Real estate
Global Real Estate Outlook Mid-Year 2024: A New Cycle of Contrasts
10 min read 26 Jun 24
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After a challenging couple of years for global real estate, there is a greater sense of optimism associated with the rest of 2024 and beyond. For the majority of markets, this year will likely mark the bottom of the cycle and the end of significant capital value falls. With stabilisation already emerging, investors are cautiously dipping their toes into the waters once again.
With the prospect of better days ahead, investing in real estate at this point in the cycle could offer attractive return potential. However, there remain a number of risks which need to be navigated.
If the era of ‘lower for longer’ interest rates represented a tide that lifted all boats, we see the beginning of the new cycle as a cycle of contrasts. In our opinion, performance is likely to be largely driven by income generation and preservation, over capital growth, and while occupier demand for most sectors should remain robust across the board, there are some notable exceptions. At the same time, rate rises have revealed cracks in the system, especially relating to high – and now costly – leverage, but also assets with structural challenges, such as sub-standard secondary offices.
Investors will therefore need to be more selective about asset qualities and specifics to help ensure their investment decisions tap into what could be a fine vintage for real estate.
A fine vintage for investments
While expectations for fast and furious interest rate cuts globally have been dialled back, an increased risk premium for property, combined with improving rental growth prospects given a brighter economic outlook, supports the view that yields may have moved out by far enough. In our view, with few exceptions (such as Japanese offices), entry pricing now also looks attractive, providing a significant opportunity for new capital, and setting the scene for what could be a fine vintage for investments.
An emphasis on income to drive performance
Yet with yield compression likely off the table for now, due to ‘higher for longer' interest rates, investors will have to rely on income as the main route to achieving target returns. Significantly, we believe income fundamentals for most global real estate is in a relatively strong position today, thanks to a limited supply of modern, high-quality assets. As such, occupational markets have proven stronger than expected, despite muted economic growth and in some markets, outright recession. Rents have continued to rise, beating forecasters’ conservative expectations even as structural headwinds blow. An improving global economic backdrop opens the door for accelerating rental growth to drive performance, albeit with sector and geographic differentials.
Prospects for stronger economic growth in Asia Pacific position the region to lead this stage of the occupational and rental cycle, in our view. Continued business expansion and rising wages alongside moderate inflation support the potential for buoyant occupier demand and rental growth. Tokyo multi-family housing and retail rents are surprising on the upside, for example, while Seoul offices are benefiting from stronger (export-led) economic growth.
Looking to Europe, economies are also showing signs of recovery, spurring occupier demand. However, rental growth trajectories are poised to diverge, given distinct economic cycles and market dynamics. Despite Spain projecting the region’s healthiest economic outlook, the country could see elevated levels of supply curb future rental rises, while the reverse could be true for larger, core markets like Germany, France, the Netherlands and the UK. Nordic markets – most challenged by economic weakness in the last couple of years – may be slowest to recover but, when the time comes, a severely constrained supply pipeline means the potential for a sharp rebound in rental growth could be significant.
Rental growth prospects are nuanced
However, the interplay between a recovering economy and longer-term changes in occupier needs means that rental growth will be nuanced and asset and location specifics could override wider regional and sector trends. The stereotype of 'beds and sheds' as rental outperformers versus structurally-challenged retail and offices will broadly hold true, we believe. Yet the path to Net Zero will also play a vital role in determining the outlook for rental growth, potentially contravening sector-based views. Best-in-class office assets could well see a better rental return than older logistics assets in markets where recent double-digit rental growth has led to a large supply response.
Rental growth is not the only route to potential outperformance. With capital values lower and occupational markets largely resilient, income returns have risen significantly, rewarding in itself, even if yield compression looks less certain. Where assets have repriced by enough to reflect heightened occupier and ESG risks, a higher income return – especially from the newly rebased retail sector – should also pay performance dividends in the medium term.
While risks for the asset class remain, we believe real estate’s recent repricing, combined with significant income growth potential and cash flow resilience, sets the asset class apart as the global economy starts its new cycle. With rates higher than they have been in more than a decade, and the prospect of 'sticky' inflation, the reward for owning property, as a real asset, offers both attractive return potential and risk mitigation.
A lack of future supply creates gaps and opportunities
Historically, downturns have tended to coincide with periods of high supply, leading to rising vacancy rates, falling rents and a slow rebound. In contrast, this downturn began with minimal new supply, as pandemic uncertainty, tougher financing conditions and higher construction costs delayed or terminated development projects, supporting occupational markets even as capital values fell. With continued economic uncertainty and rising ESG standards, Gross Development Values and therefore development feasibility has declined. Already limited supply pipelines are shrinking as a result.
For ever-popular ‘beds and sheds’, undersupply has driven significant rent rises in recent years, therefore restricted development in the face of growing demand should continue to support further growth over the medium term, albeit at a more moderate pace.
For retail and offices, an undersupply shock may have come at the right time. Now largely challenged by structural oversupply, both sectors could benefit from shrinking development pipelines, helping to mitigate vacancy – and rental weakness – even as occupiers reduce their space requirements.
Building rental pressures as a lack of development bites
Germany’s private rented residential sector stands out as a market where a stark supply/demand imbalance has meant record rises in rents, with no end in sight. Vacancy rates in major cities have now dropped to below 1% and yet no supply response is forthcoming, driving strong future growth expectations as well.
Seoul offices are at the extreme end of the spectrum: despite offices being a sector beset by concerns around structural oversupply, vacancy rates here have dropped to their lowest levels since 2008, at sub-2%. With limited new space in the pipeline, occupiers have had to revise their rent expectations upwards to secure space that meets their needs. This is fuelling a growing trend of corporates acquiring assets for owner-occupation, helping to support capital values despite rising interest rates in the last two years.
Meanwhile, a lack of recent shopping centre development in Australia1 is starting to support a burgeoning recovery in rental levels, as the worst of the structural impact in the retail sector fades. Even in the UK, where obsolete retail space is widespread, half a decade of little to no new development is finally supporting rising rents for better quality assets, as demand recovers from pandemic lows.
Bucking the undersupply trend
While these trends may broadly hold true, there are markets that do not conform to the status quo. Thanks to a strong policy backdrop, Finland (with the notable exception of Helsinki’s metro area) has seen consistently high housing delivery in recent years, limiting the country’s rental growth even as it hit double-digit levels elsewhere in Europe. Stronger growth may be on the horizon, however, with five years’ worth of oversupply set to be absorbed in the space of just 24 months as new construction falls back to minimal levels.
The Dublin office market is bucking the undersupply trend too, with high levels of space set to be delivered this year. Moreover, less than half of the space coming through is pre-let, suggesting that even the most discerning occupiers could be spoilt for choice – a stark difference to Europe’s other Central Business Districts, where prime supply is severely lacking. This is likely to mute Dublin’s rental growth potential this year and next. Yet once this space is delivered, development looks set to fall back to levels not seen since the Global Financial Crisis. In the next couple of years, super-prime space will instead be in very short supply, creating the potential for sharp rental rises for the best quality assets.
The logistics markets in Australia, Korea and Japan still have elevated levels of supply to work through in 2024 and 2025, having increased to meet high demand for modern assets. However, higher costs of construction, labour and financing have already impacted new starts from 2023, giving confidence that supply beyond 2025 could be lower than demand, and rents could be well supported.
A lack of new supply in many markets means significant challenges may be ahead for occupiers, especially given the narrowing of focus to best-quality space. However, for investors, the imminent dearth of development at a time when demand looks set to recover bodes well for rental growth, and ultimately, performance for the ‘right kind’ of stock.
Refinancing risks and tighter credit conditions
- While we believe the coming quarters could well prove to be a fine vintage for global real estate investment, investors should be aware of leverage issues and refinancing challenges . These could hinder the recovery for certain asset types within selected parts of the property market as we enter a new cycle.
Still limited sign of a wave of distress
Though there has been some growing evidence of stressed sellers in the market over the last two years, including developers becoming insolvent and property owners defaulting on loans, the dramatic shift in policy rates globally has not as yet caused a larger wave of distress.
This is largely a result of lenders’ continued willingness to compromise. In the US, over $200 billion of commercial real estate (CRE) loans due to expire in 2023 were neither sold nor refinanced, according to MSCI (adding to the large volume of loans maturing from 2024 onwards). Further, strong occupational markets and associated net operating income growth – particularly for the best assets and structurally favourable sectors – have, to an extent, also protected borrowers.
Some stress does appear to be surfacing in the system, however. Loan loss provisions among many lenders have risen in recent quarters, reflecting elevated risks faced by lending made against certain types of property. This is particularly true for the globally significant US office sector. Around 15% of German banks’ loan books are backed by US properties2, including in gateway office markets – and their loss provisions now top €2.5 billion according to a Bloomberg survey3. Further, over a year on from the collapse of SVB, there are lingering concerns over the lending characteristics and loan performance prospects of smaller, regional US banks with a high concentration of assets within the CRE sector. By contrast, Asia Pacific banks have less than 2% of loan book exposure to US properties, according to Fitch data.4
Crucially, given much more is known about problematic loan exposures and lending behaviour, we are cautiously optimistic that systemic risk to the real estate market remains an unlikely scenario. As an indicator, non-performing loan (NPL) ratios for CRE have risen only modestly over the last few quarters, and remain low. Across the Eurozone, the ratio is 4.3%5, while it is just 1% in the US6 and 0.65% in Australia7.
The risks and opportunities in this recovery cycle
Refinancing needs are, however, still likely to grow this year and next. And there could be challenges as more loans expire, even if rates do come down.
This could result in forced sellers offering properties to market at steep discounts; the need for equity injections by existing (or new) owners; or bridge/mezzanine financing needs from agile, potentially non-bank lenders. Sales of assets in distress typically, however, take a few years to work through the system. MSCI points to a peak of distressed European property sales8 in 2012 following the Global Financial Crisis, and currently identifies a significant uptick, into 2024, of publicly-reported properties in distress but not yet transacted.
Perhaps a bigger risk to the market’s recovery is a cautious approach to new lending among traditional lenders, which could dampen deal activity. This will likely impact assets in different ways, leading to contrasting performance potential between those in, and out of favour.
Banks have scaled back appetite for new loans and have also become more selective in underwriting new deals. This includes providing more conservative Loan to Value ratios, scrutinising ESG criteria more thoroughly, and avoiding weaker assets without viable transformation plans. Green credentials are now considered in much more detail by virtually all lenders compared to a few years ago, creating the possibility for an acceleration in asset obsolescence, or material pricing discounts. Some are even offering margin step downs for the highest calibre ESG strategies, but overall ESG requirements (and any incentives) vary between lenders.
Given banks represent the majority of the CRE lending market globally, their retreat coupled with the markdowns in property valuations is likely to create a sizeable debt funding gap over the coming years – globally estimated at over $250 billion by 20269– though it is an evolving picture, with changing rates and values rebounding. This is both a cause for concern of real estate equity investors, who may face challenging financing events, but also an opportunity for alternative lenders to step into the gap.
While some future credit losses on loans secured against CRE cannot be ruled out, wider systemic risk in any global region remains an unlikely scenario, in our view. The risks to the market’s recovery are more centred around a cautious traditional lending market which dampens new transaction activity and creates performance divergence, coupled with expiring loans introducing some stresses to an already challenged ecosystem.
Investment convictions: Income is key
With the turning of the cycle and a more positive outlook for real estate moving forward, investment performance is likely to be generated by income qualities, rather than yield compression-driven capital appreciation. We see attractive investment propositions reflecting one or more of the following income characteristics:
- Income Growth: Largely stimulated by strong supply-demand imbalances, owning these properties enables landlords to benefit from positive market dynamics and grow real rents between (and sometimes within) leases
- Income Return: Characterised by higher yielding property types (i.e. where income constitutes a greater proportion of an asset’s value), coupled with sustainable rental levels
- Income Preservation: Resilient cash flows with low risk of vacancy or decline and which have an ability to keep pace with inflation; may include longer leases backed by strong tenant covenants
Conclusion
Following a challenging couple of years, we expect global real estate markets to be on a better footing through the rest of 2024, with capital value stabilisation and largely positive rental growth prospects. A focus on income and asset quality will be important in the new cycle, as investors and lenders become more selective, and investment performance differentials become apparent between assets of higher, and lower quality. We believe new investments made in the next 6-12 months are likely to be recognised as a robust vintage in the long term, benefiting from high entry yields and strong occupational profiles.
Rental increases are expected to be driven by a stronger economy – particularly in Asia – or at least an uptick in economic growth, which will spur occupier demand. Challenged development viabilities have limited the supply pipeline in most geographies – though there are some examples of the converse – which should help to stimulate rental growth over the next few years, in light of acute supply-demand imbalances.
Though refinancing challenges remain, the risks within banks are largely well understood and appear modest. The risk of wider systemic stress is unlikely, in our view, but lender behaviour and financing availability will be a key determinant of asset bifurcation and performance moving forward.
Despite some challenges and risks on the downside, with investment market stabilisation having arrived, or at least in sight, and the global economy look set to recover, we are increasingly optimistic about the outlook for real estate. As such, 2024 may present the most attractive buying opportunity that has been seen for some time.
1The pipeline of incoming regional and sub-regional shopping centre space in 2024 is estimated to be less than 10% of the historical 10-year average. Source: JLL, Q1 2024.
2Based on a sample of 15 larger banks. Source: Borsen-Zeitung (2024), "https://www.boersen-zeitung.de/english/how-german-banks-are-involved-in-the-us-real-estate-market".
3For German Pfandbrief banks (which have a c.60% national market share), Scope analysis suggests the largest German lenders have manageable NPL ratios of under 3-5% across their CRE loans, some as low as 1%. Source: “https://www.refire-online.com/investment/banks-see-commercial-property-still-sliding/”.
4Based on analysis of banks that disclose this data. Source: https://www.fitchratings.com/research/banks/us-commercial-real-estate-exposure-generally-modest-for-fitch-rated-apac-banks-08-02-2024“https://www.fitchratings.com/research/banks/us-commercial-real-estate-exposure-generally-modest-for-fitch-rated-apac-banks-08-02-2024”.
5Source: EBA, Q4 2023, "https://www.eba.europa.eu/sites/default/files/2024-04/70635613-edf4-495a-b9ce-42af51e93244/press_release_rdb_q4_final_embargoed_until_04042024_1100_cet.pdf”.
6Source: BankRegData.com, Q1 2024, https://www.bankregdata.com/allLD2met.asp?loan=F161&met=NPL (note – includes Owner Occupier CRE, Non-owner Occupier CRE and Multifamily”.
7Source: APRA, September 2023, "https://www.apra.gov.au/sites/default/files/2023-12/Quarterly%20authorised%20deposit-taking%20institution%20property%20exposures%20statistics%20-%20highlights%20September%202023_0.pdf”.
8As a proportion of total deal volumes (circa 8%), rather than total € value of distressed sales (which was registered in 2014).
9For the period 2024-26 inclusive. Source: CBRE (Q4 2023).
The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. The views expressed in this document should not be taken as a recommendation, advice or forecast. Past performance is not a guide to future performance.
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