Real estate in a time of rising rates: navigating the correction, anticipating opportunity

Real estate is an essential part of the business cycle – sometimes it leads, sometimes it lags, but frequently it plays a major role in the contraction or expansion of GDP.  

Our charts analyze commercial and residential real estate prices and how they interrelate with GDP in the past seven recessions.  

Our benchmark for commercial real estate is the NAREIT index, which provides a public market valuation of a leveraged but broad composite real estate portfolio.  Research indicates that REIT prices are the most informationally efficient of all real estate value benchmarks (Barkham and Geltner, 1995).  

On the residential side, we employ S&P/Case Shiller to track price movements. Rebasing all three indicators to the same date, 2 quarters prior to a recession, we evaluate the lead and lag relationships. Each chart shows where the two real estate indicators  bottomed out, compared to the bottom in GDP.

As shown, S&P/Case-Shiller is sometimes a coincident and sometimes a lagging indicator of the trough in GDP, but never a leading one. (Note that for several instances the S&P/Case-Shiller troughed at the base quarter, meaning it continued to rise while GDP declined. We group these instances as not having a relationship with GDP). On the other hand, securitized commercial real estate leads GDP five out of the seven recessions, normally by one quarter.  

If investors anticipate GDP to decline the sharpest by the end of 2023, as we do, they should consider allocating to REITs in the next six months.  

Reference: Richard Barkham & David Geltner, 1995. "Price Discovery in American and British Property Markets," Real Estate Economics, American Real Estate and Urban Economics Association, vol. 23(1), pages 21-44, March.

The mood music is downbeat in commercial real estate, especially in the US. Hybrid work looks here to stay, with corporates taking less office space going forward. And even before the recent stress in the US banking sector, vacancies in cities like Houston and Dallas had surpassed 20 percent.  

However, we believe that there are some great opportunities in Europe, which has not seen the speculative construction seen in the US.

Anecdotally, we hear that office rents in Frankfurt and Paris are hitting records; and as our first chart shows, vacancies in central Paris are below 5 percent – one of the lowest rates on a global basis.

An investor that bought prime office space in such markets would be buying near the bottom, we believe. (This is in contrast to non-prime office space, where we expect prices to keep sliding – and potentially experiencing a serious correction; some of the least climate-friendly property is likely to become unlettable as environmental regulations gather pace.)

Even in Brexit Britain, supply is extraordinarily tight for the most sought-after office space. Vacancies for best-in-class offices in London’s financial district are approaching 1 percent.

The rising rate environment has put disproportionate pressure on some  defensive sectors, such as Industrial, given how low yields had become.  

This should ease as the bid-ask spread narrows and as 2023 progresses, we expect this denominator pressure to transition to the numerator of the valuation equation – i.e., the income component. As such, we continue to favour defensive sectors as we expect their income streams to remain more resilient – even as their pace of growth may slow or pause altogether over the short term.

Furthermore, both debt and equity underwriting are becoming increasingly focused on ESG + HW (health and wellbeing) considerations. More and more data shows that highly certified office buildings achieve both higher leasing rates and are leased more quickly. And even more regulations along these lines will take effect in coming years.

Investment opportunities are likely to continue to materialise in relation to buying standing office assets at or below their replacement or build costs, plus requisite refurbishment. However, there are risks with regard to obsolete buildings that could become stranded assets. These must be monitored, along with green premiums that could well outstrip replacement costs.

Important Notice: This information has been established on the basis of data, projections, forecasts, anticipations and hypotheses which are subjective. This analysis and conclusions are the expression of an opinion, based on available data at a specific date. Due to the subjective aspect of these analyses, the effective evolution of the economic variables and values of the financial markets could be significantly different from the projections, forecast, anticipations and hypotheses which are communicated in this Material.

When it comes to real estate investments going into 2023, the search for the “right price” continues. Sellers are holding onto their valuations, and the clearing price has not yet been defined.  

A rebalancing in yields is expected to take place, as interest rates remain at higher levels than we have experienced in recent years. As this chart shows, the yield gap between government securities and real estate has largely closed.

However, we assume that most movement has already taken place (especially in the UK) or will materialise in the course of 2023. Thus, for investors, this is the time to prepare and be ready for the right opportunities. Real estate investors will be given the chance to make a reasonable calculation between the impact of potentially lower valuations and rising rental income in times of elevated inflation.

At the time of writing, financial markets are yet again going through a time of elevated uncertainty. Even if the cycle of interest-rate hikes comes to an end soon, the longed-for planning security for investors is unlikely to materialise for the time being.  

However, long-term real estate investors focusing on strong and lasting income can nevertheless profit from the changing investment environment. Investment cycles matter for short-term valuations, yet structural changes and fundamentally strong assets that fulfil all tenant needs – and, hence, generate income – matter even more. This is where performance is achievable.

Recent bank funding turmoil will lead to additional tightening in credit conditions for commercial real estate (CRE) at a time when the asset class is already reeling from higher debt costs, an inadequate risk premium, and emerging refinancing distress. This has prompted us to lower our global baseline forecast for CRE values over 2023-2024.

The US looks particularly exposed due to the importance of regional banks in real estate financing and the role of leveraged non-bank lenders. Consequently, we now forecast a peak-to-trough slump in US all property capital values of 15 percent. That would result in a downturn just less than half the decline in 2008-2009, but significantly worse than the 4 percent correction during the dotcom bust.

In a risk-off environment, the cost of liquidity increases and the definition of a prime asset tightens as lenders and investors shy away from unquantifiable unknowns. This is bad news for the office and retail sectors. The combination of poor capital performance over the past few years and the tightening of loan-to-value requirements, coupled with lower income relative to debt payments, could accelerate forced sales this year.

The following chart tracks rising and falling property values over the past two decades (the red bars) with sentiment among lenders (the Federal Reserve’s Senior Loan Officer Opinion survey, or SLOO, as shown by the line). A higher SLOO value reflects the percentage of banks that are tightening credit standards, so the axis has been reversed.

We forecast that as property values fall, lender sentiment will veer towards tougher standards even more than it did during the global financial crisis. 

The second half of last year was characterised by a typical ‘risk-off’ response to the macro environment. Investors prioritised defensive strategies, consisting of core assets with stable cash flow in domestic or familiar ‘safe haven’ markets. By the final quarter, capital markets were largely dormant. The following chart of investor sentiment reflects this trajectory.

Coming to the end of Q1 2023, ‘wait-and-see’ remains the overarching investment philosophy for many investors, and the period of price discovery that has characterised the market recently will continue to support a more circumspect investor.

In the second half of this year, we expect those investors currently in hibernation to emerge and start taking on more risk; there is plenty of dry powder ready to deploy when sentiment does improve, and institutions continue to favour real estate as an asset class.  

For this to happen, investors generally recognise that, where it hasn’t already, pricing needs to adjust further to reflect the reality of a global economic slowdown.

As some seller attitudes switch from a position of reluctance to necessity, more supply should come to the market. Many of these ‘motivated’ sales will be triggered by refinancing events, a dynamic that will be compounded should credit conditions tighten on the back of recent troubles in parts of the banking sector (as illustrated in the following chart, banks have already significantly tightened lending standards on commercial real estate). This will provide an opportunity for buyers as there will be price realism, particularly for those assets owned by sellers with limited bargaining power, while a more stable macro environment will make it easier to underwrite new deals.  

When activity does pick up, those sectors where supply-demand imbalances exist will continue to attract investors. But while the weaker economy hits occupational demand across all sectors, supply dynamics may be more important in differentiating across individual assets and locations. This favours core CBD offices in Europe and Asia Pacific, prime logistics in good locations, living sectors with good fundamentals, and high street luxury or nondiscretionary retail. 

The world has been buffeted by a pandemic, a war and now a fledgling banking crisis – all of which have implications for real estate.

This table displaying annual REIT returns shows how investors reacted to these events, creating a rollercoaster of returns from one year to the next. However, making the correct bet on e-commerce – being overweight logistics and underweight retail – was one of the key calls of the last decade, despite the volatility experienced throughout.

There is likely to be another event – in fact, many events – over the next decade. Staying with our long-term strategy in the face of future cycles will be difficult, but it is in our nature to think of megatrends as tailwinds or headwinds, and trust that over time they will be the source of relative outperformance.  

We are especially committed to direct investment into European healthcare, social housing in France and build-to-rent residential in the UK, despite the current ranking of their respective REIT returns. Their long-term drivers of return and ESG credentials are too compelling to ignore.