-19 epidemic has grown more severe by several orders of magnitude over the past month.

With more than 84,000 cases globally^[1] ,it is now ten times larger than the SARS epidemic and has spread beyond China to more than 50 other countries. New cases have declined in recent days within China, but they have accelerated across the rest of the world. As the Chinese government and international health organizations on the front line have made clear, this global healthcare crisis is still growing, and the risks of underreacting are greater than the risks of overreacting.

In the highly interconnected society and economy of 2020, postponed travel, working from home rather than the office, and canceled in-person meetings and conferences are a small price for reducing the risk of a life-threatening, and still not fully understood, illness. For many across the Asia-Pacific region, the burden of containment has gone far beyond these inconveniences. Millions of households are experiencing economic hardship, coping with family separation, and enduring restricted freedom of movement in their own communities – all this before the toll of human suffering from the disease itself is taken into account. The swift actions of courageous health care providers and the everyday sacrifices of people across Asia have helped to buy time for the rest of the world to be better prepared for the arrival of COVID-19 in their own countries.

Economic impacts seem like a secondary concern at a time like this, but they are highly relevant for government leaders, policy makers, and investors who must first get through “crisis management” and then begin to make plans for the future. In China, which is now gradually loosening the largest quarantine in human history, the crisis is a simultaneous demand and supply-side shock. Several forecasters put a high likelihood on Chinese GDP contracting in year-over-year terms in the first quarter. At the same time, the Chinese government has already unleashed stimulus packages intended to help get business going again and to keep the financial system operating smoothly – and more stimulus announcements are expected. The governments of Singapore, Hong Kong and South Korea have recently announced their own stimulus packages, and other counties in Asia are likely to do the same.

This month’s macro deck summarizes the impact of the COVID-19 epidemic on global economic forecasts and on financial market prices. Beyond temporarily lost output, interrupted supply chains, a sharp decline in travel and tourism, and declining consumer confidence, the ripple effects have just begun spreading from Asia to Europe and North America. Property investments in China have seen direct impacts in the form of halted work at construction sites and retail rent moratoriums. Similar effects are likely in other intensely affected markets from South Korea to Northern Italy. Yet this is also a time when the durability of real estate income streams is likely to distinguish property as a stabilizer relative to other asset classes, as most leases are likely to generate income despite these temporary shocks.

The COVID-19 crisis is evolving daily. Although the first case was diagnosed on the last day of 2019, the impact will be felt far beyond the first quarter of 2020. The tumultuous end of February 2020 will go down in economic history as the week when the financial markets finally woke up to the warnings of the World Health Organization. Risk assets like stocks and high-yield bonds have entered “correction” territory in many countries. As we have pointed out before, fear tends to be self-reinforcing in economic decision making as people adjust consumption and investment decisions and perceptions quickly become realty. It is unknown how quickly the virus will be contained worldwide. Likewise, the longer-term impact on economic growth and real estate markets is highly uncertain. LaSalle’s investment teams expect to address the concerns of our tenants and clients through rapid-response communications and business-continuity plans; these actions have already commenced across our China portfolios. Real estate investors can draw some comfort from the insulating effect of real estate’s long-term contractual income and from the heavier weight of capital seeking stabilized income-generating assets as risk-free interest rates fall to all-time lows in several markets.

^[1] See the World Health Organization website for continual updates: https://go.lasalle.com/e/579181/2020-02-29/vdxnmf/898126978?h=iIsAuG6NtoLc1mNbzDxqAasaTIIcyr1uQQt-Jkmi-n8

Thoughts on the Lunar New Year

The Lunar New Year ushers in the year of the “Metal Rat”, which combines the first animal (Rat) and the fourth element (Metal) of the Chinese astrological calendar. Together, they symbolize careful planning, wealth and vitality. Since the Rat is the first sign in the 12-animal cycle, 2020 represents a year of new beginnings. Just as investors were waving goodbye to a year of tremendous geo-political volatility and celebrating the 2019 rallies in the stock and bond markets, another exogenous shock has occurred—Novel Coronavirus. Since the first few cases were detected in Wuhan, China in December, more than 200 people have died and more than 10,000 are fighting the symptoms¹. Thus far, the estimated fatality rate of Novel Coronavirus has been lower than that of SARS in 2002-03, but new cases have been spreading at a faster rate and have been detected in over 20 countries.

The outbreak of Novel Coronavirus reminds us how extraordinarily connected the world has become. It also highlights the importance of the Chinese economy on the world stage. China now accounts for approximately 20% of the world GDP, up from 7% twenty years ago (in PPP terms). Looking back, the SARS outbreak lasted six to eight months. The impact of SARS on global financial markets was negative in April 2003, yet within six months of the outbreak stock markets had more than made up their losses. The impact on retail sales and hotel occupancies varied across Asia Pacific, but generally recovered 3-6 months after the WHO announced that the virus was contained. Also, the impact on travel was much less severe in Europe and the Americas.

Nevertheless, the economic impact of the coronavirus outbreak poses another downside risk to China’s growth this year, when forecasters expected world growth to slow to its lowest level since 2009. It is far too early to say with any certainty whether the coronavirus will be a trigger for a downside scenario beyond the natural slowing growth rate of the global economy. The probability of a global recession has been reduced as populism de-escalates, or is contained, in various parts of the world – the signing of the U.S.-China Phase One deal, the reduction of tensions in the Middle East, and finally, the European Parliament’s blessing of the Brexit deal. On the other hand, these geo-political risks are not off the table permanently; to some extent, they are just beginning.

As long-term interest rates stay at historically low levels, real estate continues to attract investor capital. In particular, demand for core real estate is strong amid “risk-off” behavior and a flight to safety. Logistics and multifamily continue to be the darlings among core investors. Additionally, demand for value-add offices remain strong. Office rent growth is forecast to moderate over the next 3 years, yet still be positive in the world’s major office markets. Retail remains the least favorable sector due to structural challenges and the recent exogenous shock will not help.

The effectiveness of further monetary easing is much reduced compared to 2003. Central banks have less room to maneuver and so many are calling for fiscal policies to ramp up private consumption and economic growth in 2020. Wherever fiscal stimulus occurs, it will certainly spur real estate demand. In summary, real estate is likely to maintain strong support from asset allocators. This means that high valuations for core assets can be maintained indefinitely as long as risk-off sentiment and low interest rates persist. The coronavirus and heightened risks of a China slowdown exacerbate this “safe haven” mentality. The exercise wheel approach to 2020 may result in portfolio managers working hard to stay in one place…but they will be fitter for having done so.

^[1] WHO, as of January 31 2020.

Examining the “special relationship” between the United Kingdom and the United States

The Special Relationship is an unofficial term often used to describe the political, diplomatic, cultural, economic, military, and historical relations between the United Kingdom and the United States. The term first came into popular usage after it was used in a 1946 speech by Winston Churchill. The two nations have been close allies during many conflicts in the 20th and 21st centuries, including World War I, World War II, the Korean War, the Cold War, the Gulf War, and the War on Terror. Both countries were special for the wrong reasons in 2019, as U.S. trade policy and Brexit drove financial and economic uncertainty to high levels. The U.S. engaged in trade skirmishes with many parts of the world, particularly China, raised its military profile in the Middle East, and generally obstructed globalization trends through actions on climate change, immigration and an exit from multi-lateral agreements replaced by unilateral negotiations. To close out the year, the U.S. House of Representatives voted to impeach the President, only the third time in history. The United Kingdom failed to follow through with Brexit for most of the year, leading to the resignation of Prime Minister May and a national election.

While events in the Anglo-American sphere reflect falling trust in political leadership, the decisions of consumers, business, and investors, by contrast, showed confidence that both markets would eventually muddle through – and, in part, the closing events of the year proved them right. The U.K. is on a clearer Brexit path after a decisive December vote that should push the country to leave the European Economic Union in 2020. The U.S. Congress reached agreement on the USMCA trade agreement and stock indices hit record highs.

The misadventures of the U.S. and U.K. did not derail their long-lived economic expansions or spill over to affect the rest of the world. Global growth in 2019 was between 3 and 4%, and global equities had their best year since 2009 (28% total return). In the U.S., the S&P 500 was up by 31.5% in 2019, the second highest return of the past 23 years, while U.K. equities were up by a solid 18%.

While core private real estate returns were unspectacular in 2019 (6.2% in the U.S. and 2.0% in the U.K.), the story of the past decade is much more positive. Unleveraged core property returns averaged 10% over the past ten years in both countries, remarkably similar to returns from Global Stocks and Global REITs (11% – see p. 6), though with less volatility when looked at over rolling 10-year measurement periods. Canada and Australia – the other countries with long return histories – performed similarly, with trailing 10-year returns of 9% and 10%, respectively. Looking ahead to 2020 and 2021, LaSalle’s Investment Strategy Annual forecasts another year in which the U.S. and U.K. play an outsized role in rocking the global boat. LaSalle foresees a slowing global economy (p. 23), ongoing trade disagreements (p. 12), high asset valuations, and disruptive technology as headwinds to favorable real estate performance. However, many of these same forecasts are also linked to salutary tailwinds. Slow growth is linked to low interest rates (p. 18), which elevates values. High valuations are linked to momentum in capital markets, when investors increase allocations to real estate as a result of strong prior performance (p. 4-6), and disruptive technology is linked to higher productivity and innovation.

And what they can tell us

Sovereign bond yields and credit spreads are simultaneously the most watched and the most enigmatic of all macro indicators. For portfolio strategists, they signal risk-on and risk-off sentiment in the broader capital markets. For property investors, they anchor valuations—initial/exit yields and discount rates—as well as borrowing costs.

Bond yields have been on a persistently downward trend for several decades (p. 5), but short-term movements have often been surprising. No doubt trade tensions, divisive politics, civil unrest, wavering economic growth and central bankers’ actions will continue to make the bond needle flutter in November and December. The outcomes of geopolitical events can be especially hard to predict; with so much noise in the system, risk aversion is likely to remain high. Indeed, professional economists and financial markets alike have been notoriously poor at predicting the path for long-term interest rates (p 4). In our view, an underestimation of the linkages between demographic forces and savings behaviour could also be a contributing factor for the persistence of ultra-low interest rates. Ageing trends in many countries are a “meta” macro force that is easily overlooked behind the daily headlines of geopolitics, central bank announcements, and economic statistics.

The gradual decline in long-term interest rates is certainly linked to lower growth expectations. Weaker growth is generally consistent with less inflation, implying that bond investors require less inflation compensation. When productivity growth is low (as it is now), economic growth should be roughly proportional to working-age population growth across an entire business cycle. After a string of strong decades (1950-2000), demographic trends have moved from positive to neutral (2000-2020), and are now poised to turn negative in many countries. A recent study by the UK’s Office for National Statistics highlighted that their population projections had been too optimistic, as life expectancy gains have fallen back and fertility rates disappointed. Similar recent demographic trends are found in North America and Western Europe; demographics are already a net drag on national economic growth in Italy and Japan. Meanwhile, UN projections show that the slowing and greying trends in the world’s population are likely to be maintained or increased over the next century (p. 6). As such, economic growth, risk asset returns (stocks, corporate bonds and real estate) and inflation will all likely remain constrained. Post-Keynesian macroeconomic theory¹ did not contemplate the uncoupling of the money supply, inflation and consumption/investment behaviour, so central bank remedies have been hard to identify. Recent announcements by Mario Draghi as he steps down from chairing the ECB, by Jerome Powell at the US Fed, and by Kuroda-san at the Bank of Japan all point to the limitations of monetary policy when short-term interest rates approach the zero bound.

As populations reach retirement age, they turn toward low-risk, liquid saving rather than higher-risk, illiquid investing, pushing sovereign bond yields lower. Data from the IMF show that the globe’s total savings has exceeded investment since the turn of the century; their forecasts suggest that this imbalance is likely to remain. Moreover, developing nations save a much larger share of their national income than developed ones (pg. 7), due in part to less mature pensions and weaker social safety nets for the elderly. So, when the rising middle class in China, India, Central Europe, and Latin America generate income in excess of their immediate needs, surplus savings are generated faster than growth in stock markets or domestic consumption. The GFC’s scars may also be evident as investing with a long horizon is dampened by fears that economic conditions tomorrow could be worse than today. Thus, ageing populations imply an increased need to focus on liability-matching, capital preservation, rising liquidity preferences, and ultimately, de-cumulation strategies.

Demographic forces are like giant container ships that move slowly but steadily across great oceans. They cannot pivot or come to a full stop quickly. The demographics of ageing are likely to remain in play for many years to come, so real estate investors should keep in mind the following:

• Demographic themes have a major influence on the resilience of assets, sectors and locations. One approach is to focus on properties and locations that cater to the growth of specific cohorts (e.g., ageing, active adult populations or younger millennials). A subtler approach is to examine how younger and older cohorts interact over time, and how the locational preferences of different cohorts affect each other.
• Demographics also have a “meta” effect on macro factors like capital markets. Persistent downward pressure on risk-free rates could mean that real estate yields will decline further and remain below their previous norms. Lower for longer can become lower forever in ageing societies. Real estate’s ability to generate income will continue to attract institutional capital, particularly as populations (and pension schemes) mature. When sovereign bond yields fall or go negative, pension administrators and individual households will both turn to alternatives like real estate to generate steady income.
• Demographic trends are linked to both the capital markets and the space markets. Unlike economic and political events, population shifts get fewer headlines and move more slowly. Their influence on real estate investment strategies is often underestimated and well worth our close attention.

Political events dominate the headlines and are likely to contribute another round of risk aversion throughout the investment world.

Those who hoped that recent bouts of capital market volatility would be fleeting have been confounded by seismic political events. On one side of the Atlantic, the UK’s Supreme Court unanimously ruled that Prime Minister Johnson had over-reached on the matter of Brexit by suspending parliament. On the other side, the US Democratic Party announced the commencement of impeachment proceedings against President Trump. Across the Pacific, the Hong Kong democracy movement is also in the headlines. In all four of these political theatres – UK Parliament, the EU Council, the US Congress, and Hong Kong – resolutions are far from clear, adding to investor nervousness.

Summer stereotypes don’t always ring true

Everyone is on vacation and nothing major happens until we all return to work in September. However, this slow season was incredibly busy in both political and economic realms in 2019.

The US and China trade war bubbled on, millions of people went to the streets in Hong Kong to protest, the G-7 leaders met in France, and the EU and UK digested the new leadership of Boris Johnson. The tumultuous political backdrop led investors to take a risk-off stance, manifested in plunging interest rates and an inversion of the yield curve.

How will it change the retail landscape?

Rapid growth in online shopping is reshaping the retail landscape. Most observers believe that online shopping is eating brick-and-mortar retail’s lunch, with no end in sight.

This view is reinforced by headlines describing retailer bankruptcies, department store struggles, and half-empty malls. The combination of the changing retail landscape and consumer behaviour have also negatively affected commercial real estate investment performance. Before 2011, the retail sector posted an annualized total return of 8.7% based on the MSCI Global Annual Property Index. This is almost 200 basis points above the industrial sector. However, the retail sector has underperformed the industrial sector in recent years. This underperformance trend has been more pronounced in some countries than in others. As a result, many investors are avoiding or under-weighting retail until the future winners and losers become clearer.

In our view, the retail sector remains an essential part of the commercial real estate universe, and investors need to understand the disruption and respond to it. LaSalle has studied various retail markets, particularly in China, which has one of the highest online shopping penetration rates globally, to see how retailers react and how shopping centers evolve as they move through the disruption cycle. While there are many differences between retail markets around the world, we found that the broad trends are similar as the retail sector responds to e-commerce disruption.

Based on our framework, digital disruption occurs in four stages for a shopping center with a top tier catchment:

• Stage 1: Early Disruption
  When the online shopping penetration rate reaches the 7 to 10% range (depending on the country), the first signs of disruption are evident. At this stage, shopping centers have a high concentration of product-selling tenants (in many countries it is about 50%), even after the first round of store closures, which focus on books/audio/music content. Real estate fundamentals are still healthy, but warning signs are evident through flat/falling apparel/fashion sales and declining foot traffic at department store anchors. Store closures are not a problem at first, because of the depth of demand from retailers for top-tier mall space.
• Stage 2: Maximum Disruption
  At this stage, the online shopping penetration rate increases rapidly to 10% or more of total retail sales. Shopping centers attempt to adjust their tenant mix towards still-thriving retail segments, and increase their entertainment, food, and beverage offerings. Some department stores become liabilities that require creative management. Real estate fundamentals deteriorate due to a combination of a weak retail environment and initiatives to optimize the tenant mix by infusions of capital expenses and discounted rent levels. The UK and China went through this stage in 2014-2016. Many other countries like the US, Canada and Germany are just entering this stage of maximum disruption.
• Stage 3: Convergence: E-Commerce and Shopping Centers
  The online shopping penetration rate continues to increase in Stage 3, but online shopping sales growth begins to moderate. Shopping centers continue to adjust their tenant mix toward experiential retail segments such as entertainment, food, wellness, and creative spaces for artists, musicians, or theatrical performances (~47%). The emergence of a holistic online and offline retail experience, as online retailers push for a brick-and-mortar presence and vice-versa from brick-and-mortar retailers. Real estate fundamentals begin to stabilize at late-Stage 3 as retailers/landlords adapt to the new retail landscape. Retailers use brick and mortar spaces as showrooms and fulfilment centers that offer guided tours of their product lines to complement, rather than compete with, their on-line presence.
• Stage 4: Future Equilibrium
  Eventually, a new retail landscape will emerge where online and offline shopping co-exist and reinforce each other. Brick and mortar centers establish their comparative advantages: for entertainment, socializing, community-building, experiential services, and tactile encounters with new products or services. On-line shopping continues to excel at convenience, value and comparison shopping. Real estate fundamentals stabilize as the disrupting influences gradually are absorbed into the new, omni-channel landscape. Landlords will undoubtedly be asked to help finance some of the new fit-outs for retailers and to help replace department stores with new entertainment anchors. Values of shopping centers stabilize and investors return to treating retail properties as a mainstream property type and an important part of a real estate portfolio.

Investors must recognize that the growth of online shopping is a secular trend that is here to stay. This digital disruption framework can help investors understand where a country’s on-line and off-line retail markets are in terms of their evolution. This can help countries like Australia, New Zealand or southern Europe to understand its potential future trajectory. With the understanding of what is to come, investors can draw up asset plans for their retail properties in their existing portfolio and refine their investment strategies for evaluating the future role of shopping centers in their portfolios.

The mid-year assessment of real estate investment markets contains insights and analysis from around the world.

Thus far in 2019, political headlines have dominated our investment committee discussions and research reports. Yet national economies, capital markets and property markets all continue to be relatively impervious to the geo-political noise. It’s as though businesses, consumers and investors are all wearing sound-canceling headphones.

As the second quarter closes, momentum has shifted downward. The triggers for “Slowbalisation” include aging societies, the rise of nationalism, and trade disruption. Yet, as our monthly macro decks have shown, the capital markets generally remain strong. Stock market indices have bounced back after taking losses when the U.S.-China trade wars escalated on May 10th. Debt is cheap and plentiful. Credit spreads are not gapping out anywhere. While we identify several problematic industries and potential ripple effects from trade interruptions, the general momentum in property markets is positive.

Political and structural uncertainty has kept interest rates low on sovereign debt. One fifth of all government bonds produce zero or negative interest rates. German bonds have hit a record low, negative yield in June. Investors remain starved for yield and real estate is one place they can still expect to earn positive dividends. At this stage of the property pricing cycle, we know that there are real estate sectors, like weaker shopping centers or disconnected office buildings, that already are, or soon will be, in serious financial trouble. Yet, price discovery can take several years as owners avoid selling and memorializing any losses. In the meantime, banks will still lend money to owners who contemplate property makeovers, not all of which will be entirely successful.

As the year has unfolded, the space between real estate’s winners and losers is getting wider, as we predicted it would. Investors are putting record-high valuations on logistics properties all over the world, while investors shy away from retail properties and older offices that lack strong urban or suburban networks. The office sector has been propped up by co-working absorption and momentum in life sciences, healthcare and technology; but the costs of leasing to many tech tenants is high. The amenities they demand are expensive. Rental residential markets are generally faring well in many cities, but they are beset by new policy initiatives that may hurt their values in the future.

We maintain our recommendation for investors to pursue both “low beta” and “positive alpha” strategies. The core strategies will withstand volatility in other asset classes best. A “positive alpha” strategy, takes carefully calibrated risks and gets rewarded for doing so. As volatility rises and global growth begins to slow, income stability plays an important part in an investment portfolio. The second goal (positive Alpha) seeks specific assets and sectors within real estate capable of contributing to out-performance relative to the steady erosion of core property indices in many countries.

Two documents are included in this update: The Mid-Year ISA Update Report, and the July 2019 Mid-Year Macro Deck, which includes a summary of our much-requested report “The Investable Universe”.

LaSalle has looked at the likely macroeconomic costs of increased barriers to trade and their potential consequences for European real estate markets.

Until recently, free trade seemed to be a crucial ingredient to the dominant political and economic narrative. After several rounds of trade liberalisation, and except for the immediate aftermath of Lehman Brothers’ collapse in 2008, the world economy enjoyed virtually seven decades of uninterrupted growth in export volumes. Global tariffs dropped tenfold from 40% fifty years ago to just 4% currently. Rapid evolution of supply chains was facilitated by the removal of trade barriers that followed the completion of the Uruguay Round in 1994 and the creation of the WTO, plus the integration of China and the Soviet Union. Over that period global trade growth outstripped economic growth by nearly a factor of two resulting in world trade (imports + exports of goods and services) accounting for nearly 45% of world GDP growth since 1990.

Tariffs and the rise of protectionism

International trade has been steadily rising at a faster rate than global economic growth since the end of World War II. Yet, 2019 marks the end of this 75-year trend–the equivalent of a massive container ship slowing to a crawl.

Cross-border trade represented 6% of world GDP in 1946; it rose to 23% last year, and in 2019 this ratio is falling. New trade policies initiated by the world’s largest importer of hard goods (the US), together with tariff retaliation and the rise of nationalism and protectionism in several other countries—these are the driving factors behind the end of a seven-decade trend.

After signaling progress toward resolving the China/US trade dispute, President Trump surprised markets by raising the tariff rate on $200B of Chinese imports to the US from 10% to 25%, effective May 10, and reiterated the potential to extend 25% tariffs to the remaining $325B of imports not currently subject to taxation. This latest increase is in addition to the $50B of imports previously subject to a 25% duty. Moreover, on May 15, the US further raised stakes by issuing an executive order effectively banning US companies from doing business with Huawei, the world’s second largest smartphone maker. And on May 30, the US issued another tariff threat for Mexican imports.

Markets reacted negatively, with the US S&P 500 declining 6.6% and the Shanghai Composite declining 5.8% in May (see page 7). The US yield curve has also inverted (page 12). Unsurprisingly, China retaliated with tariffs on an additional $60 billion of US imports effective June 1 and has threatened to curtail exports of rare earth elements, a key industrial input.

If trade continues to stay stalled, the impacts on global economic growth rates could be significant, albeit with meaningful variation by country. The theory of comparative advantage is among the oldest and best established in classical economics – developed by David Ricardo in 1817. It states that producing goods based on local strengths and resources and trading for other products produces higher global production and wealth. Many economists also acknowledge that the benefits of free trade can be uneven and subject to manipulation by some countries. In other words, unfettered free trade increases the size of the global economic pie—but it does not necessarily lead to larger pie slices for all.

Oxford Economics expects global trade growth to slow to 1.8% in 2019, down from 5% in 2018 and down from an average of 7% annual growth in the last two decades. Although the direct dispute has mainly involved the US and China, many other countries and technology firms will be affected as they export intermediate goods to China, which China will curtail due to declining exports. Countries most exposed to the global trade slowdown include Korea, Taiwan and Germany, while less open economies, such as the US, Brazil and India, are better insulated.

How should real estate investors react to the recent trade news?

• Core real estate, consistent with its low beta profile, will likely be less impacted than most sectors of the economy, as operating buildings have little or no imported inputs. Harsher treatment of off-shore real estate investors vs domestic capital could be a retaliatory risk, but has not yet risen to the top of the saber rattling list.
• Real estate demand will suffer to the extent that GDP and jobs are impacted. Current forecasts are for modest impact on GDP in most countries — erosion of 50bps (or less) growth. A further escalation of the trade war would worsen the impact.
• Tariffs on materials (especially) will modestly increase the cost to deliver new buildings and upgrade existing ones. At the margin, this will reduce new construction and increase the value of existing buildings, although the impact can be muted by currency moves, lower developer profits and lower land costs.
• The warehouse/logistics sector will experience the greatest impact among property types to the extent that tariffs reduce imports of retail products and business equipment. Supply chains will be interrupted if/when the UK leaves the EU or as import substitution occurs in the US as goods from Korea, Japan, Vietnam and Mexico take the place of Chinese-made imports subject to tariffs.
• The cost savings from e-commerce and other technological improvements may offset the rise of tariffs, so that consumers and businesses are not slammed by higher costs, causing final demand to plummet. Within China and India, the fast-growing domestic economies and lack of modern logistics buildings should support the growth of the warehouse sector for the foreseeable future.

In summary, the current US/China trade dispute is a reversal of many decades of free and growing trade between countries. A few observers expect that the dispute will be resolved by the end of the year, although recent actions and remarks by both the US and China create doubts about that outcome. The impact on real estate demand and values should be modest compared to other sectors, although unforeseen consequences are certainly possible.

In addition to this month’s Macro Deck, LaSalle’s Research & Strategy team published four new briefing notes over the last month:

• Completion Strategies for Real Estate: Bringing together authors from LaSalle’s public and private real estate investment team’s, this paper illustrates how institutional investors can use publicly traded real estate securities to efficiently “complete” their real estate allocations by adding niche property types.
• Urbanization Reimagined: In this note, we look beyond the simple story of more tenant demand in urban places and consider how land prices and rents will change in different parts of the metro area going forward.
• Proptech and Predictive Data Analytics are Changing Real Estate Investment: This note expands on our 2019 ISA, examining how predictive data analytics tools and proptech companies could change how we invest, as well as how we seek to see through the hype that surrounds the growing proptech sector.
• The 2018-19 Investable Universe Update (forthcoming): This is LaSalle’s annual review of the size of the professionally-managed stock of investment real estate, whether held by a listed company, a REIT, or a private equity investment pool. Using new estimation techniques, we also rank the top 40 metros in the world in terms of the total value of their income-earning real estate.

April showers and May … flowers?

The weather is now ideal for a May stroll, or even a random walk, as April showers fade from our macro view. Positive news on the Chinese and US economies, a buoyant equities market, and a Brexit extension have all brought more sunshine into the outlook. Our macro deck is filled with financial data series – and many real estate metrics – that appear to be random walks. Global stock market indices, bond markets, and even property prices do not always revert to a stable long-run average. Nobel prize-winning financial economist, Eugene Fama, described such time series as “having no memory.” This makes them inherently unpredictable using even the most advanced econometrics.

Fortunately, this does not mean it is impossible to predict real estate prices or rents, thanks in part to the special case when random walks are cointegrated with each other. Think of this like going for a ramble with your dog. The path you take might be random, but it would be a safe bet that you and your dog would stay close to each other along that unpredictable path, albeit with variations depending on whether you are using a leash. Cointegrated time series behave much this way. For example, while recently listed Lyft and Pinterest’s stock prices (see page 13) are a random walk, analysts can price information on New York exchanges to predict the price movement of Rakuten shares in Tokyo, which has stakes in both companies. If market prices do not reflect this, then it can create an opportunity for arbitrage.

For real estate investors, the key cointegrated pair of time series are real estate values in the public and private markets: page 3 in this month’s deck. The difference between these series – the NAV premium or discount – has varied significantly over time, but has been near parity over the long-run. However, since October 2016, the implied value of real estate based on public REIT and real estate security pricing has been below the values implied by transactions in the private real estate market. This significant global NAV discount had some observers wondering if this particular “leash” had snapped entirely in two, especially for office and mall REITs.

LaSalle’s conviction that public and private real estate values must be similar over the long run – based on their cointegrated relationship – has been borne out so far in 2019. In early April 2019, the NAV gap – based on the EPRA/NAREIT global index – reached its narrowest level in 31 months. The way the gap has been resolved is meaningful. Private values did not decline to meet the public market, albeit with some exceptions, such as for US mall retail. Nor did public and private meet in the middle. Instead, public values have recovered and the gap has been resolved largely in favor of private real estate values. Underneath these headline figures, there continues to be significant variation in NAV discounts and premiums across individual countries and sectors – leaving many opportunities for LaSalle’s Securities team to make accurate, high conviction predictions of relative value changes.

We recommend that investors focus their forecasting efforts on three key areas where high conviction predictions are possible: cointegrated data series like those described above, data series that are not random walks but are mean-reverting (like the vacancy rates shown on page 23 of this month’s deck), and real-time information predictive of the near future – such as when competitive projects are scheduled to break ground. Technology and improved data frequency is changing how we do these kinds of forecasts. Not unlike taking a Fitbit or smart watch on our next ramble, real estate investors benefit from the collection of more granular and geolocated data.

A New England terms feels appropriate around the world

In the New England countryside, April is known as Mud Time¹ or Mud Season. In 2019, this coarse nickname applies to a much broader geographic area.

Many macro indicators show impeded economic progress as countries spin their wheels in the mire. Yet, a few indicators like REIT prices and tech stocks are surprisingly robust. Thus, the April outlook for property markets is as clear as, well, mud. Structural and political shifts – the fallout from the Mueller investigation, the countdown for the Brexit negotiations, and the next stages of the China-US trade disputes – are all incontrovertibly caught up in the ooze of April as well.

The Brexit deadline of 29 March was averted with just days to go. Instead, this date became the occasion of a failed third attempt to pass a Withdrawal Agreement in the UK. At first glance, the short April 12th postponement becomes the default base case. This story is not yet over. Here’s what we know: The vast majority of Parliament wants to avoid a “crash-out” scenario. The EU leadership does not want to be seen as a villain and have called for an emergency summit on April 10th. Parliament is running out of options with just 12 days to go. The Tory party is effectively without a leader capable of exercising party discipline. The capital markets (FX, FTSE 100, EuroFirst 300) are taking the latest Parliamentary setback in stride. All these facts lead us to conclude that a protracted Brexit process is still the most likely case, even though the odds for a hard Brexit have gone up and a crash-out is still possible.

Recent “risk-off” capital market trends reinforce the importance and benefits of long-term income-focussed investments. In Europe, major economies such as France, Germany and Italy are slowing. Negative-yielding bonds have surpassed $10 trillion, or about 20% of worldwide investment-grade debt. Growing economies like the Netherlands, Poland, Spain and Sweden are all past their peak expansion. And in all these countries, investors are hungry for income-generating property investments with relatively low risk.

Manufacturing PMIs (Purchasing Manager Indices) have also fallen below 50 (showing contraction) in China, Germany and Japan. This is a serious threat to the world’s three largest exporters of tangible goods. Strong momentum in the US economy contrasts with slowing throughout the rest of the G-20. But the US Federal Reserve’s recent guidance for holding interest rates steady indicates that they see trouble ahead. In short, the perception of risk today is higher, as implied by the flattened or inverted term structure of sovereign bonds around the world.

Nevertheless, investment into real estate has been high and sustained, with reports of considerable dry powder waiting to be deployed. We caution readers not to put too much faith in these “wall of capital” estimates, since the GFC showed how quickly the wall can crumble. Our macro deck does not show that another financial crisis is imminent. It does indicate that risks to fundamentals are rising, even though real estate pricing has not adjusted – probably because risk-free rates have fallen. Finally, a close look at the April deck reveals it is also a good time to relieve stress through humour.

^[1] Robert Frost’s “Two Tramps in Mud Time” contains stark economic themes; it was published in 1934—in the midst of the Great Depression.

Both are engaged in a dizzying pas de deux guaranteed to keep the markets transfixed in March.

In recent weeks, hard and fast deadlines have started to bend and break. The March 1st deadline for US-China trade tariffs was swept away by President Trump. The March 29th Brexit deadline is also turning soft, even as Prime Minister May runs out the clock. The much-ballyhooed Amazon HQ2 for New York City was a headline that was erased as fast as it appeared. The late December gloom in the stock markets, driven by fears of an economic slowdown, has lifted in all G-20 countries, ironically with the exception of the world’s fastest-growing major economy (India). So far in 2019, Donald Rumsfeld’s “known unknowns” and “unknown unknowns” should be amended to include “unknown knowns” — things perceived as certain that turn out not to be.

Private real estate investors may be more apt than others at understanding that decisions must always be made under conditions of uncertainty. By owning assets that take months to buy or sell, all private equity investors must live with their decisions for a long time — and are rarely able to re-position portfolios quickly in response to sudden shifts in policy or market expectations. To help LaSalle stay aware of the day-to-day, but still maintain a longer-term perspective, we rely on Capital Market Dashboards (CMDs). These are designed to provide a view of multiple data streams, including lead indicators that potentially signal pending changes in real estate pricing 6 to 12 months beforehand. Private real estate markets are not buffeted by every shift in market sentiment, but they are also not immune to influences from the broader markets. Recent periods of rapid swings in stock market sentiment demonstrate the value of CMDs to give an objective view of capital market conditions across several dimensions.

Looking at the CMDs in major markets today (page 4) we see caution signs, but clear danger signals are rare. By contrast, the US and UK historical data (pages 6 and 7) showed multiple danger signs leading up to the GFC. In using these dashboards, interpretation of signals is critical to understanding their meaning. For example, the decline in US CMBS issuance does not indicate the financing environment is stressed, but is driven by debt funds increasing market share and crowding out CMBS refinancing activity. This points to the challenge of separating the signal from the noise inherent in all data. Reaching high-conviction conclusions can sometimes be straightforward, but it is usually very difficult when interpreting broader capital markets or the direction of the global economy.

February 5th marks the first day of the Year of the Earth Pig

Let’s hope this ancient Zodiac symbol, which dates to the Han Dynasty in 200 BCE, portends a positive year ahead in the real estate markets. In December and early January, the global capital markets woke up to all the risks and challenges that have been around for some time. Slower global economic growth going forward, rising interest rates, unwinding of QE (quantitative easing), and rising debt levels in several countries are all known risks. Unknown risks are also looming. The US and China launched a critical round of trade talks on January 30th. The two sides are far apart on a wide range of issues including Chinese requirements for technology transfer, US demands for IP (intellectual property) protections, and follow-through on reforms pledged by both countries, but not yet carried out. A meaningful breakthrough before March 1st, when the US has said it will raise tariffs to 25%, is unlikely. Yet incentives to make serious progress are strong on both sides as both China and the US work toward establishing new trade agreements.

A similar looming deadline faces the UK and the EU in the next chapter of the Brexit saga. Economists estimate that the global economy has more at stake in the US-China trade dispute; nevertheless, the outcome of the Brexit negotiations is of vital importance to both the UK and the European Union. A third risk is the stability of the US economy. A record-long government shutdown has just ended, but there is no guarantee that the government will remain open after February 15th. The result of all this uncertainty is falling consumer and investor confidence. As the headlines on these economic and geopolitical events evolve, we won’t be surprised to see volatility increase this year.

Meanwhile, as we noted in the 2019 ISA, global economic growth is cooling. Major central banks globally are now walking on a tightrope between loose and tight monetary policies. Key messages from major central banks suggest that rate hikes are now on the back burner, as concerns over economic slowdown or recession risks rise. The “R” word seems to be on everyone’s mind. Most economists are not projecting a recession in the next 12 months (they also didn’t in early 2008). If investors can Keep Calm and Carry On, one of the longest economic expansions can be extended. Eventually, the much-feared “R-factor” will show up in several major countries, but we believe this to be a much lower risk than during the Global Financial Crisis (GFC). Labor markets in major global economies are healthy. Bank, corporate and household balance sheets are generally healthier than the pre-GFC period, with notable exceptions such as China’s corporate debt, Italy’s financial sector, Australia’s household debt, pressures to align with Basel III directives in Europe, and US student debt.

If a recession comes, leased real estate will not be immune, but it will be a “low beta”, or less sensitive financial asset. Also, portfolio managers can prepare for a downturn. In 2019, investors will be making investment decisions in an environment of rising volatility and uncertainty. We recommend that investors set realistic return targets, shift their focus to narrowing the dispersion of return outcomes, and re-set their blend of offense and defense strategies. In real estate terms, that means focusing on location/asset strength and using stringent underwriting criteria. As volatility increases, quality assets and flexibility become more important. Holding period and floor plan flexibility, early loan extensions, or early lease renewals all represent the types of optionality needed to survive a downturn.

MIT Professor Paul Samuelson’s famous quip, “the stock market has predicted nine out of the last five recessions” can now be updated, since he first said this in 1982.

With a peak-to-trough 20% decline in the stock market as a possible “R” trigger, the tally is now 13 out of the last 7 (in the US). The weak predictive power of a stock market swoon for recession forecasting is similar in other countries as well. The Shanghai Composite Stock index fell 25% in 2018, while China’s growth slowed only marginally from 6.9% in 2017 to 6.5% in 2018.

The stock market is but one of many macro indicators that tend to affect confidence, whether we are conscious of it or not. A 46% “false positive” rate for these kinds of indicators is typical when it comes to separating capital market and political noise from the “real economy” signals in macroeconomics. Since real estate valuations are linked to both fundamentals and to the fickle capital markets, we must pay attention to static along with true signals that come through. Our “Year in Review Macro Deck” captures both. Aesop was a Greek slave who collected stories and proverbs in the fifth century BCE. One fable tells the tale of a mischievous shepherd who sends out false “wolf” alerts to his local village. When a real wolf shows up and the boy needs help, no one listens. The wolf gets his dinner and the boy is either shamed or eaten, depending on which version is told.

We sincerely hope that our repeated warnings of rising volatility in the capital markets are not just “crying wolf”. In the fourth quarter of 2018, the diversification power of real estate came to the rescue of many portfolios. Readers of the 2019 ISA know that we emphasized the importance of these “low beta” characteristics, even before we knew about the December stock market sell-off. Perhaps we have been like the northern-dwelling House of Stark, murmuring repeated warnings: “Winter is Coming”1. Nevertheless, our New Year message to all our Macro Deck and ISA readers is this: “After winter cometh the spring, so be of good cheer and hold fast to real estate”.

In the 26th edition of the Investment Strategy Annual, we address the five themes that will shape the real estate investment environment for at least the next three years and likely longer. Some assets and strategies amplify these trends and will deliver “high beta”, others are much more insulated from all the noise and should be considered “low beta”.

Mastering the simultaneous need for fast/intuitive and slow/careful thinking becomes an important skill to develop in the speeding-up world of real estate, in a slowing-down economy. We review techniques to help investors determine portfolio objectives. We present our outlook for the property types and countries that are the most attractive. We share our best investment ideas.

Our macro outlook for 2020 indicates that the global economy will be slowing, which means that rent growth, leasing and other drivers of real estate income could downshift to a lower gear. Yet, slow growth means that interest rates could also stay low and contribute to elevated asset valuations.