House View by the Chief Investment Office
Real Estate Focus 2017
Turning fairy tale into winning portfolio
19 January 2017 | Tags: House View
Reading time: 7 minutes
Swiss real estate has outperformed most asset classes during the last 10 years. Solid economic growth, healthy immigration and the extended period of low interest rates after the financial crisis have propelled the asset class higher. Mortgage lending for individuals has risen 4% annually in that span, while the total performance of direct investment in rental apartments has averaged 6.5% per year. Switzerland has been a fairy tale land for real estate investors.
Real Estate Focus, UBS CIO's annual flagship study, illuminates the cracks in the property façade – the chic city condo or apartment, the single-family suburban home, the downtown office building or retail store in the shopping district. Risks lurk there – as always with all types of investments. Whitewashing the façade can be foolhardy. Refusing to invest for fear of loss may mean foregoing a business opportunity – or a fine place to live. Dealing with risks strategically, the study imparts, enables investors to house their ambitions constructively.
The opportunity of risk
Since the asset class has long been an inflation-resistant, stable-value investment, "risk management" has been an uncommon term in real estate. In Switzerland, though, where the market has fared so well since the financial crisis and the real estate bubble that caused it, investors wonder if the market still holds opportunities.
Knowing local market conditions and analyzing these alongside long-term investment targets clarifies for investors whether targets are achievable or adjustments to strategy are needed. Any choice – including doing nothing – brings the chance of gain or loss, so assessing conditions in a context of investment goals is crucial.
Swiss market investors need to consider that local interest rates are unlikely to drop further, but will eventually rise. Consumption of area per capita, long a growth factor, has reversed, and will limit domestic demand. Competition in commercial and residential segments is rising due to oversupply. Also, the drive to modernize properties is strong, and will affect especially older types.
"Switzerland has been a fairy tale land for real estate investors."
Using risk to study portfolios
Real estate investors face cyclical risks that stem from economic, societal or political conditions, and can be considered systematic risks, since they would affect all properties within a defined market, influencing supply and demand. Since systematic risks affect all properties equally in a general geographic area, for example, investors grasp intuitively that these risks cannot be minimized or eliminated by diversifying a portfolio.
Property risks, on the other hand, stem from particular characteristics such as land condition, building or technical features, legal situation and so on, and are classified as unsystematic, since these will vary from one property to another. Properties' differences protect an entire portfolio against suffering a collective loss in value due to the quirks of just one.
"Risk management hasn't been a primary focus of real estate investors yet – due to its inflation mitigating effects."
Investors can use risk factors in combination – often with professional help – to examine strengths and weaknesses of a portfolio, thus preparing them better for the next phase of the real estate cycle.
Diversify, diversify, diversify
Location, location, location, intones the real estate mantra, but the preceding discussion makes clear that owning all four gas stations at one city intersection would make an investor highly vulnerable to the development of battery-powered cars. That's far too many eggs in one basket. Better to diversify with a grocery store, an apartment building and a restaurant, and better still to locate them in different neighborhoods of the city.
Lower risks through diversification
Risk-return profile of equally weighted portfolios between 2000 and 2016
Explanation: From 2000 to 2016, adding direct real estate investments to real estate portfolios resulted in a higher return at lower risk (comparison P1 and P2). The inclusion of foreign real estate equities increased returns and risk (P3). In a mixed portfolio, investments in real estate helped to reduce risks compared to a traditional portfolio (comparison P5 and P4).
Note: The risk-return profile of each portfolio depends on the investment period. Swiss real estate funds, for example, performed very well due to falling interest rates. Once interest rates increase, however, their performance should be considerably lower.
Investors in real estate should include a range of types – residential (single or multi-family), commercial (office or retail) – as well as locations. There's a wide world beyond Switzerland, full of opportunities – and risks. Those who clarify their objectives and engage the local conditions – including currency risks or national economic fluctuation – can build well balanced real estate portfolios.
But why stop at real estate? UBS CIO advises that a small allocation of real estate investment in a mixed portfolio of asset classes can clearly improve overall risk-return ratios.
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