The period of cheap debt is over. And that can mean trouble for underperforming properties.
The real estate sector’s performance has been hit by the rapid increase in the cost of debt due to rising rates, according to Scott Davies, principal at Hamilton Lane. That means that properties like retail, hotels and office buildings, which have been able to buy time to improve operations in the previously highly liquid market, are coming under pressure.
‘Underperforming properties today are dealing with meaningfully higher debt service costs and fewer options for liquidity.’
Scott Davies, Hamilton Lane
‘Underperforming properties today are dealing with meaningfully higher debt service costs and fewer options for liquidity as traditional lenders have retreated from the market, limiting refinancing options,’ he said.
‘We think the net result of this will be a broad decline in property values from current levels over the next three or four quarters and a sharp increase in real estate owned and non-performing loan activity, particularly around lower quality, undercapitalised and under managed assets.’
Meanwhile, higher fuel and energy prices, higher labour costs, worker shortages and an increase in the cost of goods has increased operating expenses for most properties, which in turn is reducing net operating income.
More pain to come
Robert Crowther-Jones, head of private capital at Saranac Partners, thinks the true dislocation in real estate markets has not come through yet, and would expect it to take place well into the third and fourth quarters next year.
He pointed out that while the yields on government bonds and real estate are correlated, they are not completely aligned, and the spread between the two has been at one of its widest points going into the current period.
So far, real estate yields haven’t widened as much as government bonds, with spreads of around 25-50 basis points.
‘The available spread from real estate and bonds is part of what made it attractive. Over time it reduces the opportunity in real estate. In the longer term if that spread starts to widen again, with continued rate rises and bond yields widening, we would expect the impact of each incremental yield movement to be greater than before,’ he said.
Investors have already started cooling on European real estate, which saw the value of investments fall 16% to €69.3bn (£60.5bn) year-on-year in the third quarter, according to global real estate adviser CBRE. Rising interest rates are likely to continue to impact asset prices and investment volumes in the fourth quarter as well, said Chris Brett, managing director of EMEA Capital Markets.
In this environment, returns from core real estate strategies may come down, according to Crowther-Jones. While typically a 6-8% return would be expected from core real estate, this may come down to 4-6% as their ability to use leverage is reduced due to the increased cost of borrowing.
Crowther-Jones said he is cautious around value-added strategies, because there are a lot that rely on the turnover of tenants and demand from occupants might be reduced in the current environment. However, he still expects them to be able to deliver around 10-12% returns.
For opportunistic strategies, the typical expected returns would be around 15-18%. If they can bear the interest cost over the two-year period, they should be able yield and come back to the market much stronger.
He added: ‘The other thing is historically earnings in a lot of real estate asset classes have been fundamentally linked to growth, and performance has been related to the amount of consumption.
‘Those rents and the rate of rent rises may start to drop off. We’re not necessarily expecting it to continue if we go into a two-year recessionary environment. That tempers the ability for rents to offset yield expansion. If rents aren’t able to catch up and there is yield expansion, there will be a double effect on valuation.’
In the medium term, Crowther-Jones says there will be greater opportunity in real estate within a year. In the meantime, assets that are well positioned for net zero commitments for example, are ones that should outperform in this market.
Despite the challenges, Hamilton Lane’s Davies said the firm is telling clients to ‘stay the course’ as the fundamentals in real estate continue to be strong. It can also act as a hedge against inflation.
Construction challenge
As costs of materials increase, new construction will also become less feasible in Davies’ opinion, which will lead to dramatically decreased new supply. This can have a positive impact on rental rates by focusing demand on existing assets.
‘Additionally, certain property types have short-term leases and daily priced rents which can help to offset inflationary pressures,’ he said.
Hamilton Lane is particularly seeing healthy demand for industrial and residential properties, both from investors and occupiers. And as leverage use is conservative relative to historical norms across industry participants, Davies argues that some of the distress in the coming quarters should be mitigated.
‘We see the opportunity to buy good quality assets at reduced prices as a positive, and reason enough for investors to lean in. We expect that demand for real estate will continue, while income returns should prove durable and even increase over yields seen over the past several years,’ he added.
Other sub-sectors Davies finds attractive are hospitality and retail assets, which are attractively priced, as well as medical and life science offices, data centres, storage and movie studios.