2023 - a tough year ahead, but opportunities will abound
12 / 01 / 23 - 8 minute read
Inflation remains elevated across the globe. Led by the Federal Reserve in the US, several major central banks have front-loaded interest rate hikes in an attempt to cool down headline and core inflation. Unfortunately, that has also resulted in a weaker economic growth outlook.
Inflation is expected to decelerate markedly over the next 12 months, although it is likely to still be far higher than many central banks’ targets of 2% before decreasing again in the medium term. Meanwhile, consensus forecasts and market-based expectations point to maximum terminal interest rates being reached in 2023, but then coming down and settling above levels in the previous cycle.
Leading indicators also point to a continuing decline in real estate values: transaction volumes are plummeting in most markets globally, and listed markets are trading at large discounts to gross asset values (GAV). UK MSCI monthly property returns have now turned negative; historically these indicators lead less frequent continental European indices. We expect a correction in commercial real estate values of around 15-20% peak-to-trough depending on the sector, location, lease structure and asset quality.
However, it is easy to overstate the doom and gloom. Investment opportunities will emerge in the near and medium term. Exacerbated by upcoming refinancing challenges, real estate repricing will create opportunities for those with the financial firepower and acumen to invest strategically. So, where does PATRIZIA believe the best opportunities are to be found?
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When it comes to offices, structural headwinds have triggered and will continue to induce significant repricing, something that is particularly pronounced in the UK and will doubtless cause some pain.
On the flip side, the situation is expected to create significant discounted core and value-add opportunities in the near term as the lack of liquidity and the increasing cost of borrowing trigger motivated or even forced sales. Increasingly, we see a rising number of discounted core opportunities emerging in the best ‘A’ locations in some European markets.
There will also be opportunities to take on repriced assets that would benefit from sustainable retrofit: ESG credentials are increasingly key for liquidity and considered critical by tenants. The current situation provides a window to future-proof tired stock, thereby transforming obsolete stock in attractive locations into green, flexible space that meets the needs of an increasingly polarised market.
Footnotes: (1) CPPI – Commercial Property Price Index: captures prices at which CRE transactions are being negotiated and contracted (average market); (2) *Dec-22 Estimate; (3) US Sectors –Weighted Apartment 29%, Industrial 29%, Office 24%, Strip Center18% /
Source: Greenstreet, PATRIZIA | December 2022
We are also convinced that the living sectors continue to present opportunities for investors, despite existing and emerging challenges. In terms of the latter, rent affordability is under ever greater public and political scrutiny, with high inflation driving housing affordability concerns and amplifying regulatory risks for Europe’s residential sector.
More and more governments and local authorities are resorting to caps on rent indexation and links to indices other than the consumer price index (CPI), such as wage indices. In the Netherlands, for instance, there is currently a discussion on linking rent indexation to the wage index in 2023 to limit rental growth. Meanwhile, France introduced a temporary cap of 3.5% on rental indexation for residential and retail in 2022.
It also has to be said that supply and demand imbalances can be expected to widen as construction momentum slows down and less stock comes to the market. This will put upward pressure on rents. At the same time, the rising cost of borrowing means that more first-time buyers in particular could be priced out of the market for longer, although that will be partially offset by falling prices in many locations.
On the face of it, there are some serious headwinds when it comes to residential. However, we are confident that multifamily or build to rent (BTR) remain fundamentally well-placed to deliver solid investment performance, although we will continually remain vigilant on affordability metrics and indexing discussions and take a view as the regulatory environment that will take shape in different jurisdictions.
Elsewhere, student housing offers opportunities with increasing demand keeping occupancy rates high and at the same time offering a yield premium compared to traditional multifamily housing. The senior housing/care homes sector is also benefitting from ageing populations, a secular trend, and is still offering a yield premium to residential despite high investor interest.
In terms of our least favoured sectors for core strategies, hotels have made a good recovery from pandemic lows, but caution is warranted given the slowdown in economic activity, which will impact leisure and business travel. Mid-scale and extended-stay segments are less sensitive in the current macro environment.
Supply chain sectors
The supply chain sectors (big box and last-mile logistics, industrial space, self and cold storage, data centres), enjoyed their time in the sun in recent years, especially during the pandemic when more and more retail sales went online. However, it also has to be recognised that there are still issues that need to be acknowledged and managed.
The industrial sector, for instance, is not immune to the current market environment and is experiencing an outward shift in yields. Repricing in this area is led by the UK, with Q3 industrial values down 8% and agents estimating a 20% correction overall. At the same time, demand for e-commerce, while still growing, is slowing down.
Having said all that, the overall fundamentals for industrial and logistics remain strong, with structural tailwinds, very low vacancy rates across Europe, enduring demand from third-party logistics operators and still room for growth if one compares the European landscape to that of the US.
We forecast that urban logistics will prove to be the most resilient sub-sector due to its superior rental growth prospects, thanks to strong demand and competition for the best locations. Self-storage and data centres, meanwhile, are supported by structural drivers, although access to product is challenging.
Conversely, hub logistics pricing is drifting due to rising in debt costs, particularly for non-prime and, in particular, unsustainable (non Green) assets. Macro headwinds, including higher energy prices, the slowdown in e-commerce growth, and already high inventory levels, will all be a drag on profitability. That said, our five-year rental growth prospects remain robust given low vacancy rates and an expected fall in construction activity.
If industrial and logistics have been the darlings of real estate investment in recent years, the opposite was the case for retail. Unfortunately, we see little reason why that would fundamentally change in the medium term.
After surviving the pandemic, retailers now face the challenge of a customer base facing the worst cost of living crisis in decades, with high inflation causing prices to rise for the vast majority of goods and services. As a result, consumers’ disposable incomes are falling steeply, placing pressure on discretionary spending and therefore, non-essential retailers.
The upshot is that shopping centres and high street retail are likely to see the greatest challenges ahead. The current environment is indeed putting pressure on discretionary spending, certainly, but structural changes linked to consumer behaviour, not least the rise of e-commerce, are also long-term headwinds for these sub-sectors. Yields and rent correction still have some way to go.
In short, retail as a whole still faces very challenging times, with one possible exception: grocery-anchored assets. We still see the UK grocery market, especially discounters, as a growth market going forward, supported by the inflationary challenge. After all, food is an essential, although consumers will focus more on discount, white label and private label products. Well-located, modern assets with attractive catchment areas will outperform.
The importance of data intelligence
So far, we have only been considering opportunities at a macro level. However, when it comes to making individual decisions, it is important to examine opportunities in granular detail. It is for this reason that PATRIZIA has developed a series of data intelligence tools that provide a boost to our underwriting and operating expertise.
The data Intelligence tools around amenities, for instance, measure residential location attractiveness by taking quality and distance to different types of points of interest (such as a bakery, kindergarden, parks, doctors’ surgery etc.) into account and generating a score from 0 to 100 for each grid point. They are currently available for the European, Japanese and US markets.
A positive and negative shock to a site can also be simulated by adding or removing nearby amenities. Implications for investment can be derived from the results: A currently low score may not be greatly affected by a negative shock, indicated by a small decrease, while a large increase in the positive scenario indicates growth potential that typically leads to higher rents, for example.
Elsewhere, we have developed a separate data intelligence solution for urban logistics (our Logistics Impact Solution), which accurately tracks the number of households and their respective purchasing power reachable from any given site. Similarly, our Retail Impact Solution provides an assessment of the attractiveness of food retail locations based on potential demand and retail density in order to understand and predict competition.
So, while nobody doubts that real estate faces testing times over the next 12 months and beyond, this is not the time to hibernate - opportunities will abound. However, investment strategies will only succeed if they are based on thoughtful combined analysis of short-term price distortions, long-term head and tailwinds and creative and rigorous use of data intelligence tools.