Emerging Trends Report: Real Estate Hasn’t Been This Starved Of Capital Since The GFC

The influential Emerging Trends In Real Estate Europe report this week painted a stark picture of a sector in the eye of a storm at the end of 2022: Debt and equity are scarce in a way not seen since the last crash, leading to a refinancing crunch for the sector, with profits and values set to fall significantly.

While inflation might dissipate in the next five years, the report produced by the Urban Land Institute and PwC said, the interest rate rises it precipitated will still be impacting the sector.

That could fundamentally affect the attractiveness of real estate compared to other asset classes as well as the valuation of buildings. 

On top of the short-term impacts of rising rates, the “migration in value” from unsustainable to sustainable real estate has the potential to make the shift in value from retail to logistics property look like a drop in a bucket.

“Since we conducted the survey and interviews over the summer, which already highlighted deep concerns, the industry has become even more worried,” ULI Europe CEO Lisette van Doorn said. “But there is still a lot of capital available to invest and mostly not in a hurry, waiting for the right opportunities to arise.” 

Based on the views of around 900 real estate leaders from across Europe, confidence in the availability of debt and equity has not been this low since 2012 and 2009, respectively. 

Respondents believe capital coming into Europe from every part of the world is more likely to decrease than increase.

In five years’ time, only 13% see inflation being a problem, while interest rates (73%) and growth (76%) remain medium-term concerns.

Those rate rises limit the amount of capital available for real estate investment, the report said. For institutional investors like pension funds and insurance companies, real estate yields look relatively less attractive now that rates and bond yields have risen. 

Rising interest rates mean the cost of debt is heavier for investors that use it, like private equity firms. That compounds the fact that lenders are now more cautious amid an uncertain real estate environment and economy. 

Allocations to real estate from institutional investors might have to drop, the report said, because of the ‘denominator effect.' Because the value of stocks and bonds has dropped faster than real estate, institutions might now own too much property on a relative basis, leading to more selling, or at least holding off buying new assets.

In all cases, values are going to fall because no one can pay as much as they could 12 months ago.

“We think everything’s going to be worth less next year than it is this year,” one bank lender interviewed for the report said. “Now, that’s obviously a generalisation. There can be reasons why a particular asset would outperform. But if you just bought a relatively dry asset, we think it’ll decrease in value over the next 12 months. So that makes it quite a challenging time to look at financing things."

The consensus view is that the level of distress is highly unlikely to reach the proportions of the Great Financial Crisis because leverage levels are so much lower — the industry has learned its lessons in the wake of the collapse of Lehman Brothers, the report said.

But much attention will be paid to investment deals completed in 2018 and 2019, which were the two highest transaction volume years ever in Europe.

“Much of that will have been funded with five-year loans, and those loans come due in 2023 and 2024,” one value-add investor said. “Those loans were made at a time of quantitative easing and we’re now at a time of quantitative tightening, margins have blown out and the reference rate has blown out.”

Loans underwritten when interest rates stood at 1% will now have to be underwritten at rates perhaps three or four times higher, meaning the ratio by which the income covers the interest payments will have dropped dramatically.

And when a recession bites, occupier performance will be weaker, which could erode the income being used to pay the interest on loans. 

Under such conditions, some borrowers might well put up more equity and pay down debt. But others may be unwilling or unable to do that — closed-ended funds, for example — which could well end up precipitating a sale.

Whereas banks were willing to ‘extend and pretend’ after the GFC, the distress being not quite as acute this time might actually prompt them to push for sales more quickly.

As one fund manager said, loans went from 80% to 90% LTV to 120% to 130% during the GFC so “there was no reward for [banks] acting early. Now it has gone from 60 to 80%, they are not going to lose money in a sale, so it is the borrower’s problem, not theirs”.

With historically high energy prices and the prospect of shortages over winter, it is unsurprising that new energy infrastructure tops the sector rankings in Emerging Trends Europe for the second year in a row. It is a niche sector, but one garnering more attention, the report said.

It was followed by life sciences and data centres, other niche sectors seen as having very strong demand but limited supply. Beyond this, the top 10 places in the sector ranking are dominated by various forms of residential, driven by the constant imbalance of supply and demand.

That said, residential is not without its challenges in the current environment.

Of the prospect of increasing rents in social and affordable housing, one manager active in the field said: “I think it’s really naive. If you follow the news, and you talk to people, families can’t pay for the energy bill. I don’t know what kind of rental increases you want to do against that background. Even if you can raise rents, should you?” 

There is also what one global investor calls “stroke of the pen risk”, given that governments can change regulation overnight in sectors seen as politically sensitive. The UK is considering capping rents in the social housing sector, for instance.

“It should be the biggest part of our portfolio in the next 20 years, but it’s so political,” one global fund manager said.

Logistics slipped from its perennial top three place to eighth, with worries about repricing in a sector with very low yields. 

And the office sector was seen as having very poor prospects by survey respondents, with city-centre and suburban offices ranked 20th and 25th, respectively, among the 27 sectors polled. Coworking or flex offices came in at 18th.

It is in the office sector that sustainability and the battle against the climate crisis is going to have the greatest impact, interviewees for the report said. 

“All the big changes and factors affecting real estate — technology, demographics, sustainability — they all collide in office,” one global investor said. “The advance of e-commerce caused a huge migration of value from retail property owners to logistics. I think the shift in value from poor real estate to sustainable real estate over the next decade or so could be many, many multiples of that.”