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Real estate markets are cyclical in nature, and they swing from local peaks to local troughs. The second half of 2022 was certainly tough for many investors; however, the first signs of the trough seem to be in sight.
May 5, 2023
The second half of 2022 brought corrections to real estate capital values where rental growth was inadequate to compensate for higher yields, driven by higher interest rates.
The first signs of yield stabilization are visible, signaling that we are getting close to the trough of the capital value cycle in selected markets.
We are sticking to our opinion that the latter half of 2023 is likely to offer real estate investors a once-in-a-cycle opportunity to invest close to the trough.
Source: Credit Suisse, Real Estate Strategies. Data as of July 2022
2022 was a tough year for many investors. As inflation rose, fueled by a symphony of supply-chain issues, the war in Ukraine, as well as generous fiscal and monetary support, central banks stepped up their fight against surging prices. Not since Paul Volcker was chairman of the US Federal Reserve have domestic policy rates risen by so much in such a short period of time: 425bps in a year. Other central banks created similar dynamics as they jacked up their policy rates – something many investors were unfamiliar with after more than a decade of "lowflation."
Equity and bond markets retreated. And, in typical fashion, real estate markets did so as well – though with a delay. In our July 2022 Real Estate Strategies newsletter we wrote that "a 50 bps–75 bps cap rate expansion should be expected in multiple market segments by the middle of 2023." While we got the timing and the direction right, the expansion was somewhat more substantial and fiercer than we anticipated.
Real estate capital values have been under pressure, despite healthy rental growth supporting them in many markets such as logistics. Importantly, we can now see the first signs of a stabilization in real estate capital values: The trough of the capital value cycle seems to be in sight.
An inflection point is a point on a curve at which the sign of the curvature changes. More mathematically, it is the point on a curve where the second derivative of the function making the curve is equal to zero (f'' = 0). Figure 1 shows the inflection point before a local minimum as an example.
Markets are cyclical in nature, and they swing from local peaks to local troughs. Assessing whether we have now passed the inflection point in the real estate capital value cycle gives us an indication of how far away we are from the local trough. Pricing indicators based on spreads, for example, still show stress in the market. However, they show less stress than only a few months ago, signaling that high interest-rate levels are still pressuring capital values but that the pressure is waning. Following this and other indicators assists us in taking decisions on, for example, capital allocation to the asset class as a whole or the market, and whether to buy, hold, or sell a specific asset.
Figure 1: Inflection point before a local minimum
Markets are cyclical in nature, and they swing from local peaks to local troughs. Assessing whether we have now passed the inflection point in the real estate capital value cycle gives us an indication of how far away we are from the local trough. Pricing indicators based on spreads, for example, still show stress in the market. However, they show less stress than only a few months ago, signaling that high interest-rate levels are still pressuring capital values but that the pressure is waning. Following this and other indicators assists us in taking decisions on, for example, capital allocation to the asset class as a whole or the market, and whether to buy, hold, or sell a specific asset.
We can take the United Kingdom as an example. The 2022 downturn in UK real estate market values was tough: Annual total return in the UK stands close to -12% on the all-property level (January 2023 value). This is a sharper downturn than during the initial phase of the Global Financial Crisis in 2008, as can be seen in Figure 2.
However, Figure 2 also shows that while the monthly returns in the UK real estate market are still negative they are much less so than before. This indicates that while the market seems still to be on the left-hand side of the trough in the capital value cycle – the month-over-month change in capital values is still negative – we are likely to have passed the inflection point – the change in capital values is less negative than it was.
Figure 2: Month-on-month changes in capital values, UK-all-property commercial real estate market
The signs coming from the UK commercial real estate market are therefore encouraging. This is especially so in light of the fact that the leasing market continues to spark confidence in many sectors. Indeed that is the case not only in the UK. As an example, logistics rental growth in Europe's largest markets ranged from ~10–25% in 2022, including 20% in the UK. In addition, prime office market rents grew by ~5–10% in many markets. While the sharpest pressure on rents is subsiding, we expect rental growth to continue in multiple markets where supply/demand imbalances are in place. This includes logistics but also prime offices (which are in short supply, while secondary offices are in oversupply), residential (including student housing), and even selected retail markets which have seen a repricing trend since before the pandemic. It is also easy to find supply/demand imbalances in other markets, such as the US, where rental vacancy rates for housing are at levels not seen for more than three decades (see Figure 3).
Figure 3: US rental vacancy rate shows historically tight inventory
That said, capital values in many markets are still under pressure. Debt costs remain high, while spreads between rental yields and interest costs are narrow. And, while the economic outlook has improved, we are still at a low level of growth where downside risks should not be ignored.
So the eggs have been laid, in terms of the outlook for capital value growth, which is a clear improvement from the situation only a few months ago. But counting the chickens already would be premature. Careful market selection is still needed, especially since individual market cycles are divergent. Working with local partners who are knowledgeable about the local economy, regulations, and leasing trends continues to be of utmost importance as well when selecting the right assets in the markets we feel comfortable with.
In our last Global Real Estate Strategies newsletter, published in December 2022, we noted that "2023 has [the] potential to be an interesting vintage year for value-add investors, as multiple opportunities exist despite higher interest rates." We still hold this view. One reason why is the acceleration of long-term megatrends that are changing our economies, and consequently the real estate that houses that economy. This includes working from home, energy efficiency, continued but more disperse urbanization, more prominent e-commerce and nearshoring of industrial supply chains due in no small part to geopolitical changes. Another reason why 2023 may be a good entry point for value-add investors is the apparent stabilization in the short-term cycle: The trough may take place in 2023 for multiple markets. Our forthcoming Real Estate House View, due in June/July, will delve deeper into this topic.
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