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Swiss Finance & Property Group

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Swiss Finance & Property Group Quarterly Newsletter April 2019 Swiss Finance & Property Group EDITORIAL Very strong Swiss real estate The market development in the first quarter of 2019 clearly exceeded
Swiss Finance & Property Group Quarterly Newsletter April 2019 Swiss Finance & Property Group EDITORIAL Very strong Swiss real estate The market development in the first quarter of 2019 clearly exceeded our optimism. With a performance of almost 10% in the first quarter, the annual target has already been more than met. A solid sideways trend in nature, or if we were to lose our nerve in the event of minor disruptions. In other words, always breathe easy and keep a cool head so that prices may stay where they are. the coming months must be regarded as a success under the given circumstances. From an economic point of view, this should be possible in principle. Although the SNB has now admitted that interest rates will be positive again sometime in the future, there is hardly any danger from this side. FINMA s warning of the financing risks associated with investment properties will not trigger any violent market movements either, as the relevant market share is far too small. It remains the case that the greatest risks are of a political Joachim Schütz, Chief Economist CONTENT Editorial 2 Big Picture Europe and China support the expansion in the USA 3 Indirect Real Estate Investments 5 The rise of co-working 7 Technical Analysis 10 Risk management Direct Real Estate 11 Page 2 BIG PICTURE EUROPE AND CHINA SUPPORT THE EXPANSION IN THE USA Slowly but surely, the fear of recession in the USA seems to be abating. As well as the uninterrupted expansion in the US labour market, with unemployment figures recently reaching their lowest point in 50 years, the latest data from China indicate that industrial activity in the first quarter of 2019 has once again reached the solid figure of over 6% p.a. In view of the important role that China holds in the global structure of the supply chain, this indicates that the activities of its upstream and downstream global operations should have been affected as well. The same can be said for Europe. Although it is clear that the collapse in the capital goods sector, which was triggered by the confusion about the proposed Brexit deal that the British government is trying to achieve as well as the so-called Dieselgate emissions scandal, was somewhat greater than expected, the data regarding the actual edge both in Germany and in the periphery nevertheless indicate that real growth rates will pick up speed once again in the second half of Overall, it is still possible to see that the economic development in Europe is following almost exactly the same pattern as that of the US recovery, although with a time lag of some three or four years. The main reason for this has to be the excellent performance of the German export industry and the clear reduction in private debt in the southern European countries of the EU. In the meantime, at around 3%, even non-performing-loans have reached a level that finally raises expectations of a slow expansion in the granting of credit and thus an acceleration in the real growth rate. The significance of this current interlude at international level lies less in material consolidation, given the robust US economy, than in the fact that the pessimistic expectations in the US money and bond market have little credibility in the face of such data. In a first step, efforts will be made to relativise the declining dollar rate expectations of the US Fed and to interpret the current Fed position as being precisely in line with what it announced, namely that it must first wait and see. This will have two consequences. On the one hand, the drastic decline in interest rates since October last year should now be corrected. This will reduce the pressure on the ECB and the SNB, so that the fist interest rate movements upwards in Europe in the course of the year will finally become reality. Whether Exchange rates EUR/CHF and USD/CHF Source: Bloomberg, SNB Page 3 this will happen in the final quarter of this year or in the first quarter 2020 is of secondary interest. In addition, the changed expectations in the economy should then start to synchronise more strongly. This is bound to have a positive impact on the capital goods sector, in particular in Germany and thus also in Switzerland. At the same time, such a positive trend would make way for a revision in the undervaluation of the EUR and the low interest rates. For Switzerland, this would mean that part of the short-term safe-havenflows could now flow back at last, which would allow the CHF, i.e. the SNB, to correct the over-valuation of the CHF in relation to the EUR at the same time and thus also create the space for interest rates to move into more positive realms. should not present any great threat in the face of the positive development, unless building activity were to completely ignore this factor. It is clear that this scenario offers numerous areas for possible risks, but their low probabilities should not be sufficient to put the brakes on the positive development in any meaningful way. Core inflation, LIK and CHF 3M Libor In the above-mentioned scenario, Swiss real estate would initially remain very sought after since the yield advantage of real estate in comparison with long-term government bonds is expected to reduce only slowly. A greater challenge to begin with is expected to be the selectively increased vacancy rate, but even this factor Source: Bloomberg, SNB Joachim Schütz Page 4 INDIRECT REAL ESTATE INVESTMENTS The market for listed Swiss real estate investments performed strongly overall in the first quarter of The Swiss listed real estate funds therefore posted returns of +8.5% as measured by their index (SWIIT), and Swiss real estate shares posted returns of +9.0% as measured by their index (REAL). This strong performance may come as a surprise, but was only to be expected in the context of a previous almost 18-month long consolidation of the prices of these investments and the heavily reduced capital market interest rates in the fourth quarter of Thus, upon the weakening of the global economic growth in the last quarter of 2018, the FED implied the need for more patience with regard to a future rise in its base rates. With this adjustment to the previously resolute rise in the base rates, the equity markets, i.e. the markets for listed real estate investments, reacted with correspondingly strong price rises in the first quarter of In the meantime, numerous market participants anticipate a reduction in the US base rates in We are not of this opinion and anticipate a further increase in these base rates, based on the current US inflation rate of over 2% that is the critical threshold for the FED for interest rate increases. It is only the extent and tempo of the base rate increases that may slacken off in the next couple of years in comparison with the prior years 2017 and 2018, but a change in direction seems highly unlikely to us. With the signal from the Fed regarding more patience when it comes to further interest rate increases, the global capital market interest rates also deflated somewhat. The interest rates for 10-year US government bonds thus sank from 2.69% to 2.41% in the first quarter. The interest rates for Confederation bonds with this term have continued to sink further into negative figures this quarter, from -0.25% at the beginning of the year to up to -0.43% in March. Correspondingly, investments with higher and comparatively more stable dividend payments are sought after. With a view to the upcoming payment dates for Swiss real estate funds and real estate shares in the first and going into the second quarter 2019, this sector is experiencing additional demand that is expected to last into April. It is only once this first wave of payment deadlines has passed that this demand in the sector is expected to tail off slightly. In comparison to the capital market interest rates for Confederation bonds, Swiss real estate funds and real estate shares offer record interest margins with direct yields of 2.73% and 3.78% respectively. The premiums paid in comparison with their net asset values of 23.8% seem appropriate compared with their average over the last 12 months of 20.3%, if the renewed sharp decline in interest rates is taken into account. The extreme price fluctuations that can be identified on an individual basis due to increased demand, however, have motivated us to extract the profits from these positions and reposition them in more defensive positions in our investment portfolio for higher operative cash flow returns. Due to the broad-based demand for the Swiss indirect real estate investment sector, we maintained a comparatively neutral allocation between real estate funds and shares and a modest share of liquid funds, primarily from dividend payments, in the first quarter. With a view to the second quarter, we identify both macro-economic as well as sector-specific drivers that Page 5 could lead to increased price volatility and correspondingly large price falls in listed Swiss real estate funds as well as in real estate shares. On a macro-economic basis, increased uncertainties regarding global economic growth, driven by the trade war in the USA and compounded by the unruly exit of Great Britain from the EU, represent the greatest downside risks for the capital markets. In addition, higher interest rate demands for US government bonds on the part of the market participants could further depress the capital markets. On a sector-specific basis, we anticipate capital increases of up to CHF 370 million in the real estate fund segment in the second quarter, of which approx. CHF 90 million is in listed real estate funds. Finally, it is anticipated that a Swiss real estate fund, Sarasin Good Buildings, will be admitted to the index of listed funds in the first half year following a capital increase and quotation. According to their investments, passive investors will have to restructure to the detriment of the existing funds in the index. We thus anticipate that a consolidation of the strong upward trend since the beginning of the year is probable in the second quarter. Fundamentally, and bearing in mind the latest strategy presentations for collective investment schemes, we observe an increasing differentiation in the type of portfolio development. Whilst one group follows an approach of consolidation and repositioning of property in its portfolio development, a second group gives preference to a growth strategy based on further portfolio acquisitions and building projects. With our focus on the earning trends per share, we identify far better growth opportunities in the first group and have therefore based our investment approach on this. With a view to the direct real estate market, the strong building activity in the residential sector outside of the metropolises shows an increasing absorption of vacancies as well as growing numbers of vacancies in the old stock. Correspondingly, the quality of the macro situation remains the main focus in the selection and monitoring of collective investments for residential buildings. In the case of new builds, as well as the assessment of the location, the assessment of the building activity in the relevant market area, the structure of the rents visà-vis the local market and the assessment of the regional demand for living space are some of the main criteria in our investment decisions. Finally, for the third year in a row, the International Monetary Fund (IMF) and now also FINMA are warning Swiss real estate investors to adopt a cautious approach with regard to their possible over-indebtedness. FINMA is now demanding that financial institutions should tighten up their requirements for the granting of mortgages, also in the case of the financing of investment properties. In its most recent report in April, the supervisory body stated: The growth in the volume of mortgage lending has exceeded the growth in economic performance as well as the increase in incomes for some time now. This is one reason why in relation to its gross domestic product Switzerland is the country with the highest level of debt per private household worldwide. But the volume of mortgage debt is not just enormously high, it has also risen sharply: in the past 10 years by 45 percent, in the past 15 years by a staggering 100 percent. If the credit institutions were indeed to tighten up their capital requirements for the financing of investment properties, this would only deter a small part of private investors from the investment property segment that the Swiss collective investments and real estate investment companies are interested in, i.e. generally properties in excess of 10 million francs. The major drivers for further price adjustments within the transactions market continue to be the development of the capital market interest rates and the further assessment of rental yields for these investments. Nicolas Di Maggio, Head Asset Management indirect investments Johannes Schwab, Portfolio Manager Ruedi Göldi, Portfolio Manager Page 6 THE RISE OF CO-WORKING Coworking or flexible workspace enables workers from different organizations to operate in one shared office space, through either memberships or traditional leases. Coworking spaces initially attracted startups, freelancers, entrepreneurs, and remote workers. However, as the sector continues to develop, coworking operators are targeting larger firms. The movement has spread excessively since the global financial crisis. The number of coworking spaces in the US grew from less than 300 in 2010 to over 4,000 at the end of 2017, resulting in a compound annual growth rate of almost 50%. 1 Outside the US, 200 spaces have increased to 10,000 over the same time period, representing a compound annual growth rate of over 80%. 2 Cushman and Wakefield branded 2018 as the year of the coworking/ flexible office sector. Leasing activity for coworking firms accounted for 18 percent of all office deals in Manhattan in 2018, further accentuating the sector s progression. 3 Additionally, WeWork, a renowned coworking operator, recently became the biggest renter of office space in Manhattan (492,000 sqm.), surpassing JP Morgan (483,000 sqm.). 4 WeWork s valuation is now larger than any office real estate investment trust in the US and it is largely accountable for the coworking sector s increasing stake in office take-up levels. Coworking share of inventory and growth in the US Coworking space share of total office inventory Coworking space share of total office inventory Coworking space share of inventory growth 2016 Q % change 2016 Q Manhattan 1.40% 2.10% 52.90% Other top 10 markets 0.90% 1.40% 28.30% Secondary markets (9) 1.10% 1.50% 17.20% Total, all metros 1.10% 1.60% 31.30% Source: Colliers International 1. Colliers International U.S. Flexible Workspace And Coworking: Established, Expanding And Evolving. 2. Colliers International (¹) 3. Rizzi, Nicholas NYC Coworking Leasing Activity Climbs 200 Percent Last Year: Report. Commercial Observer Colliers International (¹) Page 7 Coworking operators in the US Total sqm. leased Number of sites Avg. space per site (sqm.) WeWork Regus Knotel Spaces Convene Industrious Level Office MakeOffices Premier Business Centers Jay Suites Top Other operators Grand total There are several motives for landlords to include a coworking element in a property. It offers tenants flexibility in the form of short-term leases, the opportunity to scale up or down, and immediate availability. Co working spaces commonly provide amenities, modern technology and exposure to innovators, start-up communities and creative environments. As these offerings are desired by millennials, firms may enhance their chances of attracting talent by renting a coworking space. Tenants do not have to pay for fit-out costs up front or all at once, and coworking spaces may also represent a solution for renting out smaller areas in a property that may typically be difficult to fill. Lastly, the higher footfall due to the higher number of workers per square meter can boost ground retail sales of an office property. A competitive labor market, the increase in remote workers and co working s reputation of enhancing creativity and productivity build a strong case for flexible workspace. 5 WeWork claims that its locations can generate 29% in rent premiums for landlords. 6 The typical office space is approximately 15 sqm. per person. Coworking operators utilize space efficiently and usually reduce this to about 7 sqm. per person. This higher density comes with considerations for landlords as capital expenditure requirements are significantly higher than for traditional office spaces. Coworking office fit-outs increase wear and tear, energy usage, and security issues. The lower allotted space per person may be concluded as inadequate in the future. 5. Colliers International (¹) 6. Wework. Page 8 The sector s perceived downside risk in a financial crisis is an area of concern. In the event of an economic downturn, coworking operators are not expected to display much resilience. Coworking operators are naturally vulnerable in a recession. They possess fixed long-term leases with landlords, yet their own shortterm contracts with tenants and members are likely to drop in both price and frequency. 7 Moreover, the business model of short-term leases and a tenant-base predominantly comprised of entrepreneurs and small start-ups appears more volatile in comparison to that of a traditional landlord which has longer leases with more established businesses. On the other hand, a premium might even be created for coworking space if occupiers were to place a high value on flexibility during a downturn. Coworking has swayed the construction and design of the modern workplace, prompting landlords to re-evaluate the dynamics and designs of their office spaces. The sector s evolution and strong growth trajectory over recent years suggest a continuation of development. Nonetheless, time will tell whether WeWork and its fellow operators will prove successful in the long-term. CBRE recently conducted a study on flexible space s impact on property valuations. The firm analyzed 31 sales transactions of office buildings with at least a 10% coworking occupancy, against 104 peer transactions (comparable geographic proximity, building age, size and quality, date of sale) with no coworking occupancy. The transactions occurred across 13 markets and within the last 5 years. When comparing cap rates for coworking transactions to their peers, only 10% had a lower cap rate, whilst 45% had a cap rate on par with peers and 45% displayed higher cap rates. Furthermore, 64% of buildings with more than 40% coworking space had higher cap rates than their peers, and 67% of buildings with less than 40% co working traded on par with peers. Thus, a risk premium is currently associated with a higher amount of flexible space at a property. The sample set of the study is, however, limited. If the sector s prevalence continues, a clearer story concerning valuations will arise. 8 Image source: 7. Colliers International (¹) 8. CBRE The Property Value Implications of Flexible Space. Page 9 TECHNICAL ANALYSIS Quelle: Bloomberg SWIIT Index 1. Quartal 2019 Between October and December, the downside was interrupted twice by the support line at 354 points. A double bottom formation has formed. The following price increase and the closing price above the middle elevation complete this price formation. This development signals a trend reversal. The expected price target of around 14 points (corresponding to the width of the price formation) was reached within one month. This upside, which occurred at the turn of the year, is still active today. During the price trend in the first quarter of 2019, we were only able to observe short-term counter movements. As a rule, these occurred at the level of price peaks from the previous year. The last interruption of the upward trend occurred in mid-ma
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