As the holiday period arrives, there is a growing sense that real estate markets have reached a pivotal point. Last year saw a post-COVID bounce-back and 2022 started strongly. But since then a war in Ukraine, soaring inflation, supply-chain disruption, economic uncertainty and a cost-of-living crisis have quickly caused investors to revisit their assumptions and expectations.
Oxford Economics has downgraded its five-year forecast for global real estate after just six months. In January, it predicted average annual returns of 7.1% across all property types between 2022 and 2026; today, that figure has been brought down to 5.6%. The consultancy now believes repricing will happen sooner than it did previously, leading to weaker returns in 2023 and 2024.
“We now believe valuation yields are likely to rise 30bps by year-end 2024, to counterweight the jump in long-term government bond yields,” Oxford Economics said. “The result: capital appreciation will be reduced substantially – or turn negative in certain instances.”
There has already been a noticeable slowdown in transaction volumes in Europe, as the markets have entered a period of ‘price discovery’. Data from JLL suggests $155bn (€152bn) of European commercial real estate changed hands in the first half of 2022, a 3% increase year on year in US dollars – and the largest H1 on record in euros at 14%. The change in pace in Q2 is evident, however, JLL said, with the $73.6bn transacted in Q2 down 11% year on year in US dollars and nearly flat at 1%.
But this slowdown is not necessarily a harbinger of doom, says Matthew Richards, CEO of EMEA capital markets at JLL. There are at least two reasons to be cautiously optimistic.
First, there is no shortage of liquidity. “More and more money has been allocated to real estate, and a further $3bn globally is targeted at real estate,” Richards says. “We are not in a credit crisis either, so there isn’t a shortage of debt finance – although because of what’s happening, the spreads have become more expensive.”
The other major factor to consider, according to Richards, is that the lenders are in price-discovery mode, which is making them more cautious in their underwriting. “So we’re at this interesting point, where we’ve had a record Q1 and a solid first half,” he says. “But if you look into the details of quarter two, there was a slowing: year on year, in dollar terms, as our data show, and this slowing is mostly in the UK and Germany, Europe’s two biggest markets.”
MSCI data also show investment volumes declined in the second quarter, which the company attributed to an “emergence of a multitude of risks” that prompted “some investors to pause and reassess the outlook for commercial real estate”.
In its European capital trends report, MSCI said: “These periods of uncertainty are characterised by slowing investment activity initially, as the price discovery process takes longer while buyers and sellers reset their expectations. This sequence is how the market reacted during the first months of the pandemic and the current slowdown echoes that, albeit with different drivers.”
Across the Atlantic, transaction volumes continued to increase in Q2, but it could be that the US is only lagging Europe. “Growth was broad-based, but activity was clearly decelerating from recent quarters,” MSCI’s US capital trends report said. “Pricing for assets that transacted held up in the quarter, but moves in financing costs have left many investors anticipating a moment when prices come back to earth.”
However, Richards is convinced that the current market presents “a lot of really exciting opportunities”. He says: “This is because, from an investor’s perspective, you’ve got people taking different views on the future. So we are at a point in time when there are mixed views around inflation and where interest rates are going to go. And this means you’ve got probably a greater abundance of buyers and sellers, because you’ve got people taking different views of pricing and what the future looks like.”
An uncertain market tends to benefit more opportunistic, return-driven investors. “This is a market that should be very active for a private equity investor, who may well focus on value-add where they can improve the property to add some value.”
The overriding question for Richards is just how long the price discovery period will take. “Some people are saying that you should be worried from a real estate asset class basis, because they think we are going into a crash,” he says. “But I’m not worried because there’s so much money targeted at real assets. Yes, there will be a bit of a denominator effect, but I think all the reasons and the pluses of real estate still remains.
LaSalle Investment Management recently published a mid-year update to its annual investment strategy report, remarking on the speed with which with the macroeconomic backdrop had been transformed. “With all the rapid changes, this mid-year update points to more strategy adjustments than usual, as the world experienced more geopolitical and economic history in a few months than is typically witnessed over the course of several years,” the report said.
Jacques Gordon, who has been leading the global research and strategy team at LaSalle for 28 years, is exiting at an interesting time, having announced his retirement at the end of the year. On launching the report, he said: “Real estate generally provided shelter during the waves of volatility that swept through the securities markets in the first half of the year. In the second half, we foresee different dynamics unfolding.”
LaSalle has provided a top 10 of impacts for investors to consider for the rest of the year, in order of importance. The top three are increasing costs of debt, rising corporate bonds yields and, as a corollary, higher required returns.
LaSalle’s top 10 impacts for real estate investors in the second half of 2022
| 1. Rising cost of debt | High-leverage buyers no longer dominate bidding and set prices. Home buyers may tilt to renting as home buying gets even less affordable. |
| 2. Rising corporate bond yields | Upward pressure on discount rates and exit cap rates. |
| 3. Higher required returns | As a corollary of 2, investors will seek slightly higher returns from real estate, given that alternative credit market products will now be priced at higher yields. |
| 4. Capital flows to real estate | Despite the mixed impacts listed above, real estate’s reputation as a better inflation hedge than fixed income will likely maintain its status as a favoured asset class, while the securities markets experience volatility |
| 5. Capital market shifts | Investor demand moves away from fixed long-term leases and toward shorter indexed leases. |
| 6. Rising cost of construction | Chilling effect on construction, wherever rents can’t keep pace. |
| 7. Higher energy prices | Higher occupancy costs erodes tenants’ ability to pay higher rents. |
| 8. Slowing demand | As central banks attempt to cool off over-heated sectors, broad-based tenant demand will likely step down a notch because monetary policies are blunt instruments that don’t distinguish well between sectors. In some parts of the world, ‘recession’ danger signals are flashing. |
| 9. Currency movements | Differentials in interest rates/inflation will favour currencies with rising interest rates and could raise hedging costs for currencies with lagging interest rate increases. |
| 10. Rising expenses | Just about every expense category associated with operating a property will be under upward cost pressure. Operational-intensive properties that require a lot of headcount or energy consumption could be most affected. As a corollary to 5, net leases will be preferred by investors, but tenants will be under new cost pressures that could affect their ability to renew or to expand. Long leases to real estate operators whose margins could be squeezed by both rising occupancy and labour costs are an example of the kinds of risk to avoid. |
Source: LaSalle Investment Management
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