Changing Market Dynamics: What's Ahead for Real Estate?

By Hugo Le Moing, Colomer Expertises (France)

The real estate season is shaping up to be a hot one for investments as the market enters a new cycle. 

The outlook in Europe appears to have deteriorated, with markets distrustful of the euro and European monetary policy. While the United States has decided to wage a real battle against inflation with an aggressive monetary policy, the European Central Bank seems relatively lethargic, for fear of exacerbating the recession that is just beginning. In this macroeconomic context, which is unclear, the uncertainties surrounding real estate are high.

A New Cycle of Rising Interest Rates

The rise in interest rates is the result of increased volatility, which will have repercussions on all asset classes. Real estate is a bulwark against inflation, but its status as a safe haven cannot totally protect price adjustments.

Despite a large amount of liquidity in the market, the specter of rising interest rates is likely to impact financing costs, which in turn may lead to a change in the investment dynamics. A wait-and-see attitude is embraced as market participants are still in a repricing phase.

Retail could be affected by a double effect of falling rental values. If inflation continues and Europe enters a recession, household consumption will suffer, which will be reflected in lower sales and margins for retailers. If the mechanisms for adjusting rents are not immediate in France (notably due to the rigidity of French-style commercial leases), it is likely that renegotiations will take place outside the legal framework. In addition to this effect of lower rental flows, the effect of rising interest rates will necessarily increase the risk premium.

As for the office market, it is at the dawn of a new era, with new uses that have changed its perception, both by users and investors. After the health crisis, the worst seemed to be over, but it is said that some assets are still not finding tenants unless values are significantly downgraded. On the other hand, some markets are significantly under-supplied, as is the case in Paris, where companies are coming back massively by rationalizing the surface areas leased and abandoning large buildings on the outskirts.

In the logistics sector, the scarcity of land and strong demand are factors of stability for values. However, in the face of falling demand from e-commerce, it is possible that some value adjustments may be made. In addition, the logistics asset class is the one that has seen the greatest compression in rates, demonstrating investor appetite, sometimes by forgetting real estate fundamentals.

In the hotel sector, the return of tourists and the development of local tourism have almost brought the industry back to its pre-sanitary crisis levels. The interest rate effect is obviously a factor in reducing the value of properties in the event of a downturn. Unless health-related tensions come back, the hotel outlook is quite good. But beware of the clouds that are gathering on the horizon, particularly the decline in purchasing power due to inflation, which could have a particularly negative impact on the budget of the hotel sector. The high-end hotel industry will probably be preserved if new restrictions are not imposed on global air traffic on the Covid front.

Finally, housing remains inherently more defensive and countercyclical, as does healthcare real estate. Its resilience should strengthen investors’ appetite for these asset classes, as they seek security above all else in a context of uncertainty.

A New Cycle Where the Environmental Factor Is Key

The importance of the environmental factor in investment policies will become the new paradigm. After a particularly complicated summer in Europe (drought, climatic events), the environmental factor will no longer be looked at solely through the prism of classic valuation elements (location, quality of the tenant, etc.). The environmental parameter must already be integrated into the models, otherwise, investors will face serious setbacks. Indeed, for the least suitable buildings, CAPEX can represent a substantial amount, sometimes exceeding the acquisition cost over the life of the investment. Buying on the basis of an immediate rate of return is a mistake because the rate is evolving and the investment period in real estate is long.

Energy costs will be a real issue in the coming months.

It will necessarily impact the capacity of tenants to pay the rent, hence affecting rental values for the least suited buildings. The environmental parameter must be integrated as a key factor of the value, its importance will be particularly highlighted with the problems of inflation of energy costs.

Conclusion

While it would be overstated to speak of a bubble, values have risen significantly in recent years, essentially due to an artificial effect of rate compression. Without anticipating the end of 2022, it is likely that some price corrections will take place, particularly in the least qualitative assets. Prime assets are the best equipped to resist, as they are often low-risk assets.

However, there are still reasons to remain optimistic, as times of crisis generate opportunities for the most astute. Real estate cannot remain totally immobile; a more dynamic and value-creating approach is the key to getting through these troubled times. For example, some players are positioning themselves in urban redevelopment, which makes it possible to combine environmental issues, create more value than with a traditional investment approach, and overcome certain situations of undersupply, for example by restructuring obsolete office buildings into housing.

Few players expect to freeze their investments completely. The market should slow down, but not collapse in the absence of a liquidity crisis. Despite the expected rise in interest rates, the real estate risk premium remains attractive in most asset classes, if one buys subjects where value creation is possible.

In these uncertain times, real estate fundamentals will be more important than ever. 

Share article: