How can one be both positive and pessimistic about a market at the same time? It’s relatively easy when you’re talking about the UK, suggests Hans Vrensen, managing director and head of research & strategy at AEW in Europe.
‘We remain very positive on the UK from a property market perspective, even if our view is different from an economic perspective. The UK seems to be repricing a lot more quickly than the rest of Europe, with the latest data illustrating a fast reduction in capital values,' says Vrensen.
‘That is much less the case in Europe, where capital values are not coming down as rapidly.’
Despite this, Vrensen feels that it is ‘notoriously difficult to time the market’.
‘At the moment, many are sitting on the sidelines, as pricing is still so unclear. Over the next six to nine months, we expect investors to take a more proactive stance. That could arrive before the end of the year although much will depend on interest rates,’ he says. ‘There was a lot of drama around the UK mini budget last autumn, which wasn’t particularly helpful for UK swap rates. They spiked out in September-October, but have now come back down, which means that commercial mortgage rates have come down from recent highs. Rates are already stabilising, which is a very good thing for the market, even if they remain a lot higher than they were before.’
Vrensen refers to AEW’s recent debt funding gap report, which has thrown some light on the potential shape of the next round of refinancings coming up in the market. ‘We’ve been scrutinising loans that will be maturing in the next three years – most of which originated in 2018-2020. Most of the collateral has increased in value but not all of it – for example, retail asset values have fallen.
‘We do think that there is still a gap in what banks will be prepared to offer in terms of the refinancing volume of the original loan. The so-called “funding gap” has gone up a lot – and in the case of the UK relates to capital values declining. In Continental Europe, it is also related to interest coverage ratios (ICR) – the cushion that a lender would require because they don’t want to have an ICR of less than one which can only just cover the interest. If a tenant defaults, the landlord can’t pay the interest on the loan. In the current scenario, where interest rates have doubled or tripled, but rents haven’t gone up as much, lenders may be content with a small cushion but still need an income buffer to absorb interest rate moves. This ICR factor alone is likely to force a further rebalancing of the market as it limits available volumes of debt quantum.’
Vrensen adds: ‘Between borrowers and lenders, a reset in the capital stack is required and that will need to happen a lot faster now. The downturn is inevitable, but the cycle length is likely to be shorter than during the aftermath of the GFC.’
Vrensen notes that capital values are falling more slowly in Europe – not merely because the market is lagging the UK – but because various factors are in play. ‘Valuation practices are different – they tend to happen less frequently than in the UK and some jurisdictions, such as Germany, take a longer term look at average values when deciding on a loan.’ Despite this, Vrensen says that it doesn’t mean European values won’t drop in the future or that the market is somehow inherently healthier.
Looking at asset classes and buying opportunities, Vrensen says that AEW remains bullish on logistics. ‘Not because we don’t think yields will widen out – they already have done and are even ahead of what we expected. But the market’s saving grace is the occupational side, with so much going on from the reshoring of manufacturing activity to tenants adopting just-in-case strategies and e-commerce trade. Fundamentals on the demand side remain very strong. On the supply side, we’re seeing a vacancy of 3% across Europe, where 5% would be considered a state of equilibrium.
‘Development activity is difficult due to trends including inflation on construction and labour costs, and the fact that profitability for developers is under pressure. We might expect the pipeline to slow further as capital values are still falling even if rents are rising. This leaves current logistics stock investment as a good long term bet.
‘The second sector we are highlighting is shopping centres. These have already been repriced – you can get prime assets at 5% or 6% yields already – and we think that the centres that have survived so far have proven their resilience even if rents were taken down. Prices are even likely to move up a bit, as other investors try to move in.’
