Real Estate Outlook – Global, Edition May 2024 – UBS

According to MSCI, capital values in Japan were broadly flat between mid-2022 and end-2023, having not faced the pressure of higher interest rates that markets in Europe and North America have. In 1Q24, cumulative rises in global interest rates combined with expectations for small medium-term increases in Japanese rates to push prime yields in Tokyo slightly higher. According to CBRE, office yields rose 25bps QoQ and logistics yields 10bps QoQ. Retail yields were little changed, falling 5bps QoQ.

Two factors needed to spur investment market

Following sharp falls in capital values over the past eighteen months, investors remain cautious on real estate. They are sitting on the sidelines, waiting to deploy capital when they believe market circumstances to be more favorable. Two factors look necessary to spur investment activity. First, the commencement of interest rate cuts by central banks, and second, confidence amongst investors that real estate values have bottomed out.

Neither of these factors are currently in place, but they do not look far away. In the November 2023 edition of IPM, we highlighted the significant uncertainty over interest rates moving into 2024 and what different scenarios might mean for real estate markets. The analysis proved prescient since not even halfway through the year market expectations have swung wildly, from 6–7 cuts from the Fed in 2024 at the start of the year, to just one or two cuts on the latest market pricing. Expectations have been pared back as US inflation has crept up. Indeed, no rate cuts this year is a plausible outcome. The interest rate outlook is also diverging between the US and Europe. Overall, though, we still expect to see some cuts by year-end, with Europe leading the US.

With regard to the second factor, of when the market will bottom out, we think the correction is now well-advanced. However, it’s always hard, if not impossible, to pinpoint exactly when the bottom of the market will be. Higher frequency, listed markets can give a steer as to when real estate asset values might level off and listed markets have typically led property values by around two to three quarters. This was the case during the Global Financial Crisis (GFC) and pandemic-induced downturns (see Figure 2). Listed markets themselves have been hit by interest rate volatility towards the end of 2023 and in 2024. On the basis of average prices over the quarter, listed markets showed some recovery in 1Q24 and look to have bottomed out in 4Q23. This suggests that global property capital values will bottom out in 2Q or 3Q this year.

Hence moving into the second half of the year the two conditions needed for investors to deploy capital into real estate look like they will be met. This should prompt a pick-up in transaction activity at both the asset level and for real estate funds. The main risk to this outcome is inflation remaining high and sticky and central banks having to keep interest rates elevated for longer as a result. This could translate into further investor caution, weigh on real estate values and hold back recovery in the market. The US seems more at risk of this outcome than European markets, which have not seen the same uptick in inflation as the US.

For investors higher up the risk curve in the value-add and opportunistic space, apart from offices, the next 6–9 months may be the remaining window for them to lock in deals which benefit from distressed and discounted pricing. Cuts in interest rates should gradually relieve pressure on refinancings and make raising debt to finance new investments easier and more feasible. In the medium term, lower interest rates should see debt enhance returns again, although it is unlikely to be able to turbo-charge them like it did during the post-GFC decade of ultra-low interest rates.

Given the lower contribution from leverage, real estate investors need to look to good asset management to drive returns. This means ensuring full occupancy and rapid re-letting of space as leases end, and embarking on initiatives to improve assets and drive rental growth. As well raising the spec of buildings for occupiers and users, improvements also focus on the sustainability aspects of buildings and upgrading energy efficiency. This will make them more attractive to corporates and help them ensure they meet their net zero pathway targets.

We continue to think that the office sector will underperform and be marked by a sharp polarization between prime and secondary grade assets. Indeed, it is likely that a significant number of offices will eventually need to be repurposed, when feasible, to other uses, such as residential. Conversion to lab space is another possibility, subject to exacting building specs being met. We expect stronger performance for the retail, industrial and residential sectors and also the niche sectors such as self-storage and life sciences. Debt secured against real estate is also attractive in the higher interest rate environment, as banks focus on managing their existing loan books.

Figure 2: Capital value and price indices (1Q12 = 100)