The underlying narrative around real estate in 2023 is one of caution although there is some hope for renewed investment activity later in the year following the destabilizing impact of high inflation and rising interest rates over the past 12 months.
Senior property professionals canvassed for this 2023 Global edition of Emerging Trends in Real Estate® draw comfort from signs of an improving macro and monetary policy backdrop to capital markets. They are working on the basis that inflation and base rates will peak in 2023.
But they also acknowledge that the market will still be dealing with an elevated interest rate environment for the foreseeable future compared with the zero-percent years following the global financial crisis (GFC). The familiar tailwinds of plentiful liquidity, loose monetary policy and cap-rate compression appear to be over.
As many interviewees suggest, real estate must work much harder for its returns, its favored position ahead of other asset classes no longer quite so assured.
There remain major challenges and assumptions around what most interviewees expect will be a “U-shaped” economic recovery and a similarly drawn-out response in real estate capital markets. As this gradual recovery unfolds and as companies deal with higher costs and lower revenues, some will put expansion plans on hold. Occupier markets will take time to pick up speed. Arguably the biggest obstacle to getting investment deals done this year comes down to the ongoing uncertainty over how much further interest rates will rise and when values will settle. The overall pricing gap is described as “a phoney war” between buyers and sellers, and there is no consensus on when it will close. A sign that investor confidence in pricing remains fragile has been evident since publication of the regional Emerging Trends reports in the final quarter of 2022 with the rush of withdrawal requests from institutional and retail investors seeking to cash in their holdings in various, private open-ended funds. As interviewees acknowledge, this action raises questions about the valuation of private real estate.
For institutional investors, the withdrawal from these funds is at least partly a response to what is known as the “denominator effect”, when falls in the value of their equity and bond portfolios can hinder the amount they invest in private real estate. In effect, their allocation to private property, slower to be revalued and less liquid than other asset. classes, increases relative to falling equity and bond values and therefore prevents further investment or forces asset sales. The interviews indicate that the constraints on institutional investors as a result of the denominator effect are likely to remain a significant issue this year, particularly in the US and Europe. Debt availability is also a major concern. Across global markets, banks are in “wait and see mode,” prioritizing existing clients over new borrowers. Finance is particularly scarce for new development, where high construction costs and a weak outlook for occupier demand add too much risk for most, if not all, banks.
For the immediate future, a major determining factor in the banks’ sentiment towards real estate will come from the refinancing of existing loans.With refinancing, a common view is that the banks, and lenders more generally, will put some sponsors under pressure to sell assets, quickly and at relatively low prices. There are, however, doubts as to whether alternative lenders will plug the finance gap. Amid such doubts over debt finance, industry leaders envisage a “flight to quality” when it comes to the underlying assets although this is open to wide interpretation. Nowhere is this more apparent than in the office sector. More than three years on from the onset of COVID-19, great uncertainty remains as to how much companies and their employees will use office buildings in a hybrid working world. There is an overriding concern over obsolescence here as well a strong sense that the sort of disruption that has rocked retail property is just beginning to be experienced in the office sector. Even so, regional swings in sentiment are evident. Some investors in the US are avoiding offices altogether in the short term. By contrast, interviewees in Europe and Asia Pacific indicate they are more open to seeking out value-creation opportunities despite the difficulties in the sector.
Though the future of the office is generating a lot of interest generally, real estate leaders are not looking at the sector in isolation. They once again find themselves dealing with an economic slowdown and financial crisis while addressing the structural changes to the way people, live, work and interact with the built environment.In this uneasy juxtaposition of the short and long-term challenges to real estate, the environmental, social and governance (ESG) agenda has become the unifying thread that links everyone, regardless of sector.
Most interviewees point out not only that the value-reduction process will create a widening divide between prime, “fit for purpose” assets in good locations and those energy inefficient assets in secondary locations requiring significant capital expenditure. However, the industry has a long way to go, as we set out in Chapter 2 with a detailed analysis of the limited progress to date of carbon pricing. Carbon pricing has the potential to change the way real estate firms think and act when measuring and reducing emissions from their portfolios. For the industry as a whole, the ESG agenda has clearly become more pressing as each year goes by, and it is increasingly seen as more of an opportunity than an obligation. To that end, greater adoption of carbon pricing will be vital.