Low Beta + Positive Alpha: LaSalle’s 2019 ISA Suggests a Combination of Core Holdings with Higher Return Strategies in North America as Late Cycle Macro Events Unfold
CHICAGO (December 17, 2018) — Strong performance is expected for both the U.S. and Canadian real estate markets in 2019 and into 2020, as fundamentals are anticipated to exhibit stability amidst a chaotic political climate and economic cycle. This stability does not extend to every facet of either market, but core values should demonstrate resilience, despite the potential challenges of inflation and late-cycle anxiety that have permeated the North American economy. In order to mitigate these potential risks, the construction of real estate portfolios that employ defensive (low beta) positioning while still dedicating a portion of investment to higher (alpha-seeking) return strategies is recommended in LaSalle Investment Management’s Investment Strategy Annual (ISA) 2019.
LaSalle clients can view the full report at: https://www.lasalle.com/research/reports/isa-2019
The U.S. and Canada are closely knit by trade, and their economic outlooks improved considerably in 2018 when the U.S.-Mexico-Canada Agreement (USMCA) replaced NAFTA. Real estate markets in the U.S. remain remarkably stable, though difficult choices lie ahead as outstanding recent economic and real estate performance combine with late-cycle worries to stoke fears about when the market will turn. In Canada, the USMCA alleviated threats of vehicle tariffs, which could have impacted the country’s most important manufacturing sector and tilted it into recession. While tariffs on steel and aluminum remain in place, the impact to Canada’s economy should remain relatively low.
Jacques Gordon, Global Head of Research and Strategy at LaSalle, said: “Global real estate markets continue to possess strong fundamentals, and we expect to see continued, albeit slowing, growth momentum into 2020. Real estate performance has largely remained stable in the face of global economic and geopolitical volatility, but uncertainties around these trends – as well as a potential downturn – could negatively impact the sector. Therefore, our recommendations highlight ‘low beta, positive alpha’ defensive strategies designed to insulate investors during a future down cycle, while taking advantage of secular trends that may overcome cyclical problems and capitalize on growth opportunities.”
Bill Maher, Head of Research and Strategy for North America at LaSalle, said: “Late-cycle investing requires higher degrees of both caution and conviction to keep a real estate portfolio performing at a high level. The techniques we discuss in the ISA include global screens, the Black Litterman model and a market level beta approach. These give portfolio managers new perspectives on where to focus their attention as they review the ever-expanding and complex array of available choices.”
Select ISA 2019 findings for the U.S. include:
- Job growth will continue to support real estate demand, although the pace of growth will slow as shifting demographics limit the growth of the working age population and lower the unemployment rate. With an unemployment rate of 3.7 percent as of November 2018, and facing the risk of inflation due to more restrictive trade policies, the labor market is positioned to support an uptick in inflation.
- The U.S. Federal Reserve is on a path of measured interest rate increases, with eight rate hikes since December 2015 and the federal funds rate approaching 2.5 percent, up from effectively zero. Short-term and long-term interest rates are also climbing, with the 12-month LIBOR up almost 200 basis points and the 10-year Treasury note increasing– but thus far, the increases have not been enough to move real estate pricing materially. Short-term rates will likely continue to rise in 2019, although this will not impact expected returns on higher-return investments that can be re-positioned for core buyers. As longer-term interest rates increased, cap rates have been steady and spreads have compressed – this will continue to be the case unless 10 year yields approach 4%. However, should investor expectations of future growth decline, yield spreads and cap rates are expected to increase.
- While capital dynamics in the U.S. real estate market were mostly steady in 2018, higher interest rates could trigger changes in 2019-2020 as some capital sources move away from real estate towards fixed income alternatives. However, this will not be a rapid shift – many investors hold real estate as a long term investment, and do not adjust real estate allocations quickly.
- Domestic buyers remain active but tilt towards higher return strategies in order to meet absolute return objectives, while foreign buyers have curtailed their activities, for many due to the costs of hedging their currency exposures. Debt remains widely available as debt funds are flush with capital and aggressive in competing with banks and conduit lenders.
- New supply poses a potential cyclical risk. If the macro economy experiences a slowdown, fundamentals will weaken as construction continues and supply exceeds demand. The Opportunity Zone program established in the 2017 Tax Cut and Jobs Act is one emerging risk on the supply side, as an abundance of capital from the program may lead to a flood of new supply that impacts overall market fundamentals.
- Secular risks will also continue to influence real estate markets. Climate change remains a major concern; investors increasingly consider property elevation and flooding risk. Similarly, technological changes also continue to impact a variety of sectors. For example, ride sharing impacts residential location values and parking demand.
Rich Kleinman, Head of Research and Strategy in the U.S. for LaSalle, said: “Despite market stability, attractive opportunities have become more difficult to identify, and we do not currently have a strong conviction in favor of a single asset class or geography. Instead, our investment strategy in the U.S. is focused on a micro-level, pattern-seeking approach that aims to identify high-performing submarkets and mispriced assets, and we expect to increase our use of these strategies as new micro-data sets and analytical techniques become available.”
The Canadian economy should experience continued strong economic conditions and real estate markets in 2019 and 2020, with lowered trade and recession risk following the expected adoption of the USMCA. Real GDP growth is projected to be 1.5-2.0 percent in 2019 and 2020. Despite a lower level of Chinese investment in Canada in 2018 relative to recent years, capital interest from other countries is growing. Transaction volumes are trending at record highs, bid depth for quality assets is deep, and liquidity remains high. Domestic pension plans and REITs are continuing to create attractive acquisition opportunities as they sell quality core and core-plus assets.
Chris Langstaff, Head of Research and Strategy for Canada at LaSalle, said: “Canada remains a compelling destination for real estate investment among foreign and domestic investors – particularly in the industrial and apartment sectors, which have seen benchmark-beating returns in recent years. The office and retail sectors are also attractive for their repositioning, redevelopment and densification opportunities. Investors seeking higher-return strategies in Canada should focus on these value-add plays to grow net operating income.”
While interest rate increases have driven up borrowing costs, cap rates have, thus far, remained steady. However, potential interest rate increases in 2019 and 2020 could place upward pressure on cap rates, particularly if rent growth slows. Additionally, if there is a lack of progress on pipeline approvals and construction, or a slowdown in global energy demand, it could directly impact the Calgary and Edmonton markets and prolong their recovery.
About LaSalle Investment Management
LaSalle Investment Management is one of the world's leading real estate investment managers. On a global basis, LaSalle manages approximately $65 billion of assets in private and public real estate property and debt investments as of Q1 2020. LaSalle's diverse client base includes public and private pension funds, insurance companies, governments, corporations, endowments and private individuals from across the globe. LaSalle sponsors a complete range of investment vehicles including separate accounts, open- and closed-end funds, public securities and entity-level investments. For more information please visit http://www.lasalle.com, and LinkedIn.
NOTE: This information discussed above is based on the market analysis and expectations of LaSalle and should not be relied upon by the reader as research or investment advice regarding LaSalle funds or any issuer or security in particular. The information presented herein is for illustrative and educational purposes and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy in any jurisdiction where prohibited by law or where contrary to local law or regulation. Any such offer to invest, if made, will only be made to certain qualified investors by means of a private placement memorandum or applicable offering document and in accordance with applicable laws and regulations. Past performance is not indicative of future results, nor should any statements herein be construed as a prediction or guarantee of future results.