Key takeaways
- The rise in inflation and tightening of monetary policy that occurred over the course of 2022 exposed some issues within the real estate asset class.
- In the current context a further correction of interest-rate-sensitive assets such as CRE remains possible and the liquidity mis-match of the fund-based CRE market presents a headwind for investors.
- Transformation of ageing CRE portfolios, capital expenditures to meet new ESG standards, secular trends, accelerating urbanisation and e-commerce growth provide structural support to the long-term growth potential of certain CRE sectors.
Short term headwinds
Over the past 12 months, the average drop in property values in Europe and the US was 13%. Office, industrial and residential sectors suffered the most, though significant falls were also observed in the retail sector, which has struggled to recover from the impact of the pandemic. Over the same period, publicly traded real estate investment trusts (REITs) fell by at least 25%.
Commercial real estate (CRE) has for many years generated returns in excess of investment grade or high yield bonds of around 100-400 basis points per annum. Recent interest rate increases have left many CRE assets yielding less than an average high yield bond or resulted in an unattractive yield spread over investment grade bonds on a risk-adjusted basis.
According to research, the entire CRE sector remains expensive relative to investment grade bond yields and public REITs. This provides room for further declines, with private CRE funds showing the most downside potential in our view. We believe there is the possibility of a correction of 10-20% based on our assumptions, fund leverage and geographic and sector exposures.
Liquidity concerns
Just as financial markets in general are impacted by changes in interest rates and economic cycles, so too are real estate assets. This affects investors’ expectations and liquidity preferences.
The majority of CRE investments are made indirectly, by investing into public or private REITs, funds or companies. Easy transferability of ownership, stable income streams, inflation protection and portfolio diversification make indirect solutions popular. Public real estate funds are more liquid than private funds and, consequently, more exposed to market volatility. Investors seeking liquidity favour public REITs over less liquid private transactions or private CRE funds.
2022 saw outflows from both public and private real estate vehicles. Withdrawal requests have been widespread, with USD 20 billion in requests from private core open-end CRE funds with USD 350 billion in assets by institutional investors at the end of 2022.
Long-term sector views
As explained above, CRE faces short term headwinds. Despite this, there are many reasons to remain positive on the asset class over the longer run. Secular trends are providing asymmetric opportunities across sub-sectors with winners and losers set to emerge.
The largest sub-sector within CRE is office-related real estate. Hybrid working (a mix of office working and Working From Home – ‘WFH’) is the key challenge facing this sub-sector. This trend has been more pronounced in the US and Europe than in the Asia-Pacific region, where more densely populated cities and smaller apartment sizes support office work.
Other challenges for the office sector include an ageing stock with large volumes of obsolete suburban office space and a high level of new supply. Furthermore, the sub-sector faces high capital expenditure requirements compounded by the climate related spending needed to meet new emission standards.
The residential sector is better positioned for the medium to long term. While the WFH trend poses structural challenges to the office sector, the residential sector is a potential beneficiary, with growth expected in major urban centres, supported by accelerating urbanisation trends and lower capital expenditure requirements than for offices.
In addition, higher interest rates have reduced the affordability of home purchases, supporting rental demand. While there are signs of a stabilisation in rents, particularly in the US, demographic tailwinds continue to support demand for other areas of the residential sector, such as single-family, senior, affordable and student housing.
The industrial sector, on the other hand, faces a high supply pipeline, lower demand through lower net absorption and an economic slowdown. However, ongoing urbanisation and changing consumer behaviour continue to support longer term trends such as the growth of e-commerce. This will boost demand for other segments of the sector such as warehouses, logistics and distribution centres.