High interest rates and Chinese market slump signal more pain for longer - research

Global property investors will need to rely more heavily on generating high yields and growth to successfully compete in an environment of increased interest rates and debt costs, according to M&G’s newly released global real estate outlook report.

Jose Pellicer, head of investment strategy at M&G Real Estate, said: 'The days of ‘lower for longer’ interest rates are firmly behind us. Global property investors can no longer rely on yield compression and cheap debt to drive returns – there needs to be a fundamental shift in mindset.

'Investors may be naturally drawn to growth, but income is also of key importance given today’s higher rates. Investing in areas with strong demand drivers, such as the living and industrial sectors, could offer attractive returns through high income growth; as could sectors which allow inflation to be passed onto tenants, such as long lease supermarkets.

'Committing to asset improvements or investing in unloved properties with high income yields could also generate attractive income prospects.'

Key challenges
Pellicer also observed that markets would need to 'adjust to a weakened Chinese economy, growing complexities around Net Zero Carbon and changing patterns of demand and occupancy'.

China’s recent economic slump has largely been caused by its heavily-indebted property sector. With GDP growth expected to slow from around 5% in 2023 to between 4.2 – 4.4% in 2024, this downturn is anticipated to create continued widespread economic uncertainty – not just in Asia Pacific, but also in Europe where Germany is most exposed through heavy reliance on exports to China.

However, once such factors have been accounted for, he said that M&G expected 'to see signs of greater confidence as investors recalibrate their approach to a drastically different economic landscape'.

While real estate debt costs have ballooned, the report finds that distress has been limited to date, but anticipates forced sales over the next few years with 30-40% of commercial real estate loans across the UK and Europe due to be renegotiated by the end of 2025 at significantly higher rates than borrowers currently enjoy.

Office woes
As hybrid working continues to force occupiers and investors to re-evaluate space requirements, the report highlights significantly different motivations for returning to the office, depending on the market.

The extreme challenges felt in the US – where office attendance remains at only 50% of pre-pandemic levels – are not nearly as acute across many European or Asian markets, where it is 75% or higher.

The findings also indicate an increasingly sharp divergence between city centre and out-of-town offices, as well-located, high specification schemes remain in demand, particularly those with strong ESG credentials.

Asset classes to watch
Logistics is a crucial sector for investors aiming to expedite the shift to net-zero carbon and manage portfolio risk.

The report notes that distribution warehouses generally produce 60-70% lower greenhouse gas emissions than other commercial buildings and 20-25% lower than residential assets.

Occupier demand is increasingly targeted at newly built, green-certified stock, where features such as on-site solar energy production and electric vehicle chargers are deemed essential. Tenants are usually willing to pay a rental premium for the best space and vacancy risks are currently negligible.

In the UK, where continued high inflation and high interest rates have already raised concerns about a possible recession, average real estate values have fallen by more than 20% since mid-2022.

Existing loans may increasingly fail to meet the terms set by banks, leading to refinancing challenges and distressed sales. This may provide an opportunity for alternative lenders to step in and offer debt investors a chance to capitalise on the UK’s repricing, providing the potential for attractive returns at a lower risk point.

On a more positive note, retail rents are stabilising having significantly rebased and with the best quality stock yielding above 8 percent – shopping centres could offer strong income potential once depreciation is appropriately priced in.

In Continental Europe, rising construction costs and expensive financing are already impacting European developers.

In most markets, the demand for residential permits has decreased. Over the next few years, completions look set to fall well below housing requirements, which will boost demand for homes in the private rented sector, student housing, and senior living schemes.

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