“There will be fewer transactions due to the rise in interest rates and investors with high leverage will temporarily withdraw from the market. The decline in deals is easing pressure on the market, but in the current environment higher capital values can only be achieved through rising rents and that means robust economic growth is needed,” Olaf Janßen, Head of Property Research at Union Investment said.
Janssen added that he expected more bankruptcies among property developers and cautioned investors should ensure the fund products they invest in have the bulk of their assets sustainably valued in an existing portfolio with low leverage.
“When financing real estate, lenders are likely to focus on tenant creditworthiness and the cashflow story. Future Capex requirements during the holding period of a property are a challenge for both lenders and investors at present, with construction costs having already risen sharply and no end in sight. As a result, financial models are coming under increased scrutiny by lenders,” Nick Harris, Head of UK and Cross Border Valuation at Savills said.
PGIM Real Estate, the USD 209 billion real estate investment arm of US global wealth management business PGIM, advises its clients to: “Focus on property types and real estate markets that deliver dependable rental income and in which demand for space is structurally supported.”
Property performance and occupier demand are fuelled by economic growth
Economists concur that one possible economic outcome – stagflation – would be generally unfavourable for real estate. Stagflation, in other words persistently high prices and low or zero growth, tends to push highly indebted countries into recession and highly geared companies into bankruptcy. Property sectors offering reliable rental income will, however, provide a large degree of protection from inflation provided the investments include leases with solid companies that allow the landlord to raise the rent in line with price indexation, analysts say. These sectors include residential and logistics real estate and the high quality end of the office market.
“The key driver of property performance is occupier demand which results from economic growth,” property advisory firm Avison Young said in a research report which compared historic correlations in the US, UK and Canadian property markets. Its verdict: “In all three countries, correlations between property returns and GDP growth are significantly higher than the relationship with inflation.”
Periods of slow growth and recessions go hand-in-hand with higher unemployment and lower consumer spending, meaning that the discretionary retail, leisure and hospitality sectors are likely to react early on in an economic downturn and experience falling sales. Conversely, people have to eat and live somewhere, so food retail and residential property investments tend to deliver higher total income PGIM recommends underweighting the retail and hotel sectors, and overweighting residential, particularly affordable, single-family and senior housing projects, in a recession scenario.
Logistics boom off the boil but strong potential for rental growth remains
The logistics/industrial real estate sector is a hot favourite among investors. It has experienced exponential growth in recent years due to the ongoing migration of shopping from the high street to online. Manufacturers are also increasingly ‘nearshoring,’ i.e. shortening supply chains to bring them closer to their markets. Both trends accelerated during the pandemic. Overall, however, the logistics boom is currently slowing significantly. Buildings are taking longer to build due to tighter planning constraints and construction costs have been spiralling higher. Other factors include global shortages of building materials and difficulty finding construction companies able to start work promptly on building projects.
Yet despite the challenges, analysts continue to favour overweighting investments in logistics and industrial real estate based on the sector’s strong potential to deliver rental growth.
Residential property offers decent growth opportunities and relatively low risk
The strong demand for housing in most urban areas in Europe, which is not being met by sufficient supply, means the residential property market will continue to offer reliable growth opportunities, especially when rents are linked to inflation. In particular, niche products such as senior housing/assisted living, affordable housing and student accommodation offer decent growth prospects and relatively low risk, analysts say. “Residential real estate delivers stable rental income even in difficult market phases and is a good complement to the cyclical commercial real estate market,” notes the German Investment and Asset Management Association (BVI).
Office properties: focus on ESG, science & technology
In a stagflation scenario, investment manager PGIM recommends limiting any new office sector investments to ESG-related (Environmental, Social and Governance) improvements and developments in life science and technology clusters. Lower overall economic growth is expected to depress demand for offices as a whole, but some investment themes should allow certain projects to outperform.
To qualify for the more stringent energy standards required by the EU’s Green Deal programme, Europe’s offices urgently need “greening”. That whole “decarbonisation transition” will require considerable investment. In the Netherlands, EPC ratings on new commercial leases are required to achieve a minimum Grade C by 2023. Astonishingly, 38 percent of Dutch offices have no energy label at all and 10 percent do not have energy label C or better, according to research by real estate manager Colliers. In the UK, as of April 2021, owners of office buildings must have energy ratings of at least E under the UK’s classification system to be able to rent out office space. Property advisers Savills estimate that 10 percent of the stock of offices in Britain fail to meet this minimum requirement.
How Europe will achieve its EU Green Deal goals for the built environment and tackle its housing crisis, given the expected adverse impact on the investment market from the radical change in inflation and interest rate expectations this year, is a big question. Independent market research network EUROCONSTRUCT, which provides forecasts on European construction markets, reports that construction activity is slowing in Europe. The rate of expansion was 5.6 percent in 2021 due to a post-pandemic catch-up. EUROCONSTRUCT predicts this will return to a normal level of 2.3 percent in 2022 and remain at that level through to the end of 2023. The market researchers expect growth to slow further to 1.3 percent in 2024.
The uncertainty over whether central banks will be able to calibrate raising interest rates to achieve a “soft landing” for Western economies – maintaining growth while stopping higher inflation expectations by companies and consumers from becoming embedded – or their monetary tightening overshoots, triggering a “hard landing” and recession, points to a “risk off” defensive posture for real estate investors until the economic fog clears. Standing portfolios with a proven income-focused investment performance track record, low levels of leverage and rent indexation in property sectors that are more resilient to any economic downturn are likely to be the best safe haven on offer for investors in the months ahead.
By Emma Robson