IN FOCUS6-8 min read

The sequential real estate opportunity on the horizon

Higher interest rates, bank failures and office sector gloom have prompted bleak headlines. Are we yet at the point where these factors present opportunities?

03/08/2023
Los Angeles at dusk

Authors

Kieran Farrelly
Head of Global Solutions, Real Estate

Global real estate markets have been hit hard by the new higher interest rate regime and turmoil engulfing the banking sector. The asset class has also been on the receiving end of negative press attention, much of which is centred on the challenged US office sector.

However, commercial real estate comprises far more than US offices. A wide range of sectors remain well supported by underlying operating fundamentals. Price falls in some areas will provide new investment opportunities, and we advocate a patient approach focusing on operational management as the key performance driver.

The inherent valuation lag

There is a distinction between transaction pricing and valuation. Values or “appraisals” are the basis for reporting and will take time to adjust to new market conditions, lagging comparable “live” transaction pricing. This is due to the infrequency of calculation (often annual) and the need for market evidence to justify significant adjustments (“willing buyer” and “willing seller” basis).  So the valuations-based measure of real estate assets and performance benchmarks will both lag – and be less volatile than – transaction prices.

This can be seen in the US real estate market where we compare the rolling annual changes in a transaction price indicator with a valuation-based market capital growth index. It is clear that the transaction pricing indicator has led major turning points by two to three quarters, and shows materially higher variation. For example, during the period of the financial crisis it had annual declines of 33% and subsequent recovering growth peaking at 24%; versus 26% and 14% registered on a valuation basis.

Commercial real estate data 2023

What has happened since the first half of 2022?

The impact of higher interest rates, alongside uncertainties concerning the broader macro environment, have manifested into upwards yield or cap rate movements. The effect on transaction pricing has been partially offset by increasing income levels.

According to Green Street Advisors, both Europe and the US have experienced broadly similar transaction price falls of 21% and 19% respectively from their 2022 peak levels to the end of June 2023. In both regions the office sector has seen the greatest falls (29% and 31%) – no surprise given the impact of more flexible working practices, and sustainability-led bifurcation surrounding the demand for space. This is followed by the multifamily sector which has declined by over 20% in both regions.

These are significant movements in a relatively short space of time and have been accompanied by market liquidity dropping significantly, with MSCI data for global real estate showing a 52% fall in annual transaction activity during the first quarter of 2023.

Real estate data July 2023

Turning to the “slower to adjust” valuations, the UK has seen the deepest and quickest falls to date, down over 20% through the first quarter, according to MSCI. Other major markets have also witnessed declines ahead of their financial crisis period pace but lag both the UK and transaction pricing movements materially. To put this in context, according to MSCI, the US has only seen appraisal-based values fall by approximately 7% through end March 2023.

These valuation movements are materially behind those of corresponding transaction price indicators, pointing to further expected value falls through 2023. The faster correction seen to date in the UK was accelerated by the fallout from the disastrous mini budget in September 2022, causing affected pension funds to sell out illiquid holdings, even at distressed pricing, to improve balance sheet positions, whereas other markets have been largely repricing in response to higher rates. In the UK, valuers are also able to reflect “sentiment”, whereas valuation methodologies in the rest of Europe are fully based on transactional evidence, or utilize long-term mortgage valuation based approaches.

The varying speeds of price and value adjustments underway across markets has the potential to create a sequenced opportunity for investors to access attractively rebased investments. This could be via direct real estate markets at meaningfully reduced prices or indirectly via private funds or publicly traded equity at significant discounts to (already rebased) NAV. However, there are sources of fragility that will impact commercial real estate prices and values unevenly across geographies and sectors going forward too. The question remains – is this priced in?

Commercial real estate data 2023

Implications of banking sector turmoil for private real estate – a transatlantic divide

One potential source of fragility that may not be fully priced in is the banking sector turmoil. The collapse of Silicon Valley Bank, closure of Signature Bank and the forced merger of Credit Suisse and UBS have had a major impact upon global capital markets as investors weigh the risk of a more systemic crisis. Regulators have responded quickly and the analyst consensus is that while further smaller and mid-size US banks may become distressed due to relatively higher levels of real estate exposure and valuation declines, European banks are generally better capitalized negating major contagion risks.

This is due to a combination of generally higher loan-to-value lending prevailing in the US alongside higher lending volumes and the larger market share of smaller and medium-sized banks. According to various analyst and industry estimates, European banks have an approximate 6%-7% exposure to commercial real estate, which is concentrated in large institutions. The equivalent US figure is approximately 13% for larger banks (according to Mortgage Bankers Association data) and 40%+ for smaller/regional banks (according to Goldman Sachs). The latter were originating over three quarters of all US commercial real estate loans held by banks over the past five years.

This episode risks exacerbating the real estate price and valuation adjustments already underway. Further elevated debt finance costs and refinancing constraints are also coming at a time when significant volumes of debt are maturing. This has the potential to trigger and accelerate stressed sales. We see the dynamic between commercial real estate value falls and banking sector balance sheet destabilisation with resulting liquidity issues becoming more problematic in the US than in Europe.

Have real estate markets repriced enough?

Investors’ biggest question is: have markets repriced enough? To answer this, operating fundamentals should first be addressed. Despite the negative press attention, current occupier market conditions are generally stable. The office sector is the notable exception – and in particular, US offices.

According to JLL data, return-to-work levels remain approximately 40-60% of pre-pandemic levels across major US metropolitan areas, in stark contrast to Asia Pacific and Europe, which show 80-110% and 70-90% levels respectively. The US office sector is also over-supplied, with market vacancy levels materially higher than the other two major regions. Sustainability considerations are driving depreciation risks globally in this segment, but dated US offices are most at risk of becoming obsolescent – whereas there is a lack of supply of quality, sustainable office space in the major markets in Asia Pacific and Europe.

Commercial real estate data 2023

For the majority of other sectors, operational prospects are much healthier with tight supply conditions. For example hospitality is recovering well following the pandemic period, and sectors such as logistics remain structurally undersupplied and still benefiting from increasing e-commerce penetration. Also in relatively short supply is rental housing catering to range of demographics, especially at the more affordable end of the spectrum. Even retail – with its well publicised woes – is starting to see stabilisation of the most impacted fashion-orientated formats, although this process is incomplete and may suffer from further bankruptcies as a result of inflated cost structures. New construction will remain constrained for the foreseeable future by a combination of higher debt finance and higher construction costs. This will support recovery and growth in rents and value.

To illustrate whether commercial real estate pricing is factoring in the new interest rate environment and market uncertainties, a theoretical buy-and-hold analysis for the UK market is used. An implied total return is estimated using a starting valuation yield, adding prospective growth and then making a deduction for a capital expenditure provision. This reflects investment over time to maintain buildings’ condition.

As of end June 2022, monthly valuation yields were 4.2% and subsequently increased to 5.3% at the end of June 2023 according to MSCI. To estimate projected income growth, we have used the available Investment Property Forum consensus market rental growth projections for these quarters to create net operating income projections that incorporate the impact of occupancy levels and lease events.

A capital expenditure provision of 0.8% p.a. is included, and this is based on industry studies.

Real estate data July 2023

The implied returns can then be contrasted with required return level built up from a "risk-free" rate and a risk premium, providing sufficient performance compensation for the risk entailed.

Over the long-term, UK commercial real estate has delivered a 3-4% p.a. spread over 10-year government bonds (risk-free rate assumption), and for the purpose of this piece we adopt a required 3.5% risk premium assumption – but we note that this assumes no adjustments in the face of current market dynamics. So, at the end of June 2022, when ten-year bond yields were 2.4%, a required return would have been 5.9%; whereas at the end of July 2023 this increased to approximately 7.7% purely on account of rate increases.

The repricing to date has arguably brought UK valuations to "fair value" levels: in other words, an investor would receive a return commensurate for the risk entailed.

Forecasting is a precarious business and in no way should this be viewed as a call of a market trough. Instead, it is an approach for dissecting market pricing. A multitude of factors could shift the conclusion, including further rises in interest rates or downward growth revisions. However, it does suggest that the UK market has somewhat adjusted to the higher rate environment.

When looking at our global assessments of value using a framework akin to the above, but with more emphasis on longer-term trends, the declines seen in transaction pricing have led to many more markets showing fair or better value than previously, but we also recognise that further rebasing may occur.

However, this means that lagging valuations still need to adjust significantly to catch up with transaction pricing indicators across most major markets apart from the UK. While wide variation exists across property-types, we expect both fringe markets and secondary assets to be most exposed to large falls.

What does history tell us?

Alongside fundamental analysis it is worthwhile turning to what history may tell us to understand the cyclical nature of markets. Interestingly, prior recessionary phases have been followed by above average performance.

The historic rolling five-year total returns post periods across multiple prior cycles show that for three-to-five years post a recessionary phase, investors benefitted from above average performing vintages.

It remains to be seen whether multiple major economies will enter a synchronized downturn, but we are in uncertain times with many economies on the brink. Commercial real estate markets are currently enduring a period of significant volatility and history suggests that this phase could present opportunities for outsized performance for investors going forward.

Commercial real estate data 2023

Real estate buying opportunity? We see a sequential playbook

We are at the initial stages of a broader cyclical buying opportunity into the commercial real estate asset class.  We suggest investors adopt a patient approach with a “sequential playbook”, ordering opportunities across capital structures, sectors, and geographies.

Firstly, debt capital market conditions have created an immediate and compelling opportunity for non-bank lenders to provide gap-finance and other refinancing solutions to stressed situations. Whilst not specifically addressed in this paper, prospective private real estate credit returns are currently elevated. By way of example, an average return (interest plus margin and arrangement fees) on a 70% loan-to-value ‘whole loan’ would be high single digits in Europe and the US, a level at or above their unlevered equity equivalents.

Given the downside protection afforded by equity subordination and the rebased values underlying the loan, we view this risk-adjusted return to be compelling. Closely related is a developing need for equity recapitalization to reinforce balance sheets and providing a base for future growth.

However, repriced equity opportunities are starting to become available, although wide bid-ask spreads prevail between buyer and seller expectations. As noted previously, we see a natural geographic ordering with an initial focus on those markets that have repriced the most, such as the UK and Nordic region; with the US one-to-two quarters behind, and other Continental European markets further back. APAC is positioned differently given the uneven impact of the pandemic period, but those markets most reliant on an upturn in China’s fortunes are best positioned from a cyclical perspective.

Sector-wise, logistics assets have repriced significantly and remain supported by solid structurally-driven fundamentals. More generally, those property-types providing contractual or indirect inflation protection should continue to be of most interest.The new higher interest rate regime and recent banking failures will make financial engineering less feasible, with performance instead centred on effective operational management and excellence in sectors able to provide real growth. This remains our focus. Capital expenditure will also have to increase given sustainability upgrading needs and this must be implemented by experts for risk of failure to underestimate these levels and in-turn misprice risk.

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Authors

Kieran Farrelly
Head of Global Solutions, Real Estate

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