Higher for longer
10 TRENDS FOR 2023
Contrary to most expectations, 2022 saw inflationary pressures continuing to build around the world. Faced with the prospect of a “wage-price spiral”, policymakers scrambled to respond – raising interest rates at a pace not seen since the 1970s. The implications for the real estate sector are profound, given that we believe this represents the start of a new era where money once again has a cost. Welcome to the real “new normal”.
While the world struggled to emerge from the grip of the Covid-19 pandemic in 2021, prices were already rising. A faster-than-expected recovery in demand for goods and services coincided with disrupted supply chains and reduced economic capacity due to staff layoffs and business failures. Inflation was expected to fall during 2022 as these disruptions started to fade and lost capacity was replaced, with central banks reluctant to raise interest rates given the perceived fragility of the economic recovery.
INFLATION ROSE SHARPLY IN 2022
CONSUMER PRICES % P.A.
Source: Macrobond
Such expectations proved misplaced. Labour markets remained tight as many workers were reluctant to return to their previous jobs: some were unable to do so due to long term illness, others found more attractive alternatives; many have chosen to retire or take a career break. Supply chains remained interrupted as China pursued its “zero Covid-19” policy centred around lockdowns, and energy costs surged following Russia’s invasion of Ukraine. As these pressures translated into more widespread inflation across the economy, central banks found themselves behind the curve. The key concern was – and remains – that prolonged and significant price increases would result in demands for higher wages, leading to the type of wage-price spirals that characterised the economic stagnation of the 1970s. The increased incidence of strikes in many countries in late 2022 and into 2023 shows that such concerns are justified.
Central banks found themselves behind the curve.
POLICY RATES HIKED AGGRESSIVELY
Source: Macrobond
As a result, central banks have increased policy rates sharply.
As a result, central banks around the world have increased policy rates sharply with the explicit intention of slowing economies and weakening labour markets to reduce demand and curb inflation. They are well aware this runs the risk of inducing a recession – the Bank of England has been particularly clear that higher rates come at an economic cost. However, they universally believe that a mild recession now is a price worth paying if it prevents an inflationary spiral that would require a far more severe downturn at some point in the future.
Some good news
The good news is that inflation does appear to have peaked around the start of 2023 and is now starting to fall. The expectation is that CPI indices will trend downwards during 2023 and into 2024 – in some cases quite sharply. Interest rates are set to see some further increases, likely to peak at 4%-5% in North America and the U.K., and around 3% in the Eurozone … some 400 bps or so higher than their level at the start of 2022.
Policymakers will be keeping a close eye on labour markets and core inflation – a measure which strips out volatile food and energy prices – and will want clear evidence that headline inflation is heading back towards their target level of 2% before they consider starting to ease interest rates again in order to stimulate growth.
But crucially for real estate, any expectations that this will see a return to near-zero policy rates are likely to prove unfounded. Property markets have already begun to correct in what will come to be seen as a paradigm shift in the pricing environment for the sector.
Policymakers will be keeping a close eye on labour markets and core inflation.
REAL POLICY INTEREST RATES
Source: Macrobond
The corollary of the low and stable inflation seen in the last three decades has been a long run downward trend in interest rates. But even in this context, the situation in recent years has been exceptional. If we look at real terms policy rates (interest rates minus inflation) over the long-term, the Global Financial Crisis (GFC) marked a watershed. Before the GFC, real rates were typically positive outside of recessions; since 2008 they have been mostly negative, and deeply so. Extended periods of low rates risks creating asset bubbles, and central banks are now calling time on the decades of steady yield compression seen in the bond markets – and in real estate.
Interestingly, between 1990 and early 2008 the real Bank of England policy rate never went below 2% net of inflation. If policymakers are thinking of interest rate normalisation as being a positive real policy rate (alongside an inflation target of 2%), that implies typical interest rates in non-recessionary times of 2.5%-3.5%. That would mark a significant departure from what lenders and investors have become used to in the last decade and a half.
Central banks are calling time on decades of yield compression.
INFLATION = INTEREST RATES
10-YEAR GOVERNMENT BOND YIELDS
Source: Macrobond
What does this mean for real estate?
Policy interest rates and inflation are key drivers of the ten year government bond yields which are the benchmark against which most investment assets are priced. Much attention is focussed on the spread between these bonds and the yield on real estate investments. However, we believe a better benchmark for property is the BBB corporate bond yield, which reflects the “risk free” rate but also the risk of corporate default – a key issue in the valuation of the rental income stream that underpins a real estate investment.
CAP RATES VERSUS 10-YEAR BBB CORPORATE BONDS
UNITED STATES CBD OFFICE CAP RATES AND
10-YEAR BBB CORPORATE BOND YIELDS (12M LAG)
Source: RCA, Macrobond
Our analysis of markets around the world indicates that property yields show a strong time-lagged correlation with BBB corporate bond yields, allowing for a time lag of 9-12 months or so for signals from the bond market to feed through into real estate pricing and then into valuation indices. These bond yields rose rapidly during 2022 before stabilising towards the end of the year. Euro Area BBB yields increased by 345 bps between December 2021 and December 2022, which is similar to the adjustment seen in the U.K. (315 bps) and U.S. (307 bps).
UNITED KINGDOM ALL PROPERTY YIELD
10-YEAR BBB CORPORATE BOND YIELDS (9M LAG)
Source: RCA, Macrobond
Property yields show a strong correlation with BBB corporate bond yields.
BBB CORPORATE BOND YIELDS
Source: Macrobond
In order to remain competitive against corporate bonds, and to offer a sufficient risk premium over government bonds, it was inevitable that property yields would soften – which in the absence of a material increase in rents, means that property values would fall. This is the correction that is currently underway. The immediate impact has been a sharp reduction in transaction volumes, largely because vendors are choosing to hold onto assets in the hope that values will rise again in the future.
Eventually they will, but this may take much longer than many will be able to wait. Most commercial real estate investors use debt to finance at least part of the purchase cost of their properties. Typically they use 3-5 year loans, for which they pay a margin over the policy rate set by the central bank. Rising policy rates have fed rapidly though into the cost of commercial loans which, where available today, are 200-300 bps more expensive than they were a year ago … more so in the case of riskier development or “value-add” investments. Purchases made (or refinanced) in the years prior to the current increase in rates are already falling due for refinancing – but at far higher cost.
We expect fewer distressed sales than was the case following the GFC, not least because values will not fall as far and typical loan-to-value ratios have been around 60% lately compared to the 70% or more that was commonplace prior to the Financial Crisis. Nevertheless, plenty of borrowers will be faced with unattractive options when they come to refinance, and a steady flow of property sales is to be expected over the course of 2023. This will help with price discovery, tempting buyers back into the market at values which reflect the new financing and investment environment. The early signs are that expectations are repricing relatively quickly, with overall U.K. commercial real estate values having fallen 20% in the second half of last year from their peak in June.
We expect fewer distressed sales than following the GFC, but a steady flow of property disposals is to be expected in 2023.
U.K. VALUES HAVE ADJUSTED RAPIDLY
Source: MSCI
This is a more rapid decline than was seen even during the GFC. It will take time for this to fully feed through into sellers’ expectations and an increase in completed transactions. Nevertheless, provided inflation continues to fall, interest rates should not rise above the levels currently priced into the market. This in turn should mean that the economic downturn we expect to characterise most western economies in the first half of 2023 will be painful, but not particularly severe. Given that real estate investors look to pre-empt the turning point for the economy – the best investments are made before any market recovery is evident – this offers the prospect of a return to a more active market during the second half of the year.
The best investments are made before market recovery is evident.
We see summer 2023 as a time a lot of capital will deploy in anticipation of better times in 2024. We also expect U.S. Dollar, or dollar-shadowing, capital to play a leading role in the opportunistic buying in H2 2023, given that currencies like the pound and the euro fell sharply in value in 2022 against the Greenback. We believe there will be major opportunities to acquire grade B real estate assets in or near core locations and redevelop them as ESG compliant stock, albeit this has become more challenging in the face of higher financing and construction costs.
The key takeaway, however, is that we are entering a new era for real estate investment. If we are correct that policy rates and bond yields will settle at higher levels than seen in the period since the Financial Crisis, the adjustment that is currently underway is not a blip that will re-correct: it is a return to a far more normal interest rate regime that will persist through the coming years. The sooner real estate investors adjust to this true “new normal” – willingly or otherwise – the sooner we will see a return to an active and healthy transaction market.
