Real estate 2024 outlook (part two): Interest rates, sectors and asset allocation

In the first part of our real estate 2024 outlook, we looked back over 2023, a year when it felt like the foundations were shifting under the feet of the industry, as rising interest rates and the consequent withdrawal of debt from the market led to repricing and poor performance. But understanding the fortunes of the asset class in 2024 is not just about predicting when things will go back to ‘normal’.

“The central banks were the architects of the boom in real estate which we experienced and also of the recent slowdown,” says Tom Leahy, head of EMEA real assets at MSCI Real Estate Research. “So it is only natural that keeping a careful eye on their actions going forwards will determine expectations for the sector.”

This is one area where people are becoming a little more hopeful for 2024. With signs that inflation is coming down across Europe, interest rates will follow. “2024 should start from more solid foundations,” says Paul Gibson, CIO for EMEA direct real estate strategies at CBRE Investment Management. “Inflation is past its peak; monetary policy tightening appears to be behind us.”

The US Federal Reserve, the European Central Bank and the Bank of England all held rates steady in December, although the Fed Chair Jay Powell indicated that rates could be cut faster than expected next year, triggering a rally in stocks and falling US Treasury yields. In Frankfurt and London, however, the language was less dovish.

“As a house, we do not expect interest rate cuts [in Europe] to come until Q4 of 2024 and do not believe they will provide much boost to the market In the coming year,” says Sebastiano Ferrante, head of Europe at PGIM Real Estate. “Not least because lenders will seek to increase margins as there is a much greater concentration on risk, particularly ahead of the Basel III [banking] regulations coming in. In this environment leverage will be highly restricted in the real estate market.”

Oxford Economics has warned about the lagged effect of past rises in interest rates. “A greater prevalence of fixed-rate debt has slowed the effect of rate hikes on activity compared to past rate rise cycles,” wrote associate director Mark Unsworth in a 2024 outlook research briefing. “As a result, the peak effects of policy tightening probably won’t be felt in the major advanced economies until next year.” So whilst rate cuts are coming, “it won’t be an immediate silver bullet for the sector, since the rolling over of fixed-rate debt means the effective interest rate paid by the market will still rise in the near-term.”

What is more, the timing and scale of cuts is unlikely to be uniform across economies. The relatively strong economic performance in the US this year and less scope for disinflation from lower energy and food prices means Oxford Economics “envision the Federal Reserve moving cautiously and expect cuts to commence slowly from September 2024. By contrast, low eurozone inflation will give the European Central Bank scope to cut rates earlier and more aggressively next year – we anticipate the ECB will start loosening policy in Q2. The Bank of England is expected to sit somewhere in the middle, with UK rate cuts beginning in the late summer of 2024.”

Some sectors have brighter prospects

Of course, such broad outlook assessments hide the nuances playing out in various subsectors and different parts of the market. “You have to consider that valuations and transactions can sometimes be moving in different directions,” says Ferrante. “Overall, we have a two-tier market across European real estate. On the bottom tier are the retail and office sectors, while on the top tier are logistics, residential, hotels and data centres.

“There is a huge bid-to-ask spread, most especially in shopping centres. There is simply no demand for those, even at yields of 8% or 9%. So whilst I don’t feel valuations will drop much further it is still a very dysfunctional market and there will be very few transactions. In logistics, I feel valuations are very close to the right level, and in the prime logistics markets investors are now competing for the best-in-class assets.”

Now could be a good time go into logistics. “Adjusted valuations have now created a more attractive entry point than was on offer two years ago,” says Leahy. “There is also evidence that occupier activity still is relatively strong in this sector, as some markets are experiencing double-digit rental growth.” In the UK, it is 7% per annum, but in Germany it is closer to 11% and in the Netherlands 15.5%.

The sector continues to be propelled by the structural shift to online retail. But Oxford Economics says it could also be boosted by a “broader public policy shift in advanced economies away from relying on production from any single country” and a consequent increase in ‘reshoring’ or ‘friendshoring’, where supply chains are focused between friendly powers. “The US presidential election next year, regardless of the result, is likely to lead to a protectionist agenda which would further support domestic manufacturing and the reshoring of production,” the consultancy says.

Housing also finds itself in Ferrante’s top tier, alongside logistics, and it looks more stable than other sectors. “It is likely in ‘24 we will see more of the newer concepts that have been in favour rolling out, such as co-living and senior living,” he says. “Here there will be transactions.”

But Leahy adds a word of caution that there are signs of distress in Germany. Vonovia, the country’s largest residential property group, has sold €1.4bn of assets this year to deleverage its balance sheet and has another €1.6bn of disposals under contract. “Nevertheless it is clear that buyers like the residential sector across Europe, and are looking to increase their exposure,” Leahy says.

LaSalle Investment Management’s 2024 outlook talks of a residential sector suffering chronic undersupply and demand growth powered by migration. “Surging student demand and rising mortgage rates are causing people to rent for longer,” the report says. In the year to 30 September 2023, average rent levels rose by 8.2% across continental Europe and by 10% in the UK.

The hotel sector, meanwhile, is the “comeback kid”, according to Ferrante. “The fundamentals are strong and achieved roommate rates are growing. Investors are interested in playing this sector and I would expect more transactions from the value-add funds in 2024.” Core funds are likely to return soon after. “Investors continue targeting hotels for their flexible income potential, countercyclical dynamics and long-term structural shifts,” he says.

Data centres Ferrante characterises as “the new kids on the block”, which have largely been “untouched by the current crisis because of their very strong underlying fundamentals thanks to the global digitalisation trend”. He says: “The dynamics behind the growth of this sector are unlike other sectors in real estate.”

Real estate’s role in portfolios?

It is helpful to focus on the underlying fundamentals of different property markets and sectors, but done in isolation this can miss bigger picture. How attractive real estate will be in 2024 on a relative basis – versus other asset classes – and other constraints and asset-allocation forces will help determine how much capital is deployed.

The denominator effect – where falling listed markets cause investors to hit or overshoot their private-markets allocation targets – made a big return in 2022 and 2023. But the phenomenon is easing now and AEW predicts a reversal of the denominator effect to “unlock dry powder capital for real estate investment”. In its outlook report, it says: “The downward adjustment for property, combined with the rebound in stocks and bonds in 2023, should be bringing the real estate allocation of many multi-asset investors back in line with their targets, freeing up some restrictions for multi-asset investors.”

But how much capital returns to real estate markets in 2024 is not just incumbent on the denominator effect. Leahy says there are longer-term “questions about what the role of real estate will be in portfolios”.

For many years there was a shift to real estate as a bond proxy because of exceptionally low interest rates. “It would seem likely that it will have a slightly different use case going forwards,” Leahy says. “Investors can no longer rely on the market to do the job for them when it comes to capital appreciation, so there will be a greater emphasis on asset management and income generation.”

Jose Pellicer, head of investment strategy at M&G Real Estate, agrees. “Global property investors can no longer rely on yield compression and cheap debt to drive returns – there needs to be a fundamental shift in mindset.”