Global real estate investors entered the year in buoyant mood. Many property sectors racked up bumper returns in 2021. Globally, self-storage and industrial assets, for example, achieved total returns of 77.5% and 50.9% respectively, according to the National Association of Real Estate Investment Trusts (Nareit). Investment activity continued in a similar vein into this year, with global volumes 13% higher in the first six months of 2022 compared with the same period in 2021, Savills data shows.
But with central banks around the world beginning to raise interest rates to tackle surging inflation, real estate investors who had grown accustomed to cheap borrowing are now facing the prospect of far costlier loans, in some cases at rates that were higher than the yields available in the underlying real estate assets.
“When swap rates were lower, the typical all-in debt costs for most European markets were around 100 basis points, which meant leveraged investors could still buy real estate assets even at yields of around 2.5% to 3%,” says Craig Wright, head of European real estate investment research at Abrdn.
“At that level, you can still make your return targets, but with the cost of debt going up roughly 200bp, that means the cost of debt in many cases is in excess of the yield that you’d get on the asset; therefore debt is not adding to performance anymore.”
That has had an immediate impact on deals. In May, Innovo Property Group reportedly put on hold an $855 million deal to buy the New York office building known as HSBC Tower because it wasn’t able to secure financing.
“Many deals have died or have been renegotiated as pricing that made sense earlier in the year no longer pencils out,” says Gregory Fishman, co-managing shareholder at law firm Greenberg Traurig in Los Angeles.
We’ve seen hedging costs increase by over 150bp in the last few months, which has made it very challenging for [certain] buyers to participate in the US markets
Alex Foshay, Newmark Group
This is already weighing on asset prices. Over the past three months, commercial real estate prices in Europe have declined by around 10% on average across the board, says Cedrik Lachance, director of research at Green Street Advisors.
While those declines make for uncomfortable reading, market participants say real estate investors are not as leveraged as they were in the run up to the global financial crisis (GFC), potentially softening the impact of any downturn.
“Everything that has been put in place since the GFC in terms of restraint on lending markets means that it would have to be a much worse recession than the biggest bears are predicting to lead to that kind of forced selling and banks foreclosing on debt,” says Mat Oakley, head of UK and European commercial property research at Savills, which is the number one ranked adviser for western Europe in Euromoney’s real estate research this year. “Banks are only going to start to stress out when values are 40% down.”
Despite this increased focus on debt costs, credit is still readily available for borrowers that can find assets at the right price.
“There is certainly a risk of distress coming, but the issue is more down to pricing and what leveraged investors are willing to pay,” says Lachance.
This is likely to have a dampening effect on activity as investors become more circumspect about what deals they pursue.
“In this environment investors are naturally going to be more cautious about value,” says Chris Pilgrim, director of global capital markets at Colliers International, which was ranked fifth best adviser in western Europe. “Anecdotally, what we’re already seeing is a more cautionary note around certain investment committees, particularly with the bigger institutions, in terms of what can or can’t be approved.”
Another issue that is cooling investor appetite is the potential for increased tenant risk. While real estate has traditionally been seen as a relatively reliable hedge against rising inflation because of the ability to charge tenants higher rents, the broader cost of living crisis could make it harder for renters to pay more.
“The big challenge is a lot of those inflationary pressures are more difficult to pass on, particularly in the residential space where tenants are being hit disproportionately with the costs of heating and keeping the lights on,” says Lachance.
For commercial tenants in Europe rents are typically linked to consumer price indices, meaning as leases come up for renewal, landlords can increase rents in line with inflation.
“Most of our commercial tenants at the moment are absorbing the full indexation because they are able to pass it on to their customers,” says Wright. “But some are coming to us and saying: ‘We don’t want to absorb 100% of the inflation increase we’re facing in our lease’s indexation clause; can we do half of it and we’ll extend our lease by five years?’ Others are also asking if we can take the break option out of their lease in exchange for not passing on the full indexation to the tenant.”
Wright says this environment is going to test whether commercial real estate can live up to its reputation as an inflation hedge, particularly if inflation continues to rise and tenants find it more challenging to renew their leases.
“At the moment, even though year-to-date is quite high, office leases have been based off annual indexation of 4% or 5%; but as we see some bigger numbers come through on the index, upwards of 7% or 8%, that could lead to some different conversations next year,” says Wright.
We’re going to have to retrofit buildings at a pace of 3% per annum to meet the net-zero carbon targets that are set by most countries – so far we’re only at about 1% to 2%
Richard Bloxam, JLL
Even if the market does become more unstable, the broadening of the real estate investor base is giving market participants confidence that activity won’t grind to a complete standstill.
“If we were in a purely institutionally dominated world and everyone was investing in closed-end funds, that would be something of a canary in the coal mine that there’s going to be less activity,” says Richard Bloxam, chief executive of capital markets at JLL, which was ranked fourth best adviser overall in western Europe. “But the diversity of equity in real estate now is so broad, particularly with institutions directly investing, insurance companies needing to liability match and a huge swathe of retail capital now moving into real estate through large non-traded Reits [real estate investment trusts] in the US.”
There is also a hefty amount of dry powder still on the sidelines. Globally, real estate funds were sitting on $376.2 billion of unspent capital at the end of the second quarter, according to Preqin.
The cost pressures on investors who rely on debt to finance the majority of their asset purchases mean that cash buyers have an advantage in the current climate. Those cash buyers tend to be family offices, high net-worth individuals and state-owned investment funds.
“Sovereign wealth funds are obviously extremely well capitalized and always view dislocation in the markets as an opportunity in which to put their equity to use and buy on a large scale,” says Alex Foshay, head of international capital markets at Newmark Group, “whether it be portfolio or platform-level investments and either purchasing outright or recapitalizing existing ownership structures.”
The currency markets are also influencing where investors can put their cash to work. With the euro trading at a 20-year low against the dollar, real estate advisers say non-European investors may see Europe as an opportunity to pick up relatively cheap deals. By contrast, the stronger dollar is suppressing cross-border investment into the US.
“It’s not just in terms of what the conversion rate for your currency is, it also relates to the cost of hedging against movements in the dollar,” says Foshay. “For some overseas investors, specifically South Korean institutions and German open-ended funds, they are required to hedge the equity position of their investments. And we’ve seen hedging costs increase by over 150bp in the last few months, which has made it very challenging for those buyers to participate in the US markets.”
Office space
One area of commercial real estate that has seen valuations particularly hard hit is office buildings, which for average institutional property in Europe has fallen by 17% over the past 12 months, according to Green Street. Part of the challenge is that companies are still trying to figure out how much office space they are going to need in the wake of the Covid pandemic and the shift to remote and hybrid working.
“A lot of the decisions on what hybrid working means for office space haven’t really been taken yet,” says Angus Johnston, leader of the Europe, Middle East and Africa real estate practice at PwC. “Many companies accept that hybrid working is going to be here to stay, but they need to figure out how to make that work. If overall occupancy across the working week is down to 60% or 70% of what it was pre-Covid, they want to find a way to adjust their space requirements.”
The pace at which people are returning to the office also varies depending on geography. For example, workers have returned to the office at a faster clip in Asia Pacific compared with Europe and the US.
“Whether you attribute that to cultural differences or just the fact that if you live in Hong Kong, your apartment is so small that you’re desperate to go back to the office – it’s probably a bit of all the above,” says Oakley. “But there are parts of Europe and North America where companies are reacting to the fact that their offices are only 30% full – which is about half of normal levels – by quite sensibly getting rid of half of their office space, which does start to scare the market a bit.”
In August, for instance, Deutsche Telekom said it is planning to ditch around half of its office space.
The world used to talk about very neat lines of products – we had office, we had multifamily, we had industrial. But now all those lines are blurring
David Steinbach, Hines
While location is one factor that is likely to dictate future appetite for office space, environmental, social and governance (ESG) requirements will increasingly drive demand, given the commitments many companies have made to cut their carbon emissions. That is likely to create a supply and demand mismatch because of the relative lack of ESG-compliant buildings.
“The imbalance is pretty acute – 60% of the leasing activity in the office market is on the highest grades of ESG-compliant buildings, yet only 20% of the available space,” says Oakley. “That’s going to insulate parts of the office market from the worst of any recession because there is such an acute undersupply of this kind of space, which is going to put upward pressure on rents.”
That scarcity of ESG-friendly office space means there is a growing urgency to retrofit existing buildings, such as installing more efficient lighting and replacing outdated heating systems.
“About 80% of the buildings that will exist in 2050 have already been built, so we’re going to have to retrofit buildings at a pace of 3% per annum to meet the net-zero carbon targets that are set by most countries – so far we’re only at about 1% to 2%,” says Bloxam.
Legislation may require retrofitting to advance at an even faster pace. In the UK, from 2030 it will be illegal for landlords to rent out non-domestic buildings with an Energy Performance Certificate rating that is lower than ‘B’.
“In the office market, that’s the majority of offices,” says Wright. “So it’s almost a systemic issue for the economy, let alone the real estate market. Those buildings need to be upgraded otherwise they will become stranded assets.”
That could create a potential opportunity for certain investors to pick up assets on the cheap if the current owners don’t have the budget to pay for the necessary ESG upgrades. Abrdn estimates that the cost of upgrading an office building to best-in-class ESG criteria would be around £240 per square foot. That compares to about £100 to £150 per square foot for a standard refurbishment.
“It will all be about finding assets at the right price in the right locations where that retrofitting makes sense, but that won’t be everywhere,” says Wright.
Instead of retrofitting offices, some could be repositioned for alternative uses. Take South Temple Tower in Salt Lake City in the US. Real estate investment firm Hines acquired the 217,000 square foot office building in June and intends to repurpose it as a 255-unit luxury residential apartment block.
“In most markets that we’re in, a lot of cities would say the housing crisis is still here – there’s not enough housing for people and, at the same time, there’s probably a bit too much office,” says David Steinbach, global CIO at Hines. “There’s going to be a spectrum of things that happen with the reposition play. On one end, there’s going to be things torn down and then rebuilt. And then on the other end, there’s going to be full reposition or partial repositions for mixed use projects.”
That could involve combining residential units with retail and even last-mile logistics.
“The world used to talk about very neat lines of products – we had office, we had multifamily, we had industrial,” says Steinbach. “But now all those lines are blurring, and so our best projects are the ones that really bring all those products together, which allows you to create something that is pretty unique.”
Housing crisis
Residential real estate assets are also expected to be more resilient during an economic slowdown, in part because of how the asset class performed during previous downturns such as the GFC and the Covid-19 pandemic.
“In both instances, it was predicted that occupancy rates in multifamily would decline significantly, and in both instances, what proved true is the last thing you stop paying is your rent check,” says Foshay.
The fact that renewals typically roll annually means investors can mark rents to market faster than other real estate assets, which potentially makes residential property a better inflationary hedge, Foshay says.
While institutional investors have long been active buyers of multifamily real estate assets in the US and parts of Europe, other markets such as the UK are now starting to grow. Build-to-rent investment volumes in the UK hit a record £4.7 billion last year, more than double the level of investment in 2012, according to Colliers data.
“This is driven by the idea that as interest rates increase, fewer people can get a mortgage for their own residential purposes and therefore more people are going to have to rent again – and that just further fuels multifamily as an asset class,” says Colliers’ Pilgrim.
Because there’s such little product coming through the market, the long-term effect of this across pretty much all sectors is valuations increasing because there’s going to be more demand and less supply
Chris Pilgrim, Colliers International
This is in stark contrast to China, where a funding squeeze has left property developers unable to complete projects and homebuyers refusing to pay mortgages en masse for buildings they had purchased before they had been built. Despite that backdrop, global investors are undaunted by China’s unfolding property crisis.
“The Chinese economy is large and increasingly important, but from a global institutional real estate investor perspective, it’s just not a very big slice of the pie,” says Steinbach. “Evergrande was obviously a concern everybody was talking about at the time, but the government seems to be working through it. So it is definitely more of a domestic Chinese investor issue.”
Real estate investors are watching China, however, through the prism of a global supply-chain disruption that has implications for the wider logistics market. Logistics assets have been caught up in the recent repricing, in part because prices had become extremely elevated, but the undersupply of warehouses and the broader trends underpinning demand – from the growth in e-commerce to the need to diversify and localize supply chains – should insulate asset prices from any substantial declines.
“Running long-distance supply chains is very costly because of high energy prices and also very risky because of the conflict in Russia and lockdowns in China,” says Wright, “so running shorter supply chains and manufacturing more in Europe means demand for logistics space is likely to remain strong.”
However, rental growth might not be as strong as investors had previously been banking on because of the pace of inflation and the potential impact of indexation on rents.
“A lot of investors were predicting significant rental growth going forward on last-mile urban logistics because there is a lack of supply in almost every single market and almost no vacancy,” says Luke Dawson, managing director for cross-border capital markets at Colliers International. “There is a bit more of a question mark now because of the inflationary pressures in terms of how much organic rental growth you will achieve on top of indexation.”
Higher inflation and the risk of recession are likely to deliver a further blow to retail asset valuations, while e-commerce has continued to chip away at traditional bricks-and-mortar retail.
“Value retailers like Aldi or Lidl are probably more defensive than their peers in this environment, but retail is definitely at the top of the pyramid of pain from this inflationary shock,” says Oakley.
Given the extreme macroeconomic uncertainty around inflation and interest rates, market participants are looking for clues that might indicate the direction of travel for real estate over the next 12 months.
Dawson, for example, says Colliers is closely watching fundraising momentum to track how much dry powder can still be deployed. Fundraising declined to just under $32 billion in the second quarter from $41 billion in the opening three months of the year, according to Preqin.
“If Q3 proves to be a much stronger quarter, that at least shows there’s some renewed optimism into European real estate,” Dawson says. “Where that trend line goes over the next three or four quarters will help us gauge how much confidence there is in the market.”
Yet while the market may remain bumpy for real estate investors in the short term, asset prices are likely to be supported over the longer term by the challenging construction environment, which is being hampered by supply-chain delays and higher raw materials costs, slowing the pace of new developments.
“Because there’s such little product coming through the market,” says Pilgrim, “the long-term effect of this across pretty much all sectors is valuations increasing because there’s going to be more demand and less supply.”
