01 Feb 2024
Author: Craig Wright - Head of European Real Estate Investment Research
Real estate investors have been left battered and bruised by interest-rate rises. Craig Wright reckons he can finally see light at the end of the tunnel, as valuations look attractive, ESG drives tenant demand and opportunities emerge for investors to offer property loans.
Direct real estate valuations likely to bottom out in 2024, offering opportunities.
Recent market corrections boost relative value vs fixed income.
Global deficit of ESG-approved commercial buildings drives up rents in prime locations.
REITs well placed for share price recovery as interest rates fall.
Real estate lending opportunities as banks pull back from new loans.
After a challenging couple of years for real estate, will 2024 prove to be the turning point for battered and bruised investors? The answer is subjective, as challenges for some present opportunities for others.
While a lot of the pain is now behind us, the skies are not yet clear for this asset class. There are several cyclical and structural challenges to overcome before we can signal the all-clear.
Yet, in a less crowded marketplace, we believe there is a compelling opportunity for investors in 2024 to selectively acquire high-quality assets at substantial discounts.
Market corrections of the scale experienced by real estate typically create lasting shockwaves.
Investors using debt face a particularly challenging time. Low fixed-rate loans are gradually rolling over to today’s higher rates, but banks are tightening lending requirements and reducing their exposure to the commercial property sector.
There is around €284 billion (US$312 billion) of real estate debt in the UK and Europe that needs to be refinanced in 2024, a 7% increase on 2023 (see Chart 1).
Unfortunately, a growing proportion of these loans are for more than their underlying collateral are worth as property values drift lower. This places loan-to-value covenants at risk.
Source: Listed REITs/PropCos under Green Street coverage. AEW, Bayes Business School CRE Lending Report, Company disclosures, Green Street, abrdn September 2023
Many investor groups will need to sell assets in 2024 to reduce debt, repay redeeming investors and rebuild balance sheets.
According to data from MSCI Real Capital Analytics, distressed real estate sales peaked five years after the 2007/2008 global financial crisis, as bad loans and fund liquidations took time to clear through the system.
However, market corrections also mean core real estate prices moving back to good value on a relative basis. Yield spreads between fixed-income assets and real estate are starting to widen back towards their long-term average, albeit more slowly than previously expected (see Chart 2).
Source: LSEG government bond yields, Savills, Cushman & Wakefield, CBRE prime office yields, November 2023
In Europe, the ‘prime all property’ real estate yield has increased by one percentage point since June 2022 to 5.3%, compared to the weighted-average Eurozone bond yield of 3.5% in November. This leaves a yield premium of 1.8% percentage points1.
While this is well below the sizeable pre-pandemic spread of more than 4%, further real estate yield expansion and the likelihood of fixed-income yields dropping alongside interest rates in 2024, means real estate is set to find its way back onto institutional investor ‘buy’ lists once more.
Sector allocation will continue to affect relative performance across portfolios. Thematic drivers and an economic recovery support the outlook for some sectors more than others.
Distinct segments of the market are likely to behave differently over the next few years from both a cyclical and thematic perspective (see Chart 3).
Source: abrdn , November 2023. This visual is not based on specific data and only represents our views on sector trends from a thematic perspective. It should not constitute specific allocation advice in isolation.
There is a growing deficit of high-quality sustainable space. Since the global financial crisis, the real estate market has experienced an interrupted development cycle.
The Eurozone crisis, Brexit, the Covid-19 pandemic, the war in Ukraine and now the current interest-rate spike, have limited new supply for a decade. With some 30%-higher construction costs, labour shortages and expensive development financing today, the outlook for new supply is worsening rapidly.
A two-speed market between so-called ‘future-fit’ buildings and ‘the rest’ has emerged. The preference amongst tenants to gather in ‘best in class’ sustainable buildings, means competition for a finite amount of space is pushing prime rents higher.
On the other hand, building-efficiency regulations mean investors need to invest more money into older assets that’s not been budgeted for, suggesting a faster pace of obsolescence for older buildings.
This polarisation in quality will be an important performance differentiator in 2024 and beyond (see Chart 4). The chart shows the difference between the performance of higher-quality offices in London last year compared to those of lower quality.
Note: Lower-quartile equivalent yield is a proxy for prime, upper-quartile is a proxy for weakest quality. Source: MSCI, abrdn September 2023
While we have focused on the outlook for the performance of physical assets, investors have more choice when looking for opportunities to tap a recovering asset class. This includes direct and indirect vehicles and private credit (debt funds).
We believe these three areas offer different, but equally compelling, opportunities in 2024:
Direct real estate. We think direct real estate valuations will bottom out in 2024. Opportunities for investors to pick up high-quality sustainable assets at discounted prices will increase through this phase, prior to a broader market recovery. Both ‘core’ and ‘value add’ strategies should increase in appeal, while price dislocation could also lead to interesting mergers and acquisition opportunities (see Charts 5 and 6).
Listed real estate investment trusts (REITs) and other indirect vehicles. Since 2022, share prices for global REITs have underperformed global equities by over 20%, positioning REITs for a strong recovery. On a relative basis, REITs tend to perform better than other listed equities after a rate-hiking cycle. For instance, in the 12 months after the global financial crisis, the global listed real estate sector soared 74%, compared with 49% for equities. A similar trend was seen in the wake of the Fed pivot in December 1974. Other non-listed indirect investment vehicles also offer opportunities for investors to enter the market at discounts to underlying asset values. Some investors are willing to find an exit through a secondary trade more quickly than the liquidation of underlying assets would permit. In exchange for this liquidity, units are often available at a discount for new investors.
Real estate lending. Real estate debt funds are continuing to offer investors interesting cash flows, backed by high-quality commercial real estate. From the non-bank lenders’ perspective, lending at lower leverage levels against an asset that has already reduced significantly in value presents an attractive opportunity from a risk perspective. Increased safety margins and significantly higher base rates combine to support an elevated interest rate that is well in excess of the long-term average. Given the debt funding gap in the market today, as banks focus on existing loans, non-bank lenders can be highly selective and source strong lending opportunities.
Source: abrdn , September 2023. Forecasts are not a reliable indicator of future results and there can be no guarantee that these will be achieved.
While we are cautious about the challenges still confronting the market today, we believe that 2024 will present interesting opportunities and prove to be a good vintage for new allocations into real estate.
Sector positioning will remain a key driver of relative performance, while a clear focus on quality, environmental, social and governance (ESG) credentials and location will also have a growing impact.
Although market risks remain elevated, investors should also begin to explore the opportunities ahead as the cycle shifts onto a stronger footing, crucially underpinned by a structural deficit of sustainable space.
The value of investments, and the income from them, can go down as well as up and an investor may get back less than the amount invested. Past performance is not a guide to future results.
Before investing, investors should consider carefully the investment objective, risks, charges, and expenses of a fund. This and other important information is contained in the prospectus and KIID document. The information is intended to be of general interest only and should not be considered as an offer, investment recommendation or solicitation, to deal in the shares of any securities or financial instruments.