Despite the ongoing turbulence in commercial real estate, Daniel McHugh discusses why market repricing represents an opportunity for long-term investors.
Read this to understand:
- The impact market volatility has had on commercial real estate pricing
- Whether this repricing reflects a progressive shift in capital values
- Why it is essential capital pricing models better-reflect new factors that carry material risk and rewards for investors
Events in commercial real estate over recent weeks have yet again reminded us 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 when you look 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, and record levels of monetary stimulus and outstanding government debt. Added to this, we have inflation at its highest level since the 1970s.
In September, ten-year government bonds were yielding more than property for the first time since 2007 according to MSCI, despite being the conventional ‘risk free-rate’. This negates any benefits from owning property compared with government bonds.
The consensus is that UK commercial property values across the board will fall by 15-20 per cent. Although this is less than the 40-plus per cent falls seen during the Global Financial Crisis between late 2007 and 2009, recent movements suggest this 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.1
The increased cost of borrowing has injected uncertainty into the market
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 on 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. For those who are over-levered, exposed to secondary risks or particularly reliant on discretionary spending, it is highly likely they will be required to crystallise a capital loss. For others, the repricing is a buying opportunity, coming at the expense of forced sellers.
Long-term investors who are 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 period of time.
The answer largely lies with central banks and the future path of rates, whether that relates to duration of monetary policy tightening, the extent of that tightening or where rates 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.
Real estate is likely to settle at its new equilibrium over the next two years
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 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 – something I talked about in my last column – is one such example.
As we work through the current phase of price discovery, 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.
This article was originally published in Property Week.
