Global Capital Markets: record Q2 for global activity

Following more than two years of the pandemic there has been a huge amount of pent-up capital which saw a record first quarter for global commercial real estate transaction activity.

Written By:

Victoria Ormond, Knight Frank

06 Sep 2022

5 minutes to read

Categories: Topic Economics Forecast

This has been followed by record activity for Q2. It has been particularly driven by domestic activity as cross-border investors take stock of global economic headwinds.

Markets may polarise, but demand for the right real estate to persist.

Headwinds and downside risks have since increased, as challenging economic and geopolitical environments started to bite following the crisis in Ukraine and responses to this. Equity and bond markets remain volatile as investors try to navigate the uncertain unfolding economic and financial story and make financial decisions, as well as predict central banks responses over this period of time.

In this environment some investors may rotate investments towards real estate which offers one or more of inflation hedge properties, growth potential, diversified portfolio benefits, income and/or relative stability.

Cost of debt to increase – but temporary in some locations?

Increasing swap rates are also contributing to the challenging environment and one to watch particularly in those markets reliant on leveraged investors.

Real estate markets have historically tended to have a lagged response to outwards shifts in the cost of debt, although the degree of lag varies across sectors and markets. Nevertheless, this is something to keep mindful of, particularly for those markets which are particularly debt driven.

Investments due for refinancing over the coming 18 months or so are also likely to face increased costs. Swap rate curves around the world indicate different paths of rates over the next few years, with for example, the UK swap curve inverting, suggesting rates may peak over the coming 12-24 months before moderating.

Drivers of dislocation

While the future looks uncertain, real estate has so far shown to be relatively resilient compared to other types of investments, although this is not a predictor of future performance.

Looking back at previous periods of dislocation in the commercial real estate market, there has typically been one or more of the four triggers below:

Over-supply
Under-capitalised banks
Over-leverage
Sentiment
Increased construction costs as well as heightened focus on embodied carbon is likely to limit supply of new assets over the medium term, although there will be local market differences.

Banks are subject to improved regulatory capital requirements compared prior to the global financial crisis (GFC). These enhanced BIS capital rules apply to banks in many countries, globally. We have seen an increase in non-bank lenders since the GFC which are not party to the same capitalisation rules. However, these tend to be a smaller proportion of the market, although there is some obscurity over the exact magnitude.

Overall loan-to-values are also lower than in the run up to the GFC.

Sentiment remains uncertain and this is an indicator to keep watching.

Real estate still has a story but the market is expected to polarise

Overall, investors are increasingly positioning for resilience with a focus on liquidity, quality and ESG factors. Localised growth hotspots will become increasingly important over the coming 18 months onwards. While transaction volumes may see moderation, they are coming from a record base. We could also see polarisation of real estate performance, driven by asset, location and tenant covenant considerations, rather than particular sector or macro-markets.

Asia-Pacific capital markets

Wyai Kay Lai, Research Associate Director, Singapore

Global macroeconomic headwinds and the quickened interest rate hiking cycle took the steam out of investment activity in Asia-Pacific as commercial transaction volumes slumped 6.7% year-on-year to US$53.7 billion in Q1 2022.

The decline can be traced to the region’s biggest markets of Australia, China, Japan and Hong Kong. Powered by deals for offices, South Korea and Singapore were the bright spots during the quarter. However, cross border investments remained active, growing by over 10% in the same period as Asia-Pacific investors trained their firepower within the region.

While appetite for assets remains strong, external factors are expected to prompt investors to rethink their capital deployment strategies for the remainder of 2022.

Europe capital markets

Judith Fischer, European Research Associate, London

The start of the year saw mainland Europe domestic transaction activity in the first quarter 31% higher than the year prior and one third above the Q1 long-term average. However, the second quarter saw mainland transactions down 9% on Q2 2021 but slightly above the Q2 long-term average as the increased headwinds and downside economic risks started to feed through to investment activity.

Above target inflation is a global issue. Energy prices and supply chain constraints have pushed Eurozone inflation to a new record high of 8.9% in July, higher than US inflation but it remains below the inflation rate in the UK (10.1%). The ECB forecasts inflation of 6.8% in 2022 and 3.5% in 2023 before returning closer to the 2% target in 2024.

Given significant inflationary pressures, the ECB raised interest rates by 50bps to 0.0% in July. While this was higher than anticipated, it is still relatively low compared to other major economies. The Fed raised interest rates by a further 75bps in July, taking its benchmark rate to a range of 2.25%-2.50%, while the Bank of England raised the interest rate to 1.75% in August.

As the cost of debt rises, leveraged investors are seeing their returns come under pressure. The outlook for swap rates remains volatile.

The five-year Euro swap rate has come down from its recent peak in June but remains elevated at around 1.99% at the end of August compared to around 1.0% at the end of Q1 and -0.4% a year ago. It, however, remains below other regions in terms of absolute pricing.

The EUR has continued to depreciate against the USD, with the single currency falling to below parity with the USD at the end of August. Should the euro remain relatively soft, this provides potential inbound investment opportunities through currency weakening as real estate denominated in EUR looks relatively cheaper. We expect assets in safe haven locations and in local innovation-driven growth hubs to offer the greatest prospect for resilience for commercial real estate investors.

Assets with strong ESG credentials and especially those positioning against inflation also offer the greatest prospect for resilience for commercial real estate investors.

Indeed, inflation-linked European real estate may offer particular inflation – hedge opportunities.

Read more or get in contact: Victoria Ormond, head of Capital Markets Research