As has been well documented, real estate investor sentiment transformed dramatically over 2022. The general consensus is that there’s a more active market coming, providing there’s more certainty in the economic outlook, giving investors confidence to underwrite new deals, and some pricing continues to adjust to reflect macroeconomic realities.  

Property prices have already started to move, particularly in Europe and to some extent in North America, underpinned by a simple arithmetic to the higher interest rate environment. But while buyers are forward looking, some sellers remain reluctant to adjust expectations. The period of discovery that has characterised the market recently has further to run: those expecting a cliff edge event triggered by year-end 2022 valuations may be disappointed, but the pricing adjustment will accelerate through this year in some sectors and geographies.

Supply should increase as some seller attitudes switch from reluctance to necessity, often triggered by refinancing events. Loan distress is yet to materialise: at end-2022, the delinquency rate of commercial real estate loans held by the largest 100 banks in the US was just 0.8 per cent, compared with 10 per cent post GFC. But there’s a significant quantum of debt that needs rolling over in 2023. In Asia Pacific, investors are watching Australia and South Korea, with the latter already seeing some signs of distress amongst domestic Limited Partners (LPs). The combination of higher debt costs and falling valuations will make some deals impossible to refinance without injections of new capital, something not all investors can or will be willing to do. Interest coverage multiples are back in vogue for lenders given the sharp rise in debt servicing costs, and in any recession there are corporate failures, which will push more assets to market as landlords struggle to finance outstanding debt payments.

There will be other drivers of increased liquidity. Nearly one-third of global institutions were over-allocated to real estate at the beginning of 2023, compared with less than 9 per cent last year, after incurring outsized losses on listed and credit portfolios. Most will wait for a rebalancing between public and private portfolios as valuations catch up, but some funds may need to liquidate assets to rebalance, especially if equity markets face further pressures. Cash-flow will also be important for many open-ended funds, where redemptions will likely encourage sales even if the underlying funds remain profitable. Then there are some funds coming to a natural termination, with around US$ 345 billion in liquidations expected next year.

Looking ahead, there’s a renewed focus on fair value against higher interest rates. The new world order is probably characterised by lower excess returns to commercial real estate, with pricing settling where there’s limited or no accretion from taking debt. Investors, particularly those cash-on-cash driven, previously encouraged by outsized returns, will consequently struggle to hit historical targets which probably means fewer active market participants and lower investment activity. This will take time to wash through an increasingly saturated marketplace.

There are plenty of commentators prophesying a new age of alpha in investment markets; i.e., a focus on outperforming the market. This is true for real estate as much as any other asset. The era of asset prices supported by an ultra-loose monetary policy globally has gone, and rental growth has never been more important. Investors with dedicated teams and strong experience are positioned to outperform. The good news is that there’s plenty of room for alpha in private markets, underpinned by information asymmetries and a lack of transparency. And there remains plenty of interest in real estate as a source of alpha from the major LPs. 

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Contact Oliver Salmon

Taking Stock: A Review of the Global Real Estate Capital Markets