Events in commercial real estate over recent weeks have yet again reminded us that market cycles are long, but investors’ memories are short. Although history is not repeating itself exactly, we have been at this point in the cycle before and seen the same warning lights flashing.
What is different this time is the repricing has started from a particularly disadvantageous point, not only with regards to where we sit in the cycle, but also looking across the headline market figures and at the broader macroeconomic picture.
The market has experienced some of the most extreme data points in recent memory: record low yields; record low base interest rates, record levels of monetary stimulus; and outstanding government debt. Added to this, inflation is at its highest level since the 1970s.
In September, 10-year government bonds were yielding more than property for the first time since 2007, according to real estate data provider MSCI, despite being the conventional ‘risk free-rate’, negating any benefits from owning property compared with government bonds.
The consensus is that UK commercial property values across the board will fall by 15% to 20%. Although this is less than the 40%-plus falls seen during the global financial crisis between late 2007 and 2009, recent movements suggest this fall in values has further to go, with the full extent of an economic downturn and liquidity pressures yet to be experienced.
According to JLL’s November ‘Global Real Estate Perspective’, central banks’ aggressive actions to combat inflation will lead to further interest rate increases in 2023, which is weighing on sentiment.
The increased cost of borrowing has injected uncertainty into the market as to where interest rate rises might ultimately peak. This has had a substantial knock-on effect for valuations and resulted in a substantial pull-back from lenders.
Of course, re-pricing is only a bad thing if you are on the wrong side of it. Those who are over-leveraged, exposed to secondary risks or particularly reliant on discretionary spending are highly likely to crystallise a capital loss. For others, the repricing reverberating through the market will represent a buying opportunity, coming at the expense of forced sellers.
Long-term investors looking through the cycle rather than at it, including ourselves, are entering a phase with capital available and an opportunity to access mispriced assets.
The question is how long this phase will last and whether the market repricing will be one of – if not the most – extreme we have seen, or if it is representative of a more muted and progressive shift in capital values over a sustained time.
The answer largely lies with central banks and the future path of interest rates, whether that relates to the length of time monetary policy is tightened, the extent of that tightening, or where rates ultimately settle over the long term. The potential for unexpected turns along the way cannot be ruled out either; the extraordinary environment we are in makes it difficult to accurately predict how sensitive the market will be to waves of monetary tightening. This makes the policy path less clear, potentially less linear, and could result in some surprising themes emerging along the way.
Our longer-term view is that although the start of 2023 is likely to be volatile, real estate is likely to settle at its new equilibrium over the next two years, reverting to its long-term record of providing solid income, a sensible illiquidity premium and a modest level of capital growth. This will continue to be enhanced further by the benefits of partial inflation protection and a lack of correlation to liquid markets.
If we are to get there, however, the market’s approach to capital pricing models must evolve. These models will continue to include traditional factors we are familiar with, but it is essential they better reflect new factors we are learning about that carry material risk and rewards for investors. Sustainability-related obsolescence is one such example.
As we work through the current phase of price correction, debt defaults, liquidity issues and recapitalisation, which are all bound to occur to differing degrees, we should be thankful supply has been muted compared to other peak market cycles. At the same time, we should be wary of the acceleration of obsolescence and its potential impact for our industry and investors.
Daniel McHugh is chief investment officer for real assets at Aviva Investors
No comments yet