By Tom Walker, Co-Head Global Listed Real Assets at Schroders

Now that rates are stable and fundamentals are strong, global real estate is regaining prominence as a core component of multi-asset funds, providing diversification and resilient compounding returns.

In 2024 strong global real estate fundamentals generated positive returns of approximately 5%. While this may seem an obvious statement, it contrasts to both 2022 and 2023 when it was the macro, namely interest rates, that dominated investor focus and led to weaker returns for the global real estate sector.

We believe sector fundamentals are likely to be stronger in 2025. In the last 2 months of 2024 we met with approximately 75% of our holdings. Management teams were brimming with confidence for several reasons.

Firstly, demand is strong and growing at a time when there is very little new supply entering the market. Since the onset of the Covid-19 pandemic, building costs have become prohibitively expensive due to increased raw material prices and higher development finance costs. This has led to a dramatic reduction of development activity across many sectors. Management teams see little competition for their assets, leading to optimistic rental growth and earnings assumptions.

Secondly, for the first time in a number of years a select group of global real estate investment trusts (REITs) have a lower cost of capital compared to private market counterparts. With access to both international debt and equity markets, REITs are able to execute transformational transactions. We expect to see many value-enhancing deals from companies held in our strategy over the next 12 months.

Finally, implied valuations in the global listed market are below the prices at which assets are trading in the private market. We have already seen M&A activity throughout 2024; this will continue in 2025 until the arbitrage between public and private markets closes. These deals will prove that implied pricing in the listed market is too pessimistic. This, in turn, will help to attract generalist investors who remain very negatively positioned.

Capital values are now stable

In 2022 and 2023 the global real estate sector was almost paralysed as asset values fell dramatically. Capital values decreased to levels comparable with the significant falls witnessed during the great financial crisis (GFC) in 2008. 2022 was the worst year for the sector since that painful crisis. This all occurred at a time when the market fundamentals were strong. Why did values fall so much? Interest rates.

Macro factors drove down valuations as investors adjusted to a higher risk-free rate.

Fortunately, that is now in the rear-view mirror. Asset values have adjusted to a ‘higher for longer’ environment. Therefore, we see limited downside from this point. If we see a weaker economy emerge pressure will build on central bankers to reduce interest rates. Just as higher rates hurt the sector in 2022 and 2023, lower rates should now provide a tailwind.

It is important to stress that our base case is for interest rates to stay at existing levels. We believe attractive total returns are possible from the sector at the current pessimistic valuations.

Real estate fundamentals are now more important than interest rates

The years 2022 and 2023 saw some of the largest interest rate movements in history around the globe. This had a dramatic impact on the international real estate sector, causing rapid declines in asset values. Given current inflation and historical data, consensus views suggest that such volatility will not happen again any time soon. Assuming we are back in a ‘normal’ interest rate environment, with relatively predictable moves both up and down, sector fundamentals should once again drive earnings.

This presents a great stock picking environment.

M&A set to increase as investors are attracted to discounted valuations

One of the key reasons for our optimism heading into 2025 is the large number of M&A transactions we witnessed in 2024. These deals demonstrated how discounted asset values are in the (pessimistic) listed markets. Acquirers were able to take advantage of a clear arbitrage between the public and private markets.

Structural trends – landlords face little competition as demand is far outpacing available supply in

Throughout 2024 we have seen several landlord companies increasing their rental growth expectations. Recent meetings indicate that this is likely to continue into 2025. The key reason behind management’s confidence is the lack of new supply.

Interestingly, current rental levels do not generate the profit margins needed to justify new development. Until we reach that point, landlords face little competition and are able to push existing rents upwards.

It seems counterintuitive that supply would be low when demand is known to be strong. So why is this the case?

As inflation started to creep into the economy in 2022, the cost of raw materials began to rise, continuing at a faster pace into 2023. Developers began to delay projects as their margins decreased. Adding fuel to the fire, as interest rates increased, so did the cost of development finance. This further reduced levels of new supply, in some sectors, to all-time lows.

While supply decreased, demand, aided by structural changes, continued to increase. Therefore, in sectors such as data centres, healthcare and residential we expect earnings growth to continue throughout 2025.

We believe this organic income growth will drive asset values higher and lead to more interest from generalist investors.

Real Estate offers defensive edge as ‘Mag 7’ tech and equity indices hit all time highs

Broader tech and equity indices are approaching all-time highs but because the real estate sector is not correlated to either of these, it is still attractively valued. The market appears to be overlooking the defensive attributes of the sector.

We see global real estate as an important tool to help diversify a client’s returns.

Optimistic outlook

We share the optimism for 2025 expressed by the management teams we have been meeting over the last two months.

Fundamentals are strong and earnings accretion will boost the sector in 2025, whether from organic portfolio-level growth or transformational deals.

Finally, implied pricing in the listed sector is more attractive than the very same assets in the private markets. M&A will continue until this arbitrage closes. In addition, we anticipate strong earnings growth will attract generalist investors who have been underweight the sector since interest rates began rising in 2022.

Overall, 2025 is likely to remind investors why real estate is such an important allocation in their portfolio - offering resilient, compounding income streams behaving differently to the ‘Mag-7’ and the broader equity market.

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