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How will macro headwinds impact the commercial real estate sector?

With rising interest rates and the cost of living crisis, what is the outlook for commercial real estate? Our recent webinar, How will macro headwinds impact the commercial real estate sector? asked three leading industry experts their opinion on the outlook for the sector. Here are some of their thoughts.

Steven Matz, Content Specialist, WBEF
15 August 2022

Evidence of an improvement in sentiment amongst the real estate sector appears to have stalled, according to the results of the Q2 2022 Global Commercial Property Monitor. Although this does not imply a major shift in tone, it is reflective of the ongoing tightening in monetary policy by key central banks (led by the US Federal Reserve) and the acceleration in inflation which does not, as yet, appear to have run its course. Whether higher inflation becomes more firmly embedded in the expectations of both businesses and wage demands will be critical in judging the extent to which policymakers will need to continue raising interest rates and, inevitably, the impact on the prospects for the world economy.

Our recent webinar, How will macro headwinds impact the commercial real estate sector? canvassed the opinions of three leading industry experts, one each from the UK, US and Germany, on the outlook for the sector.

 

Wait and see

Rising interest rates are a further stress factor on a commercial property sector already having to deal with logistics problems, the increasing cost of construction materials and labour shortages, says US-based Ann Gray FRICS, Principal at GRAY Real Estate Advisors and President-Elect of RICS. On their own, interest rates could probably be accommodated, but it’s one more risk factor in the investor formula, so a lot of money is moving to the sidelines, with investors adopting a wait and see approach, she says.

“A general rise in interest rates will lead to higher liquidity costs, and that's a blocker for those who need that financing,” comments Susanne Eickermann-Riepe FRICS, Chair of RICS European World Regional Board and Senior Advisor in Real Estate.

In Germany, she says, with a tripling of interest rates (as at time of webinar) industry players are somewhat static awaiting the next direction indicators take.

 

A good hedge for inflation?

There are mixed views as to whether real estate is a good hedge for inflation, says Simon Durkin, Head of European Real Assets Research and Strategy at BlackRock. He explains there are some sub-sectors where rents are indexed and are able to pass through inflation more easily than others, for example, where a typical five-year rent recycle might prevent landlords passing on increases. He also points out that in recent weeks (as at the time of webinar) 10-year gilts in the UK have been highly volatile, and this is driving uncertainty, and unsurprisingly, investment transaction activity has started to slow.

A general rise in interest rates will lead to higher liquidity costs, and that's a blocker for those who need that financing

Susanne Eickermann-Riepe FRICS
Chair of RICS European World Regional Board and Senior Advisor in Real Estate

Rent pressure

Against a background of a cost of living crisis and rising inflation and consequent pressure on the rental sector, how will governments respond? Speaking about the situation in Germany, Susanne Eickermann-Riepe comments that with Generation Rent, especially in Berlin, there is much discussion about what action government can take, such as whether on the build or rent side. Uncertainty, over rental values of new multifamily homes is likely to stall investment and slow down residential growth, she says.

With some exceptions, notably short-term measures taken during the pandemic such as eviction moratoriums and rent caps, the US has been reluctant to interfere in capital markets, says Ann Gray. Furthermore, court decisions have gone against policy affecting property values, so unless owners can be compensated, rent policy is not allowed. She suspects that as a response to rising rents, families will gravitate to smaller units or living in larger family groups.

Rental affordability is going to come under increased stress as a result of the cost of living crisis, particularly through the winter and the spring of next of next year, thinks Simon Durkin. Conversely, there is a paucity of professionally managed stock, that is clearly still in demand, he says. He believes that the track record of rent controls has not been great overall, attributable to both a reluctance to interfere in capital markets – which needs stock – and the negative impact on financial viability and certainty, he says.

From the investor perspective, multifamily benefits from short-term leases, says Ann Gray. Shorter leases compared with offices and high annual turnover will protect investors somewhat, she explains.

“Any sector that is underpinned by a demographic story, given that demographics are more easily forecastable is going to be a more resilient sector over the long term,” adds Simon Durkin.

 

No going back on sustainability

On the question of sustainability, there is no going back, despite the current macro climate, believes Susanne Eickermann-Riepe. “We are in middle of the transition phase, from the old to the new economy in real estate and the side effects from the pandemic and war in Ukraine will make this transformation a little bit faster,” she says.  The good investors will already have learned how to manage their portfolios to decarbonise and have defined the critical points on each transaction where they are not willing to buy, she adds.

Rising fuel prices actually bodes well for sustainable projects going forward, says Ann Gray. While property owners already have sustainability obligations, the cost of energy will push them voluntarily to increase the sustainability of their projects, especially with huge demand for more sustainable kinds of construction from both the office and residential side, she says. One area we are going to have to solve going forward, she stresses, is energy use around data and cryptocurrencies.

“Larger corporate occupiers will have to be seen to be living to their own ESG agendas, so they will be looking to move to higher-rated, more sustainable stock,” says Simon Durkin. Investors will have to start providing the right type of stock for them to move into and that is where the capital markets have a role to play, he says. He also believes that it will become far less palatable to demolish and rebuild buildings, particularly in the context of the decarbonisation targets being set, so refurbishing to a better standard is imperative.

Where sustainable stock is going to come from, either new build or refurbishment, is a key question, he says. Capital is more likely to come from the value-add or opportunistic funds, who are debt reliant. Their performance is driven by the availability of debt and with cost of debt increasing considerably from where we were six months ago, it makes it more challenging, he concludes.

How will macro headwinds impact the commercial real estate sector?