The combination of increased volatility and higher interest rates is weighing on investment volumes, and current pricing is being challenged by the deteriorating economic outlook
The economic outlook continued to deteriorate through the second quarter. A realisation that the global economy cannot easily withstand both higher inflation and higher interest rates is starting to shape the market narrative. Investors are fixated on the dreaded R-word: recession.
A global recession remains a possible, rather than probable, outcome. But the risk of recession is enough to weigh on investor sentiment. An economic slowdown would help to bring inflation under control and put a ceiling on interest rates, but it would also derail the one bright spot across most office markets: the strength in occupier demand.
It is therefore unsurprising to see investors scale back their ambitions this quarter; just over US$69 billion of office space was transacted globally, down by nearly 12% compared with the same period last year. Given it typically takes many months to complete a transaction, these figures likely overestimate the amount of liquidity in the market as we begin the second half of the year.
Soft landing or recession?
The question troubling investors is not if there will be a slowdown in growth, but rather how severe that slowdown will be. The answer will largely be determined by the stickiness of inflation, and the resolve of global central banks to bring it under control. By raising interest rates, central bankers are trying to engineer some disinflation, or outright deflation, by reducing demand for goods and services. The big unknown is just how much demand destruction is needed to bring inflation back towards target, typically 2% in major advanced economies, given much of the ongoing inflationary impulse is driven by factors outside of their control (i.e. energy and food prices, supply chain bottlenecks, etc.).
Markets are relatively sanguine about the prospects of inflation coming down next year, allowing central banks to again resume counter-cyclical monetary policy. Short-term interest rates in the US, for example, are expected to peak in early 2023 before falling thereafter, which would help to cushion the ensuing downturn. Economic forecasts produced by the likes of the IMF and OECD tend to agree that a significant global recession is avoidable.
Assuming we get a soft landing, then interest rates may have already peaked in this cycle. Indeed, by the end of the second quarter of 2022, long-term US Treasury yields had fallen by around 50 bps from recent highs, despite continued tightening from central banks, which is already priced in to market rates. Of course, this does not necessarily mean that debt costs will also stabilise – lenders typically increase margins during economic downturns, compensating for higher default risks – while deteriorating credit conditions will impact the LTVs that banks are willing to lend at.
Impaired price discovery
In the interim, the combination of increased volatility and higher interest rates is weighing on investment volumes. In private real estate markets, where assets are heterogeneous and rarely exchanged, establishing a price is difficult. This is especially true in periods of heightened uncertainty; a decline in transactions distorts the tried-and-tested ‘mark to market’ valuation process. Instead, we rely largely on anecdotes to size up the market and establish a direction of travel.
There are still buyers and sellers active in the market, but they are reduced in number, and across many jurisdictions their price expectations are diverging. For a market to exist, some compromise on price is needed between the two, but unlike in listed markets, this adjustment process takes time. In the interim, we are hearing of sales being paused or at least processes taking longer, as the interested parties try to agree on pricing. Investors who don’t need to sell won’t, particularly core assets, where they have likely faced significant competition to attain them in the first place. But at some point, we may start seeing distressed sales as investors, facing the need to refinance existing debt, are either unable or unwilling to meet the worse terms that will inevitably be offered by lenders.
The wall of money still exists, but it is increasingly following occupiers into the best and most ESG-compliant buildings. These are in short supplyOliver Salmon, Global Capital Markets, World Research
Investors may, however, adopt ever-more innovative strategies to avoid selling their prime buildings. This is because, in the midst of the ensuing turmoil, occupier demand for best-in-class assets has continued apace. This is driving a wedge between prime and secondary asset valuations; the wall of money still exists – as evidenced by Blackstone’s recent record-breaking fundraising antics – but it is increasingly following occupiers into the best and most ESG-compliant buildings. These are in short supply, a situation that is unlikely to change soon given the precipitous rise in construction costs.
Occupier demand still key
The optimists hope that the labour market will put a floor on the economic slowdown and continue to support high take-up rates and solid rental growth. The labour market is, however, a lagging economic indicator. It takes time, and sometimes plenty of bureaucracy, to hire and fire people. In the US, for example, which has one of the most flexible labour markets, at the point at which the former investment bank Lehman Brothers filed for bankruptcy in late 2008, the unemployment rate was 6.1%. It eventually peaked at 10% a full 12 months later.
Given the sharp rise in interest rates, investors are looking to rental growth forecasts to help support their underwriting. Even if recession is avoided, it is becoming apparent that current pricing is being challenged. In some markets, the adjustment is already happening, and we have moved net initial yields out in several markets this quarter. But these changes do not fully offset the rise in debt costs, with nearly all markets seeing a decline in cash-on-cash returns this quarter for a typical investor using a mix of debt and equity. More price adjustments are therefore expected in the next 12 months.
Europe, Middle East, and Africa (EMEA)
Even by usual standards, this summer is likely to be quiet in Europe. After an encouraging start to the year, investment in office space across the region fell by around 26% year-on-year in the second quarter. Germany was at the forefront of this decline; investment in the first half of this year was around 50% lower than the same period last year.
The reticence being displayed by investors is understandable. Market interest rates have continued to rise despite limited action from the ECB, with higher inflation prompting markets to bring forward expectations of monetary policy tightening. This has underpinned an increase in the total cost of debt of around 120–140 bps in Frankfurt, Madrid, and Paris, compared with the first quarter. Credit conditions are unlikely to ease up in the second half of the year either; in the latest ECB Bank Lending Survey, the commercial real estate sector is expected to experience a further tightening in financial conditions (see chart below).
With net initial yields hovering around 3% and lower going into the downturn, there was little room for manoeuvre at the core end of the European market. So it was perhaps inevitable that yields would rise in response to such a major repricing in debt. Indeed, we have revised our prime office yields across key regional markets this quarter, implying a 5–10% decline in capital values.
Meanwhile, the outlook for growth is deteriorating in response to news that Russia is restricting natural gas supplies ahead of the winter months, prompting concerns that an energy supply crisis will necessitate the rationing of gas across the region. This will have a major impact on economic growth, particularly across the CEE, as well as Italy and Germany, where exposure is highest. Vacancy rates have remained stable across the region this quarter, partly due to a shortage of prime office space, in turn supporting rental growth. But this trend could quickly reverse in the event of a major economic slowdown. A further correction in prices may be needed to keep the market functioning.
Weight of money and supply shortages are still important factors in the City of London, but investment activity was also more subdued after breaking records in the first quarterOliver Salmon, Global Capital Markets, World Research
In the UK, the movement in debt costs this quarter was less pronounced, primarily because the Bank of England is much further advanced in its tightening cycle. Weight of money and supply shortages are still important factors in the City of London, but investment activity was also more subdued after breaking records in the first quarter, and investors face a similar set of challenges as in the euro area.
We have moved the London City prime yield out by 25 bps to 4% this quarter, although the outlook for the next 12 months is a little more encouraging. In particular, the depreciation in sterling – which has lost around 13% in value against the USD since the beginning of the year, and 5% against a basket of the UK’s major trading partners – provides a relative value opportunity for international investors (who typically account for around three-quarters of all transaction volumes).
In Dubai, while not immune to rising interest rates and other global headwinds, investor demand continues to hold up amid a lack of investment-grade opportunities. When supply does come to the market, there is a large amount of capital to ensure good competition, which is likely to keep pricing steady despite falling cash-on-cash returns.
A similar narrative is playing out in the US as in Europe. Debt costs have continued to rise quickly as the US Fed pursues its fastest tightening cycle in decades; investors can now expect to pay 6% on a typical loan to finance the purchase of prime office space in local markets.
This is feeding through to expected returns, with cash-on-cash yields down by more than 200 bps in comparison with Q1. In New York, for example, the return on a typical 60% LTV debt-financed deal for prime office space in Manhattan would be equivalent to just half the yield for a pure equity investment. This is a far cry from the days when investors could enhance their returns by introducing debt into their capital structures.
Market pricing has yet to respond – we have held our prime yields at 4.5% and 5.0% for New York and Los Angeles, respectively, this quarter – primarily due to a lack of suitable transactions from which to benchmark current valuationsOliver Salmon, Global Capital Markets, World Research
The composition of buyers still active in the market is changing as a consequence; private money accounted for over 43% of US office transactions in the first six months of this year, more than 10 percentage points above the long-term average. Cross-border investors are also less active, given the strong USD and negative carry when hedging some exchange rate exposure, notably the euro.
Market pricing has yet to respond – we have held our prime yields at 4.5% and 5.0% for New York and Los Angeles, respectively, this quarter – primarily due to a lack of suitable transactions from which to benchmark current valuations. However, in both cases, we expect yields to rise in the next 12 months, particularly as the outlook for occupier demand is also softening. In LA, for example, leasing activity was down by 20% on the quarter, and landlords are having to offer generous concession terms and stable rents to attract and retain tenants amid some oversupply.
Hybrid working trends are not helping; occupancy levels have stabilised at around 40% of pre-Covid levels across the US, limiting the feed-through from the strong labour market to office take-up.
In the Asia Pacific region, prime yields have shifted in Shanghai and Seoul in the second quarter, while Sydney is also likely to see a softening in prices in the next 12 months.
In Seoul, while fundamentals continue to support solid rental growth, the repricing is underpinned by a rapid increase in the cost of capital, with total debt costs rising by 140 bps in comparison with Q1. Even at the revised yield, this leaves the cash-on-cash return at a very low 1%, implying a negative premium over the prevailing risk-free rate. Yields are likely to move out further over the next 12 months as a consequence.
Leasing activity in Singapore was relatively subdued in the second quarter, but low vacancy rates and a lack of new stock coming to market will help to support rental growthOliver Salmon, Global Capital Markets, World Research
In Sydney, much like in the US, yields remained unchanged on Q1, as the large decline in transaction activity made it difficult to benchmark the market. However, investor sentiment has fallen sharply amid a significant repricing in debt: the all-in cost of debt rose by 160 bps in Q2 alone after the Reserve Bank of Australia hiked interest rates at successive meetings. Australians have also adopted hybrid working styles more aligned with the west than with regional norms, putting a ceiling on the recovery in occupier demand. Yields are likely to move out in the coming year as a consequence, but cash-on-cash returns remain relatively healthy at nearly 5%, implying a real return of over 2% per annum when considering forward-looking inflation expectations.
Leasing activity in Singapore was relatively subdued in the second quarter, but low vacancy rates and a lack of new stock coming to market will help to support rental growth. Debt is still accretive at the current net initial yield, supporting a cash-on-cash return of 3.6%. Investors remain active despite uncertainty over the future path of interest rates, as well as other economic headwinds (as a small open economy, Singapore is exposed to a global slowdown), given the socio-political stability that it offers, as well as its attraction as a regional hub.
In Tokyo, while the vacancy rate of 3% across prime office space is low by global comparison, it is higher than the five-year average. This is giving tenants more options, putting downward pressure on Grade A rents. But there remains little upward pressure on debt costs as the Bank of Japan remains steadfastly committed to its current ultra-loose monetary policy stance.
Rasheed Hassan, Head of Global Cross Border Investment
Lots of rumour, not enough fact
It seems we may be at, or at least approaching, the point of maximum uncertainty in the market. It is very hard to read where we are going.
Inflation is still widespread, central banks are trying to use evermore dramatic rate rises to control this, and we have been all but promised a recession. Yet, unemployment levels are looking very strong in many markets, there is still a lot of rhetoric about a store of wealth that will help cushion us from the blow of rising costs, and the cost of borrowing in the commercial markets has actually dropped in recent weeks.
Last quarter we were feeling a change in the water in the global real estate markets. It is now the case that this rumour has become a fact, albeit there is a dearth of true data points, and it is hard to know how deep into the fact we are.
Transaction volumes are down, and we are seeing pricing soften in most markets and sectors globally. However, like the unemployment rate, the occupational markets in most sectors are still posting strong stats. As such, most of the move so far is just down to a readjustment in cost of money, inflationary pressure on build costs and, of course, sentiment.
We aren’t seeing desperation or panic. If sellers stay robust while things are adjusting from some heady highs, the amount of dry powder and appetite for real estate should mean we will avoid a major fall in valuesRasheed Hassan, Head of Global Cross Border Investment
The question in the real estate market is now, to what degree will the abundance of equity and rental growth be able to cushion and limit price corrections?
We are hearing about some investment committees being closed for the summer and investors pausing, but we are still seeing bidding from these same groups as they try to identify ‘special situations’ and those owners that ‘have’ to sell.
We talk about being in a period of price discovery. It is certainly not a case of no ‘bid’, it is now simply waiting to see how frequently and far ‘the ask’ moves. This will determine short-term transactional activity.
The press often portrays examples of ‘failed sales.’ But in every example I have seen, I know there have been bidders, albeit perhaps not quite meeting seller aspirations. The owners could have sold, but have just taken the view that there is more value for them in holding. They are comfortable holding real estate, and either think pricing will improve, or were maybe just testing the market in the first place because they thought they could get something extraordinary.
We aren’t seeing desperation or panic. If sellers stay robust while things are adjusting from some heady highs, the amount of dry powder and appetite for real estate should mean we will avoid a major fall in values.
Net initial yields are estimated by local Savills experts to represent the achievable yield, including transaction and non-recoverable costs, on a hypothetical Grade A building located in the CBD, over 50,000 sq ft in size, fully let to a single good profile tenant on a long lease. The typical LTV and cost of debt represent the anticipated competitive lending terms available in each market. Cash-on-cash returns illustrate the initial yield on equity, assuming the aforementioned LTV and debt costs. The risk premium is calculated by subtracting the end-of-period domestic ten-year government bond yield (as a proxy for the relevant risk-free rate of return) from the net initial yield. Data is end-of-quarter values.
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