Article

Global Cyclical Opportunity

February 5, 2024 7 Minute Read Time

office

This perspective is part of our Enhanced Return Real Estate Strategies series.

A New Playbook for a New Paradigm

Today’s real estate markets are undergoing a reset. Sharp interest rate rises triggered a turn in the cycle, causing prices to correct. These corrections create opportunities, especially given real estate’s track record of generating high-quality returns over medium and long-term time horizons.

Historically, pricing and fundamentals have typically moved in lockstep—when capital values fall, so too do rents. Not this time. In certain sectors such as residential and logistics, while capital values have been falling, vacancy rates have remained low and rental growth has continued unabated.

A Paradigm Shift?

Arguably, what we’re seeing is a paradigm shift in the global economy, with multiple secular drivers at work:

  • Inflation and interest rates: interest rates are back to levels seen pre-1992, while the market no longer believes that central banks around the world will step in to limit stock market falls
  • Geopolitics: the war in Ukraine and escalation of the Israel-Palestine conflict have displaced people, heightened geopolitical tensions, disrupted supply chains and triggered economic volatility
  • Deglobalization: the pandemic, supply shortages and geopolitical tensions have led to a decline in global trade and rise in protectionism, stalling the globalization trend of the last 30 years
  • Demographics: lower population growth, particularly in the developed world, is putting pressure on productivity, government finances and public services
  • Sustainability: pressure is mounting on regulators, policymakers, businesses, and consumers to address the climate crisis, social inequality, nature loss and dwindling resources

Combined, these drivers are forging a new equilibrium in terms of higher discount rates, not just in response to today’s higher base rates but also to the volume of debt in the system. More debt equals more volatility; more volatility requires a higher risk premium. Increased risk has not only been in the form of higher levels of volatility, but also in structurally lower asset values or the risk of obsolescence. The result is plentiful opportunities to acquire attractive assets at attractive prices. By applying a global lens and switching allocations from one region to another depending on the degree of repricing that has taken place, investors can extend the cycle and at the same time expand the opportunity set.

Capturing the attractive returns on offer will likely require different strategies than those used in the past. Whereas strategies founded on cheap leverage worked well post the 2008 global financial crisis, for example, today’s volatile environment of high interest rates and high inflation, coupled with the secular growth drivers at play requires a different approach.

A New Playbook

Strategies centered around active management will likely be best placed to maximize the opportunities on offer in the new paradigm.

The higher risk of obsolescence is particularly relevant to sustainability. A rental property that fails to keep up with rising energy-efficiency standards is likely to attract lower rents and lower-quality tenants. At worst, the asset will remain vacant for extended periods and risks becoming stranded. As the graphic below shows, green office prices in London and Paris currently benefit from favorable pricing:

Office Green Building Price Differential1

Office Green Building Price Differential between Paris and London from 2016 - 2022

1. RCA Hedonic Series pricing; difference between buildings with and without environmental ratings from BREEAM or LEED.
Source: RCA as of Q1 2023.

The risk of obsolescence, however, can be turned into an opportunity by acquiring assets that require energy efficiency upgrades at a discount. Through retrofitting, assets can be upgraded with strong environmental credentials. These properties are likely to attract better tenants, higher rents and greater liquidity/exit pricing potential. Knowledge of how the regulatory landscape is evolving can turn the sustainability risk into a sustainability opportunity.

Outdated real estate that fails to meet the expectations of today’s more discerning occupiers presents an opportunity for investors to purchase assets at a discount. Here, strong relationships with occupiers are crucial to keep pace with ever-evolving requirements and deliver product that is fit for purpose. Understanding not just the needs of investors but also those of occupiers, is key to transforming out-of-date assets into properties attractive to prospective tenants and unlocking stable and long-term income streams.

The higher cost of debt environment is another risk that can be turned into an opportunity. Today, debt is expensive, but it is often still accretive in terms of value-add returns—debt remains cheaper than equity. According to The Harvard Business Review’s March 2023 article, Capital Is Expensive Again. Now What?, over the 12-month period from March 2022, “…the cost of debt for most large corporations…increased—from an average of less than 2.3% for most Baa-rated corporate debt in early 2022 to nearly 5.75% today.” Meanwhile, “…the cost of equity capital also rose for most large companies over this period—from less than 7% to approximately 10%.”

To turn the risk posed by the higher cost of debt into an opportunity requires being selective and prudent when it comes to asset financing. Maintaining strong relationships with lenders is key to sourcing debt. The flexibility to secure certain deals unlevered with a view to refinancing once asset values and interest rates stabilize and when liquidity improves is another opportunity. Having a platform with established relationships with lenders and access to competitive funding is essential not only to navigate the new paradigm but also to benefit from it. Loan-to-value (LTV) and loan-to-cost (LTC) ratios are expected to be substantially lower for the foreseeable future, potentially closer to 45% rather than the 65% level that until recently had been considered normal. Returns, therefore, will likely need to be driven more by asset management rather than by adding risk through leverage.

As the graphic below highlights, each phase of the cycle generates a different set of opportunities and, hence, requires a different strategy.

As an example, the initial shock and market pricing in Phase 1 has historically first impacted the share prices of listed vehicles such as REITs. REIT share prices (like all share prices) can overreact, resulting in opportunities to invest at substantial discounts to net asset values that more than compensate for the higher level of risk. In Phase 2, falling markets can trigger the denominator effect, whereby portfolios are rebalanced to take into account the divergence of performance of different asset classes. Private property funds that have performed well could, therefore, become victims of their own success and be hit by redemption requests. Cash will have to be raised to settle these and this is achieved by selling either high-quality assets or secondary units in the funds themselves at attractive prices. Similarly, Phase 3’s recapitalization opportunities and Phase 4’s resumption of growth, require different skillsets and strategies to maximize value during these phases.

Opportunities Through the Cycle

Phase 1 is the early period with initial shock and market repricing. Phase 2 is when sentiment bottoms and broader repricing occurs in private markets. Phase 3 focuses on restructuring catalysts and recapitalization opportunities. Phase 4 is market normalization with fundamental growth resuming.

Source: CBRE Investment Management, as at September 2023. For illustrative purposes only. Based on CBRE Investment Management's subjective assessment and subject to change. There can be no assurance any targets or business initiatives will occur as expected.

The thread tying all the above is a global platform that fosters close relationships with occupiers, investors and funding partners, powered by comprehensive datasets, with both a local and global presence and which promotes active management. A global platform enables investors to stay ahead of the curve and navigate changes.

Unusual Correction

Seemingly conflicting dynamics are at work—repricing and a capital vacuum on the one hand; resilient structural fundamentals (in certain sectors) on the other. Rapidly correcting prices, lack of competing capital and scarcity of debt all go hand in hand with real estate market corrections. Rental growth, together with near-record low vacancy rates (in certain sectors at least) are not typical of corrections, but what we are experiencing currently.

Repricing

The origin of the real estate reset currently underway was the sharp increase in the cost of debt that was triggered by central banks rapidly hiking rates to bring inflation down. The below graph for the core logistics sector illustrates that the cost of debt in Europe, the U.K. and the U.S. has been on the rise for over a year.

Cost of Debt for Core Logistics

Cost of debt for core logistics between France, Germany, UK, and the US

Source: CBRE Investment Management as of July 2023.
For illustrative purposes only. Source: CBRE Investment Management, as at July 2023.

Capital Vacuum

Sharply higher interest rates have contributed to an equally sharp and rapid tightening in real estate liquidity conditions, as highlighted by the Real Capital Analytics (RCA) Capital Liquidity Scores below that show how liquidity tightened significantly over the course of 2022.

Real Capital Analytics Liquidity Index

Real Capital Analytics Liquidity Index from 2008 through 2023

Source: RCA Capital Liquidity Scores as of Q3 2023.
The RCA Capital Liquidity Scores measure the depth and breadth of capital active in all major global real estate markets. The liquidity scores use a combination of absolute and relative measures to calculate market liquidity. All quarterly inputs use 12-month trailing figures, and all measures are ranked using percentile calculations to create final inputs. The inputs are then weighted to create final market scores. For illustrative purposes only.

It’s no coincidence then that private market valuations started declining sharply in H2 2022.

Private Capital Value Growth, %, Q/Q

Graph comparing private capital value growth between France, Germany, U.S.,  Japan, UK, and Australia from Q1 2008 through Q4 2023

Source: MSCI Europe Quarterly Property Index, MSCI Australia Quarterly Property Index, MSCI UK Quarterly Index, NCREIF NPI as of Q3 2023. MSCI Japan Property Index, as of Q2 2023.

Resilient Structural Fundamentals

Long-term structural demand drivers, such as population growth, on the one hand, and long-term structural undersupply, particularly of modern assets, on the other, are largely behind the resilient fundamentals being seen in real estate sectors such as logistics, housing and retail. The graphic that follows highlights the low vacancy rates being seen across the European logistics sector, a beneficiary of the e-commerce revolution—a long-term secular driver.

European Logistics National Vacancy Rates Q3 2023(%)

Logistics Vacancy Rates, %

European logistics national vacancy rates Q3 2023

Sources: CBRE, CBRE Investment Management, as at Q4 2023.
* Europe is defined as Belgium, Czech Republic, France, Germany, Italy, Netherlands, Poland, Spain, UK.

Europe’s housing sector is another area with a structural tailwind behind it. Population growth, together with a chronic demand/supply imbalance, is driving vacancy rates lower, as shown in the below graphic.

European Logistics National Vacancy Rates Q1 2011-Q4 2022, %

European logistics national vacancy rates Q1 2011-Q4 2022

Sources: CBRE, PMA October 2022, CBRE Investment Management. For illustrative purposes only.

It’s a similar story in the U.S. Here too (except for office), low vacancy rates can be seen across a broad range of real estate sectors.

Two graphs. Graph on left showing Vacancy Rates by Sector. Graph on right showing Average Annual Forecast Asking Rent Change from Q1 2024 to Q1 2028

Source: CoStar Market Rents for office, logistics, life science, and retail (as of April 2023); RealPage same-store effective asking rents for apartment (as of April 2023); Green Street Advisors m-RevPAF for Self-storage (as of April 2023); John Burns Real Estate Consulting for Single Family Rental (as of April 2023).

Low vacancy rates also underpin CBRE IM’s expectations that asking rent growth in the apartment, retail, self-storage, and medical office sectors and subsectors will match average historical rates.

NPI Value Index by Property with CBRE Investment Management Forecast

Graph showing NPI Value Index by Property with CBRE Investment Management Forecast

Source: NCREIF, as of Q4 2023; CBRE Investment Management House View as of Q4 2023. History is per NCREIF NPI, forecast shows value changes predicted in CBRE IM’s Q4 2023 House View For illustrative purposes only. Based on CBRE Investment Management's subjective views and subject to change. There can be no assurance any targets or business initiatives will occur as expected. Forecasts are inherently uncertain and subject to change.

Values are still being adjusted according to CBRE IM, although certain sectors have further to correct than others:

  • Retail: had five years of value erosion and pricing is likely at its trough
  • Residential: apartment prices are also thought to be near their trough although the window for acquisitions may stay open for longer as cap rates remain elevated
  • Logistics: CBRE IM expects a sharp rebound in logistics values resulting in only a narrow window of opportunity to acquire assets at reset prices
  • Office: faces an extended period of value declines, as the sector adapts to the work-from- home and hybrid working phenomenon

Across regions, the correction in private market valuations has moved at different speeds. The UK, owing to turbulence driven by domestic policies led continental Europe, with the US lagging both.

However, there is growing evidence that all regions find themselves in a similar position at the end of 2023, with the spread between valuations and prices having narrowed significantly in H2 2023– particularly for higher quality portfolios. The spread is now arguably at the point where it presents an attractive risk-adjusted opportunity for investors to access strategies such as core/core+ open-end funds, where entry price is based on NAVs. Particularly once consideration is made for the typical trend in capital flows following a change in sentiment where capital queues for open-end funds can build quickly. First mover advantage has proved to have a meaningful at market inflection points. Using U.S. ODCE funds during the GFC as an example, an investor would have achieved an additional 1.7% per annum if their capital had been drawn 1 quarter before versus 4 quarters after the trough in NAVs. A strategy of delaying a commitment until two or more quarters of stability or growth in NAVs could materially impact an investors’ realised return.

NCREIF ODCE Net Total Return at Different Entry Points Before and After the GFC Cyclical Trough in NAVs

Graph depicting the annualized total return percentage per annum against the number of quarters to/from cyclical NAV trough.

Source: NCREIF ODCE Index, As of March 2023.

Current market conditions differ from prior market conditions; including during prior periods of stress and dislocation. There can be no assurance any prior trends will continue. For illustrative purposes only. There can be no assurance any targets or business initiatives will occur as expected. Forecasts are inherently uncertain and subject to change.

Summary

As with all corrections, today, Class A assets can be acquired at attractive prices. Unlike previous corrections, the successful strategies of the past, centered around securing cheap debt to acquire assets and then letting the market do the rest, will likely no longer be enough.

Active strategies that are nimble and backed by global platforms underpinned by comprehensive datasets, strong local networks and a deep understanding of the regulatory landscape and the needs of occupiers are required. Investors need an active strategy that can deliver through-the-cycle solutions to capture the opportunities generated across all four phases of the cycle. Such solutions can turn risks into opportunities and maximize returns in the new paradigm.

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