Global Capital Markets: record start to the year for real estate
Domestic investors increasingly returned to the market while cross-border activity continued at pace.
5 minutes to read
Following more than two years of the pandemic there has been a huge amount of pent-up capital as well as capital raising and this was reflected earlier this year, which saw a record first quarter for global commercial real estate transaction activity.
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 humanitarian 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, as well as predict central banks responses.
In this environment some investors may rotate towards real estate which offers one or more of inflation hedge properties, growth potential, diversification 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 financial 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 opacity 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
Wyai Kay Lai, Research Associate Director, Singapore
Despite headwinds from continuing tensions in Ukraine and an accelerated hiking cycle by central banks worldwide, Asia-Pacific commercial transaction volumes remain on track to equal or even surpass those registered in H1 2021.
Total commercial transaction volumes in the Asia Pacific region, including pending deals, hit US$97.3 billion in H1 2022, just shy of the US$113.0 billion set in the same period last year. Quarter-to-date gains in Q2 2022 will likely be led by activity in South Korea and Singapore, powered by deals for offices. While the effects of the current hiking cycle will be clearer in the second half of 2022, indications suggest that deal flow in the region will continue to remain active given the weight of capital and degree of market liquidity.
Europe
Judith Fischer, European Research Associate, London
While 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, there are indications of a slowdown over the second quarter as the increased headwinds and downside economic risks likely start to feed through to investment activity.
As seen globally, downgraded economic growth forecasts, high inflation, supply constraints and elevated systemic financial risks are creating headwinds across Europe. However, also reflecting the global picture, labour markets remain tight, with historically low levels of unemployment.
Given high inflationary pressures, central banks across Europe are in a tightening cycle. The ECB is expected to raise interest rates by 25bps in July and again in September. On the back of a recent widening of peripheral bond spreads, the ECB announced an ‘anti-fragmentation instrument’. While spreads narrowed in response to the announcement, it depends on the final details of the instrument as to whether the improvement will ultimately last.
The outlook for EUR swap rate remains volatile, with the five-year EUR swap rate currently oscillating around the 2.00% marker, circa 70 bps up on the end of the Q1 figure.
However, the EUR has depreciated against the USD, with the single currency trading at around $1.06 at the end of June. Should the euro remain relatively soft, this provides potential inbound investment opportunities through currency weakening as real estate denominated in EUR looks relatively cheaper. This is supportive of our Active Capital research, which expects Germany and France to be among the largest recipients of cross-border capital in EMEA in 2022 and for Europe to be the top destination for cross-border capital.
We expect assets in safe haven locations and in local innovation-driven growth hubs, with strong ESG credentials and especially those positioning against inflation to 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
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