Swiss real estate offers opportunities as interest rates decline

Key takeaways

• As interest rates fall and valuations in some areas reach an attractive point, we now seek select opportunities in the listed real estate space
• We have recently added listed Swiss real estate exposure to Swiss franc-denominated portfolios for its attractive yield and supportive fundamentals, including strong demand, low vacancy rates, and rising apartment rents
• Falling Swiss sovereign yields should boost real estate valuations, which should increase demand for real estate funds
• Listed Swiss funds may also see end-year gains from investor repositioning.
   

The outlook for listed real estate investments is shifting. We examine the global outlook and explore particular opportunities for Swiss-based investors.

As market dynamics and global interest rate cycles change, so do the relative attractions of real estate. Over much of the last 18 months, we have had a negative view on the asset class, expressed via an underweight allocation to listed real estate investment trusts (REITs) within our equity exposures. From a macroeconomic perspective, our expectation of a higher-for-longer interest rate environment means we have avoided stocks with a high sensitivity to rates. REIT valuations looked vulnerable, given unattractive yields in comparison to the high risk-free rates and income available on sovereign bonds. The sector traded in a persistent downtrend, and we expected outflows to persist after more than a decade of investors increasing allocations to ‘alternative’ assets.

Perhaps surprisingly given negative headlines, the operating fundamentals of real estate assets appeared less of a concern, with the exception of some overcapacity in offices, and some that were not worth retrofitting to meet tighter environmental standards. The lack of speculative construction activity meant that vacancy rates remained rather low in most real estate sub-segments – including residential housing, industrial warehouses and, to some extent, hotels – and rental growth continued.

Selective opportunities emerging

Taking this into account, in July we shifted our stance on REITs from negative to neutral. What changed? First, the global rate cycle is turning, as a result of normalising inflation and slackening growth rather than a worrying downturn. Whilst we believe that recent US recession fears are overblown, we expect the Federal Reserve (Fed) to join other major central banks in cutting interest rates from September, as inflation reverts to target and labour markets weaken. Declining rates in developed markets should provide a tailwind for real estate investments, which investors sometimes view in a similar way to bonds. Falling rates should also alleviate some concerns on commercial real estate debt refinancing and banks’ exposures to the sector.

Commercial real estate valuations have now fallen to a point where some long-term investors have started buying attractive assets. Blackstone acquired an REIT worth USD 10 billion specialised in multi-family residential housing in April. August saw the largest purchase of a US apartment portfolio by a listed REIT in seven years, valued at over USD 1 billion. The UK REIT sector has seen a wave of takeovers and mergers this year. In our experience, such moments often coincide with the bottoming of the cycle, and an improving outlook. We have also seen a slowdown in investor outflows and redemptions from real estate funds, suggesting a healthier backdrop is emerging. Taken together, we believe the investment case has improved and investors with a long-term horizon should now be on the lookout for selective opportunities.