Europe is not in recession, but risk aversion is rising and there are early signs that real estate transactions are slowing down.
The cautious optimism about the business outlook expressed by delegates at Mipim has taken a knock in the weeks since the show took place.
In Cannes in March, there was no sense that the real estate market was stalling, despite some sobering geopolitical and inflationary events.
Now, with inflation continuing to worsen - hitting 8.1% in the eurozone in May and a 30-year high of 9% in the UK in April - interest rates have started to rise in response. The European Central Bank has yet to follow the US Federal Reserve and the Bank of England, but on 9 June, the ECB governing council finally gave clear guidance about its intentions. It announced it will raise the minus 0.5% deposit rate by a quarter of a percentage point in July and stop its bond-buying programme.
The ECB also said it expected to raise the rate again in September, and that ‘if the medium-term inflation outlook persists or deteriorates, a larger increment will be appropriate at the September meeting’.
The first hikes after more than a decade of very low inflation and ultra low or negative interest rates have become the number one preoccupation for almost everyone involved in real estate. For years and years, the consensus at every property gathering was, that when interest rate rises eventually came they would be measured and gradual. Markets, including real estate, would therefore be able to adjust without difficulty.
Unfortunately, there’s not much measured or gradual about the speed of rising inflation, but hope remains that rate rises will still be modest - and Europe will swerve stagflation and recession. For now, we just don’t know.
Public markets fall first
As in previous cycles when markets turned, it is the public markets which moved first in response to today’s worsening economic backdrop. Even before Mipim, in February, the debt capital markets became more expensive by 100-150 basis points, except for the very highest-rated real estate companies. Issuance fell dramatically.
For borrowers in the UK, where the BoE began raising rates last December, swap rates had already risen by early 2022 and the Bayes Commercial Real Estate Lending report for 2021, published in early May 2022, said lenders’ average margins in the private debt market were also climbing. As Savills observed this month in its annual Financing Property survey, ‘the rising debt cost comes at a point in the cycle when yields are historically low, meaning that the all-in-cost of debt stands at the same level as prime entry yields for many markets across the UK and Europe.’
As a consequence, it warned, ‘inevitably, for those leveraged buyers focused on income-based investments, returns are coming under pressure’.
Some European listed fund managers and developers moved early too, issuing profit and forecast warnings in Q2. In May, Patrizia cut its expected 2022 operating result (EBIT) by almost 40%, from the previous €82 mln-€107 mln, to €50-€70 mln, citing fewer deals and significantly lower revenues from transaction fees.
Developers were already struggling with rampant construction cost inflation, making some projects uneconomic. By Q2 2022, those developing residential for sale, like German-listed Instone, were worrying about rising interest rates coming on top of continuing cost inflation, and the company said it was not able to provide a concrete financial forecast, at all, for the 2022 financial year.
In May, the company announced availability of materials had ‘deteriorated again significantly’ and construction cost increases ‘intensified.’ It added: ‘Moreover, the significant rise in interest rates may also affect the affordability of the Instone product for certain buyer groups.’
Some of the steam has started seeping out of the commercial transaction market - which had begun the year positively. Activity slowed first in CEE countries, on the borders of the Russia-Ukraine conflict. In early April, Colliers’ CEE director of capital markets, Kevin Turpin, reported: ‘In the CEE region, we are registering some investors returning to a wait-and-see approach before making investment decisions.
‘Similarly, we have seen some leasing deals put on hold or completely withdrawn. Some of these are claimed to have been related to Russian companies being involved and others due to the uncertainty of the war and its physical proximity.’
Recently there has been a steady drip of anecdotal stories of building sales being pulled in other European markets too, because those looking to offload can’t get 2021 prices for them. In another sign of shrinking liquidity for some properties, agents observe that more activity is happening off market again, as it did during the height of Covid in 2020. Transaction lawyers report the return of price-chipping.
The Financial Times had some interesting observations about GIC and Greystar’s recent acquisition of UK student housing investor/operator Student Roost from Brookfield, at a price said to be £3.3 bn. It is one of the largest real estate transactions so far this year in residential, a sector expected to be more resilient to a period of high inflation and lower economic growth because rents can be raised comparatively frequently. The paper said the sale price achieved was a shade under what the vendor and agents Eastdil and CBRE had hoped for, with some bidders put off by doubling debt costs.
Transaction numbers turn down
MSCI’s Tom Leahy calculates that €106 bn was spent on European property in the five months to end of May, which is broadly in line with the current five-year average of €108 bn.
However, he notes that average property prices are well ahead of levels five years ago (logistics values for example have doubled since 2015 according to DWS). The number of deals YTD is actually down 25% on 2021, and 16% on the five-year average.
In the biggest European real estate market, Germany, Savills says both transaction volume and numbers fell in April and May. The broker said April was ‘weak’, followed by a weaker May. ‘There is hardly any doubt that the steep rise in interest rates and possibly other negative factors, such as the lower economic momentum coupled with high inflation, have at least temporarily led to significant distortions on the German real estate market,’ says its latest Investment Market Germany monthly report.
May registered fewer than 100 German deals - March 2011 was the last time there were so few; commercial transactions totalled €2.5 bn (five-year average €5.5 bn); residential deals €0.9 bn (€2.1 bn).
Confirming it is seeing a high number of halted or protracted sales, Savills expects low turnover in Germany in the coming months, but added: ‘This also means that transactions are piling up and we expect activity to return to normal later in the year with prices then likely to be lower.’
M&G Real Estate, which like many fund managers saw strong capital inflows at the start of the year, launched its six-monthly Global Outlook on 14 June. Real estate investment strategy chief Jose Pellicer argues that although pricing for property with questionable rental growth assumptions will indeed be vulnerable, there will be a floor under values for assets where landlords can pass inflation on to tenants.
He believes: ‘There is an increase in risk aversion, and assets where it is easier to pass on inflation to tenants, because there is tenant tension, will be less affected than assets where passing on that inflation to tenants is harder.’
To keep rents moving upwards in properties where leases expire, landlords will also need to be ready to invest in the assets and work with tenants to help manage their cost pressure.
In office submarkets with low vacancy and where it is hard to build, occupier demand is holding up and there is tenant tension. According to GPE, the listed central London office developer mainly focused on the West End, there will be a 55% undersupply of new office stock in its stamping ground in the next three years.
Unveiling record leasing numbers for its financial year to 31 March 2022, CEO Toby Courtauld said this supply-demand imbalance was ‘super interesting for us’. In particular, he says GPE has seen steady growth in demand for flex office space with almost a quarter of the £38.5 mln of new annual rent coming from customers taking fully managed space. Although it’s off a very low base, GPE wants to increase this portion of its portfolio from 250,000 sq ft across 17 buildings to 600,000 sq ft or a quarter of its assets. Net effective rents on this space are 75% ahead so it is adding additional value to the buildings it is in. ‘Our customers love it,’ Courtauld said.
Office REITs with a relatively low cost of capital like GPE - or Colonial which last month said it has €2.6 bn of dry powder which it could use to invest in opportunities as they arise - hope to benefit from the coming, more challenging times and give private equity funds a run for their money as cheaper opportunities materialise. This time around many of those managers, from Hines with its new core+ fund that has raised €900 mln at first close, to Blackstone with its whopping $63 bn global private REIT, have lower-cost, longer-term capital to invest.
In the coming months, the picture regarding rental growth is likely to be increasingly nuanced across all property types, including in the outperforming logistics and residential sectors where investors agree the prospects are strongest for rents to match inflation over the medium term. The European logistics leasing market shrugged off comments made on 2 May by the sector’s bellwether tenant Amazon. The online retailing giant rocked share prices in this market with a profit warning and admissions about overextending, but other companies continued swallowing space.
Last month saw investors from EQT Exeter and Segro, to Invesco and Angelo Gordon, achieving big lettings to the likes of Rewe, Mercedes Benz, the Raben Group and ITG.
Continental Europe’s largest listed developer/manager of warehouses, CTP, saw strong rental growth of 4.8% in Q1 and in May said it had ‘largely’ been able to ‘mitigate rising costs thanks to our in-house construction team, and inflationary pressures through increased rents on both new developments and within our standing portfolio’.
A European logistics report from fund manager DWS, however, released in April 2022, questions whether at current pricing some investors are having to underwrite exceptionally strong future rental growth to meet return targets. The firm points out that the retail sector accounts for almost half of logistics take-up, hence a decline in consumer spending would likely impact logistics demand.
Against this backdrop, it concludes that supply-constrained urban logistics markets are likely to outperform corridor logistics ‘where we see short and long-term risks to supply’.
M&G’s Pellicer observes that real estate is now at a turning point. He says that at such times ‘there tends to be a dip in liquidity first, before there is any impact on pricing.
‘We are in that dip in liquidity, and so there might be an impact on pricing in the next six months, with the opportunities appearing for investors with a slightly higher risk appetite in the next 18 months.’
It isn’t at all clear yet what the degree of impact of higher interest rates will be on property yields and the financing and valuation of real estate. But the impact seems to have already started. The next few months will reveal more about investor attitudes as they digest the changes in the macroeconomic environments, and real estate’s prospects and relative attractions compared to other asset classes.