Investing in uncertain times
A prolonged reset in the real estate market is continuing to keep the asset class in flux. After the challenges of the pandemic comes the surge in cost of debt that has precipitated a sharp and broad revaluation in the asset class. These are occurring alongside structural changes in occupier demand in almost all the sectors. These challenges may seem daunting, but look deep and there are pockets of opportunity now emerging for investors.
Offices – suspended animation
The uncertainty in the real estate market is most acute in this segment, which is going through profound changes on multiple fronts: price adjustment after the sharpest increase in debt cost that we have seen in decades; working patterns that continue to suggest reduced demand for space; and a regulatory framework that will continue to increase obsolescence. These issues have led the sector into a period best described as “suspended animation” – alive but with reduced activity. We still think that the pricing impasse will resolve itself over H1 2024 as monetary policy reaches its terminal rate in the current cycle. In terms of occupancy, demand remains focused on the best units, continuing the dynamic established post pandemic, reflecting the desire for occupiers to both reduce space and occupy buildings that meet energy regulations.
Logistics – first off the blocks
2022 saw the biggest correction in the logistics market, on the back of surging financing costs. Equally, the recovery for logistics so far this year has been much faster, in some countries, than in the other real estate sectors. We continue to see a steady and broad recovery over the remainder of the year. Nonetheless, there are some notable headwinds for the future performance and transactional activities in the sector: lack of land supply, particularly in the urban locations where demand is most acute, the cost of incorporating ESG into logistics building and elongated supply chains that will likely increase near-shoring and demand for space. These issues underline the robustness of the occupier market in the sector. However, we are also aware that the resultant increase in rental values so far in some cases quite substantial, are affecting tenants unevenly. Investors will need to bear this in mind at lease events.
Retail – an opportunistic play
The sector has seen one of its most prolonged declines on record, driven by profound structural changes in our shopping habits. The share of retail in European investment activity has fallen meaningfully over the years and consequently pricing has adjusted significantly. The effect has been uneven in this broad sector. We think the down cycle may have reached the bottom as evidenced by the limited effect of the current interest rate cycle on pricing. Moreover, we are seeing pockets of rental growth again. This leads us to wonder whether the sector is now worth an opportunistic play in a broader real estate portfolio.
Residential – the sector that keeps giving
This is a sector where movements in interest rates present a double edge sword. On the one hand, increasing debt cost negatively affects the ability of individuals to purchase their own homes. As such, transaction volumes have fallen significantly on the back of the sharp rise in financing rates. The flipside to this is increased demand for rental. This is the reason for growing institutional interest in residential allocations; demand for rental properties is increasing significantly across Europe. However, the rental segment faces two key challenges that investors need to take into account; both are in the regulatory space. Increased regulation on both rental controls and ESG requirements will heighten the operational risk that investors will need to factor into their expected return.
