Global Real Estate Investment Markets Are Facing A Long Winter

Even before the volatility in the banking sector over the past four weeks, real estate investment markets were set for a period of nervousness and subdued volumes, according to a major industry report.

Lenders are likely to remain cautious, debt-backed investors are finding it difficult to make deals stack up, and institutional investors are still wrestling with the impact of falling values in their equity and bond portfolios, according to the Urban Land Institute and PwC’s Emerging Trends in Real Estate Global report released this month. 

In the medium term, the sector faces something of a crunch point: Investors will need to put up significant capital to upgrade properties to meet environmental regulations and increasing expectations from occupiers, particularly in the office sector. But the money to make these improvements is drying up. 

When investment markets may thaw is now anyone’s guess.

“I think it's very much a moving target, which we've seen constantly shifting,” ULI Europe chief executive Lisette van Doorn said on a webinar about the report’s findings.

“When we were preparing our reports in the summer of last year, it was towards the end of 2022. When we launched those reports in the autumn, it was the beginning of 2023. When we were preparing this report, people expected a recovery in the summer. Now as we launch it, people are saying the end of 2023 or even early 2024.”

That turning point will be different across the globe.

“We don't think that the U.S. is going to see as deep a correction as Europe, and Asia Pacific is looking to be a little bit more resilient,” Nuveen Global Head of Strategic Insights Abigail Dean said.

Nations in the Asia Pacific region have seen lower levels of working from home, supporting office use and values. The fact that the Bank of Japan has not raised interest rates as sharply as other central banks made Tokyo real estate attractive, speakers on the webinar said.  

“We also think that market stress and potential overcorrection, particularly in Europe, will provide a really attractive entry point towards the end of the year,” Dean said. 

Lenders are taking stock of what the failure of banks like SVB and Credit Suisse means for financial markets. While they work that out, borrowers are going to have to be patient when it comes to securing new debt. 

“Lenders have become more cautious,” Eastdil Secured Senior Managing Director Jim McCaffrey said.

Eastdil is one of the largest real estate debt arrangers in the U.S. and Europe.

“Investment committees, credit committees haven’t made decisions as to what they're going to do," he said. "When you're in the middle of a dislocated market without a lot of perspective in terms of how it's all going to play out, people tend to go quiet. And that's where we are in the cycle.”

McCaffrey said that lenders remain well-capitalised and have balance sheet available to lend.

“How eager that balance sheet is to be deployed, we’re gonna learn a lot over the coming weeks,” he added. 

For institutional investors that typically don’t use debt, like pension funds or sovereign wealth funds, a big issue keeping them out of the market for the past nine months or so has been the “denominator effect,” according to the Emerging Trends report. 

Such institutions typically have a maximum amount they can allocate to each asset class, including real estate. Because the value of their stocks and bonds have fallen quickly and real estate reprices more slowly, they are now at or above the maximum amount they can invest in property. Even if they think that the current market might throw up bargains, they don’t have the capacity to invest more. 

“Institutional investors, because of the denominator effect, probably are on the sidelines for the moment,” PIMCO Prime Real Estate Global Head of Research Megan Walters said.

She said that for insurance companies, like the capital PIMCO manages for German insurance giant Allianz, regulatory rules mean they have to put aside a certain amount of capital to guard against losses from assets like real estate, and this is also influencing decision-making. 

“So what's the cost of regulatory capital?” Walters asked on the webinar. “What’s the return you get on real estate for the amount of regulatory capital you have to set aside versus the return on other asset classes?”

She said those regulatory requirements present an opportunity for investors from other parts of the world like the Middle East or East Asia — where pension funds don't have such a high allocation to real estate — or for private companies that don’t have to meet regulatory or capital allocation targets. 

Nuveen’s Dean also said that, over the medium term, institutional investors are still attracted to real estate, partly because some subsectors provide a hedge against inflation. And when bond prices and stock markets start to recover, the pressures created by the denominator effect would start to ease. 

The denominator effect and the need to set aside regulatory capital is also having an impact on investors' efforts to upgrade their existing portfolios, particularly offices, to improve their environmental credentials and also make them more appealing to tenants. 

Prior to the sudden rise in interest rates, investors might have split their assets into three buckets, BVK Head of Global Real Estate Investment Management Manuel Wormer said: assets that were already up to scratch; those that were never going to be brought up to standard, which would just be sold; and those that could be made fit for purpose with some investment. 

The denominator effect takes away much of the capital available to invest in that third bucket. 

“Investors need to be very careful on where they put any capital next to the wall of maturity,” Wormer said. “We are forced to prioritise. Do we keep money back to keep the regulator happy, or do we focus on [capital expenditures]? I feel like everybody knows what the answer is going to be.”

This bleeds into the issue facing the sector in the medium term, the ULI’s van Doorn said. Lenders are going to be demanding more capital from investors over the next few years to recapitalise loans where interest cover ratios and values have dropped. But that money needs to be put into improving assets, or tenants will walk away and go to better buildings when leases expire. 

“Before, for occupiers, ESG was very much linked to talent attraction and retention: Having a great sustainable office helps to attract talent,” she said. “Now, [because of rising energy prices] it's hitting their P&L as well. They pay for that. So while everyone seems to fully focus on the refinancing date, I think the lease expiry date is one to keep an eye on as well, because I think tenants very much will critically review the total occupancy cost, not just the rent. I think when it comes to paying to improve the quality and sustainability of a building, at some point you might not be in the position to wait.”