Heightened macroeconomic volatility spurred by high inflation and elevated geopolitical risks saw risk-free rates and the cost of capital lift sharply in 2023, pressuring commercial property pricing and transactions across most markets.
Following a challenging 24 months, selective opportunities in private markets are emerging as pricing adjusts, including in the logistics sector, reflecting the tighter financing environment.
Different markets and sectors are moving at varying speeds though, and valuations are generally lagging with sales well down on recent years.
Nonetheless, firming investor sentiment across asset classes, declining real bond yields and narrowing pricing gaps between public and private markets towards the end of 2023 – if maintained – should boost property transactions and liquidity as the year progresses.
Additionally, any pivot towards looser monetary conditions, as implied by markets and expected by US Federal Reserve Board members, which helps to lift global growth from expected 1H24 lows, should aid the property recovery.
Higher capitalisation (cap) rates are creating better entry points for new investments, boosting unlevered expected returns from cyclical lows.
US core real estate returns from long-term buy and hold investment strategies are lifting with higher cost of capital
Sources: Green Street, Macrobond, as at December 2023.
Improving relative pricing for real estate
With bonds rallying towards the end of 2023, expected total returns from real estate for buy-and-hold strategies appear to be approaching fair value against investment grade corporate bonds.
This is helping to stabilise prices in leading markets, at least temporarily, and slow the rate of decline in lagging countries.
In Europe, cap rate spreads to bonds widened sharply from cyclical lows but remain below 20-year averages, suggesting some caution is still warranted for core investments, especially in sectors with weaker fundamentals.
Jobs growth has supported rents and cashflows in this cycle
Unlike previous real estate cycles, jobs growth remained supportive of property revenues in 2023, with rising rents partially offsetting the negative impact of cap rate expansion on returns across most property types.
This is most evident in the logistics sector where online sales spending remains healthy across most markets with ecommerce penetration rates normalising after the COVID-19 pandemic.
Timing could be the issue given the long and variable lags of monetary tightening as households run down their savings, existing borrowers roll over to higher rates and new investors face higher financing costs.
Rental growth momentum has decelerated heading into 2024 but remains positive, especially in asset classes boosted by structural drivers related to demographics (housing, health care), digitalisation (data centres, premium offices) and deglobalisation (supply chains and logistics).
We believe the extent to which labour markets hold up will be a key swing factor in maintaining positive near-term demand and rising rents throughout the year.
Any material slowdown should see risk-free rates fall back further but lending margins rise from current levels with deteriorating credit conditions.
This adjustment would be brought forward if general investor sentiment sours sharply and rates are cut aggressively to boost demand in a global recessionary scenario.
Real estate development pipelines are under pressure across sectors
On the supply side, the impacts of higher rates and construction costs alongside tighter lending standards are becoming evident as new development starts to fall back.
Leading indicators for construction activity are down sharply across sectors. Similar trends are playing out across markets to varying degrees.
While less construction will be a headwind for economic activity and jobs in 2024, reduced new supply may boost rental growth over the medium to longer term, supporting the recovery in property values, particularly when demand accelerates.
Quarterly US construction starts fell sharply towards the end of 2023, including in the logistics and multifamily sectors
Source: CoStar, as at December 2023.
Regional property positioning and opportunities expected to be led by the UK and US
Globally, the UK has corrected more quickly than other countries and regions, reflecting both the forward-looking approach of valuers and London’s liquidity where pricing evidence is more apparent.
The US has followed with cap rates and transactions impacted by sharp credit tightening and repricing of debt, though there is considerable variation across markets, reflecting local supply and demand fundamentals.
Our view is that the UK and US markets are likely to emerge first when global growth accelerates, and we are already beginning to see real estate investors without significant legacy exposures and portfolio issues take advantage of better pricing metrics available today.
Europe’s adjustment, excluding the UK, is catching up with pricing now 15% lower than mid-2022 peaks for prime logistics, 20% lower for rental housing and 20% to 25% lower for prime offices according to PMA and Green Street. Secondary valuations have seen larger declines.
Shifting demand drivers for global logistics and industrial exposure
We believe the logistics sector is likely to remain one of the more liquid asset classes in 2024 and recent capital market volatility is creating better entry points for new investments.
For example, US nationwide net operating income (NOI) cap rates have expanded to 5%, having touched lows of 3.5% in late 2021, according to Green Street.
At today’s market pricing – which factors in the strong cyclical uplift in rents since 2019 and akin to the UK’s equivalent yield concept – US logistics yields are 50 to 100 basis points higher as leases reset to much higher rents.
Similar trends have been observed in Europe where prime net initial yields have expanded to 4.8% from 2021 lows of 3.3% in the UK and from 3.6% to 4.8% on the continent, according to data from PMA.
Japan remains the only major developed market where cap rates continued to firm in 2023, with valuations supported by a combination of steady macroeconomic fundamentals, accommodative debt markets and a cheaper yen which is boosting domestic manufacturing and investor sentiment.
Industrial market cap rates have expanded from 2021 lows across major developed markets ex-Japan reflecting higher cost of capital
Sources: Green Street, JLL, PMA, as at December 2023.
Refinancing and redemption events are also triggering sales of industrial facilities, despite their solid fundamentals.
With the turnaround from the tight pricing and low cap rates during the COVID-19 period, the sector is still seeing healthy NOI growth relative to other core sectors, persistent demand and rental growth, which is normalising with jobs growth.
In terms of demand, changing consumer behaviour and rising online sales are not the only factors driving the leasing activity.
Businesses are increasingly facing up to the risks that geopolitical tensions pose to their supply chains and operations and their exposure to any single supplier or market.
The pandemic exposed the downside of just-in-time production. Businesses are now diversifying supply chains and onshoring manufacturing, lifting the demand for warehousing and logistics facilities in strategic locations.
These trends are particularly evident in the US, where government subsidies are driving a surge in investment in electric vehicles, batteries and semiconductors, boosting construction in manufacturing facilities.
We believe this gradual retooling of Western producers in select industries alongside near-shoring and shifting trade patterns, supported by governments, corporates and producers seeking to diversify their supply chains, will be an important driver of logistics over the coming years.
Likely beneficiaries include parts of the US and Mexico and low-cost manufacturing producers in Southeast Asia and in Central and Eastern Europe.
Surge in US private structures investment particularly in computer/electronic/electrical manufacturing facilities is driving demand in Sun Belt and lower-cost locations
Data in nominal terms, quarterly annualised
Source: Macrobond, as at December 2023.
Capital markets have corrected well ahead of any sharp deterioration in global macroeconomic conditions
Following a surge in property transactions during the COVID-19 period, global property sales were down 50% in 2H23 versus prior year levels.
Looking at past relationships, both returns and transactions have corrected well ahead of global GDP growth.
In part, this reflects the material increase in transactions that occurred during the COVID-19 period which established new valuation benchmarks with many investors holding real estate on their balance sheets at these high prices.
In today’s market, many of these properties would now likely sell at discounts to purchase prices.
On the flip side, it does suggest that any acceleration in global growth in 2H24 could boost prices and transactions more swiftly than many expect, with fundamentals and supply conditions – with the exception of certain US office markets – generally in good shape.
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