According to global property consultant CBRE, following a strong global economic recovery in 2021 and early 2022, macroeconomic headwinds are raising fears of a broad-based downturn as central banks address persistent high inflation.
The Russia-Ukraine war is also negatively impacting energy supply and weighing on economic growth, especially in Europe, as consumers and businesses grapple with higher energy prices.
CBRE also says strict pandemic-related lockdowns and an ongoing government campaign to rein in the tech sector are slowing growth in China. With relatively low inflation to contend with, China’s central bank continues to cut interest rates to spur economic growth.
Despite these challenges, all three global regions registered very strong investment volumes in the first half of 2022, reports CBRE.
Inflation, higher interest rates and slower economic growth will also cause full-year investment volume to fall below 2021 levels but remain relatively healthy on a historical basis.
Higher interest rates prompt sellers to accelerate bringing assets to market
CBRE is reporting that sellers in markets with rapidly increasing interest rates are bringing assets to market more quickly. After holding properties for the past several years and sitting on material profit, owners are understandably keen to ensure a clean, profitable exit.
In the U.S., the rising cost of capital resulting from tighter monetary policy, along with broader economic and geopolitical uncertainty, has caused both buyers and sellers to reassess asset values and enter a period of price discovery. This is causing investors to become more selective about their preferred property types, locations and expected yields.
Despite the current investment market volatility, some lenders remain active. Others are either pausing or seeking terms that are unacceptable for borrowers. Loan durations and fixed- vs floating-rate options are becoming more important than ever for borrowers.
Higher interest rates are also beginning to affect lending activity in Europe. Bidding pools have thinned out, pricing has declined by around 10% to 15% and average cap rates have risen by 25 to 50 basis points (bps).
As in the U.S., Europe has seen a recent increase in for-sale properties. More institutions are trying to lock in investment gains before prices fall any further and to avoid refinancing at higher interest rates. Many investment fund managers have been in sales mode. Having met their initial underwriting returns, these sellers are willing to accept a current 10% to 15% pricing discount rather than potentially larger reductions in six months.
While Asia-Pacific has witnessed some of the same trends as the U.S. and Europe, higher interest rates are not the norm across all markets. In New Zealand, Australia and Korea, where interest rates have risen materially, investors are starting to readjust their pricing expectations as negative carry appears in these markets.
Investors are paying extra attention to borrowing costs, rent growth and exit cap rates. In the region’s other markets, interest rates have largely remained unchanged and the spread between yields and the cost of debt has been maintained–a trend CBRE believes will support investment activity in these markets throughout H2 2022. Investors in markets with stable interest rates generally are not motivated to harvest gains so quickly. However, many are more selective about the type, quality and location of potential acquisitions. Tenant quality is becoming an increasingly important consideration in the due-diligence process.
Investment volumes healthy, for now
Macroeconomic headwinds will weigh on U.S. investment activity in H2 2022, which will result in a decrease of 5% to 10% in full-year volume compared with 2021, says CBRE.
Real estate will provide an attractive hedge against inflation. Assets with strong fundamentals and the potential for rent growth will garner the greatest amount of capital.
Major concerns include the “denominator effect,” with recent declines in institutional pension funds’ stock and bond portfolios leaving them with less capital to invest in real estate.
Foreign investment in the U.S. will also be hampered by the strength of the U.S. dollar and higher hedging costs.
In Europe, despite the weakening economic environment, there remains a substantial amount of equity capital targeting real estate.
While some sellers are seeking relatively quick disposals, most are sitting on strong profits–especially for assets that were purchased more than five years ago. This should ensure they come out ahead of their projected exit pricing.
While Europe’s very strong first quarter and subsequent slowdown makes it challenging to forecast full-year investment volume, the near-term pipeline of transactions is strong. CBRE believes full-year 2022 investment volume will be down 10% from 2021’s record level.
CBRE expects Asia-Pacific investment volumes to remain relatively healthy from a historical perspective but end the year down 5% to 10%. High levels of investment are anticipated in Japan due to its loose monetary policy, low cost of financing, relatively weak currency and strong real estate market fundamentals.
In Singapore, underlying market fundamentals across all sectors remain strong, encouraging both institutional investors and private capital to seek opportunities. In emerging Asia, a shift by manufacturers out of China is driving demand for industrial assets in Vietnam. India continues to record growth on the back of solid leasing activity and strong investor demand for development deals.
Despite mainland China’s ongoing zero-COVID policy, recent interest rate cuts should support pricing and spur investment activity in H2 2022. Investors in this market retain a strong appetite for logistics facilities, business parks, data centers and rental apartments.
Inflation hedging top of mind for investors
CBRE says continued strong demand in the U.S. for multifamily and industrial real estate will drive further rent growth in H2 2022. However, multifamily rent growth may be peaking as high inflation constraints tenants’ ability to pay higher rents.
Both these asset classes, along with hotels and self-storage facilities, can be repriced relatively quickly, making them particularly attractive in an inflationary environment.
Assets providing predictable long-term income streams will also garner stronger attention, although buyers may wait for lower prices. Anecdotal evidence suggests that cap rates for prime U.S. assets across most property types may have increased by 50 to 75 bps so far this year.
In Europe, any asset with guaranteed rent increases tied to the Consumer Price Index (CPI) remains keenly sought-after by investors looking for a natural inflation hedge.
Long-leased logistics assets continue to attract the strongest demand. The residential sector is seen as a natural hedge against inflation, with GIC’s and Greystar Real Estate Partners’ recent purchase of U.K. student housing provider Student Roost from Brookfield for £3.3 billion demonstrating the growing interest in this segment.
Long-leased office assets remain high on investors’ shopping lists. However, as environmental, social and governance (ESG) criteria become more important for buyers, pricing for some Grade A properties with comparatively older features will be negatively impacted.
As in other regions, real estate in Asia-Pacific has typically performed very well during periods of elevated inflation. CBRE expects industrial assets will continue to show income increases that keep pace with or exceed inflation.
The standard three-year office lease term in Asia will allow landlords to adjust rents to inflation in a timely manner. With the easing of COVID restrictions, a surge in regional travel is expected to boost hotel demand, particularly as room rates rise in an inflationary environment.
Rising construction costs will limit new supply and the pace of new development, supporting the underlying rents and performance of existing assets.
ESG moves up the agenda
ESG criteria are becoming increasingly important for U.S. investors in pricing potential acquisitions, says CBRE.
Assets that comply with or exceed certain ESG standards will have substantially greater appeal to both investors and occupiers. “Brown discounts” may be factored in when pricing older assets that are less ESG compliant and require significant capital outlays to upgrade.
Most real estate investors, advisors and tenants in Europe now include ESG criteria in their decision-making.
Recent trends include a stronger focus on green building materials and how this could affect redevelopment.
Furthermore, legislation potentially making it more difficult to proceed with highly carbon-intensive procedures– such as demolishing a property–will have far-reaching impacts on investors and their selection of target acquisitions.
The focus on Energy Performance Certification (EPC) and the variety of measures that are being introduced by regulatory authorities across different European markets is also top of mind for investors.
ESG continues to see steady adoption in Asia-Pacific, driven by occupiers’ commitments to reaching environmental goals and a regulatory drive by governments to make their economies carbon neutral.
More investors are seeking real estate that meets the highest ESG standards, a trend CBRE believes will eventually see assets with the top certifications and performance achieve a premium in terms of pricing.
Industrial assets to remain highly prized
With an overall vacancy rate of less than 4%, the U.S. industrial real estate sector will remain highly favored by investors and lenders, as will the multifamily sector.
Operational real estate such as self-storage and data centers also will retain appeal for some investors. However, data centers’ high water and power usage may deter some investment.
CBRE expects investors in Europe will have a strong preference for multifamily assets, followed by logistics properties–particularly those that have been repriced for the current environment. Retail assets also will be increasingly sought-after due to relatively attractive pricing compared with other property types.
While office buildings will see strong demand, investors’ remaining focus will be on any asset providing long and durable income streams and fixed rent increases, such as health-care and student-housing properties.
Across Asia-Pacific, industrial also remains the most preferred asset class. Other sought-after sectors include hotels and multifamily, which remains popular in developed markets, especially in Japan. With APAC leading the world in office occupancy levels, its outlook for that sector is upbeat.
Investors see higher likelihood of recession
While many capital markets professionals are sensing an elevated risk of economic recession in 2023, there is no consensus on how long it will last and the extent of recovery. This depends on central banks’ ability to tame inflation by raising interest rates without tipping the economy into a severe downturn.
Amid growing concern about an economic downturn in Europe later this year, owners are increasingly mindful of the potential for falling values and profit erosion. However, many investors view the current situation as an opportunity. Following a decrease in pricing, buyers with dry powder are now evaluating how to purchase assets that were previously out of their valuation range.
Real estate remains an attractive hedge against economic uncertainty and inflation. Whether by sovereign wealth funds, institutional capital or private investors, more capital likely will target the sector than pull back from it.
In Asia-Pacific, particularly in markets where inflation has remained elevated, the risk of an economic downturn has increased in the near term and these markets will have below trend growth in 2022 and 2023. However, this will be counterbalanced by the reopening of economies in some countries and continued accommodative monetary policies in mainland China and Japan.
Lockdowns have constrained key areas of China’s economy over the past three to four months, but activity is expected to pick up strongly once restrictions are loosened. Japan’s reopening will also provide a counterbalance to slower growth and higher interest rates elsewhere.
More capital eyes debt investment
Liquidity in both the U.S. equity and debt markets remains robust with a substantial amount of dry powder, although investors often prefer the relative safety of debt during times of uncertainty, says CBRE.
However, the current perceived risk in the market has put upward pressure on cap rates and lowered loan-to-value (LTV) ratios, prompting investors to create a capital stack that is more resilient to risk.
With debt harder to secure in Europe, equity investors remain active, particularly for “generational assets”– properties under the same ownership for multiple decades–that were unavailable during previous cycles.
CBRE expects that in coming months, more major investors will take equity positions in European real estate, particularly at the top end of the market.
Investors considering debt in Asia-Pacific at this point of the cycle can secure attractive yields, often on a first mortgage-secured basis. On a risk-adjusted basis, the returns from debt strategies can be highly attractive. Distressed opportunities might appear in mainland China.
Regarding equity, there is some evidence of market dislocations amid interest rate hikes. Equity investments will therefore remain important, with attractive points of entry likely to emerge for the owners of assets facing financial distress, concludes CBRE.