Commercial Property

Lower values and lower returns in prospect as real estate adjusts to the new normal

Market has entered into a period of ‘price discovery’ as era of ultra-loose interest rates comes to an end

Salesforce's new European headquarters in Dublin's north docklands.

Kenneth Rouse
Wed Nov 23 2022 - 05:45

2022 is shaping up to be quite the transformative year for the real estate market. It has been a tough few months since the passing of summer with a slowing economy and the re-emergence of stubbornly high inflation. Meanwhile, monetary conditions are normalising, leaving behind the ultra-loose rates that were a long-lasting legacy of the great financial crisis. Current yields are simply incompatible with debt servicing and rental growth cannot keep pace to support existing capital values manifesting in the now ongoing price correction that will set a base camp for the next cycle.

On several fronts, the news flow in recent months has been grim. Among them are supply-chain disruption due to stringent Covid-19 policy in China, war in Ukraine, the squeeze on energy supply and now the unprecedented speed of monetary-policy tightening. All have contributed to a slowdown in the global economy alongside heightened inflation. Stagflation seems to be looming large and in Europe talk of a recession in the coming quarters appears to be a “given”.

There is thankfully one positive aspect, the labour market remains generally robust. However, while tech employment continued to rise by 7 per cent per annum in September, moves to right-size this fast-paced sector through cost-cutting measures, including redundancies, may have a bigger impact in Dublin than in other European capitals.

Supply now becomes an even bigger policy headache with the ever-increasing cost of delivery making most schemes economically unviable

For real estate, the changing economic landscape is affecting all sectors similarly, even if there are differences in the degree of magnitude. In the occupational market, the increased cost of living is an added headwind for the already omni-challenged retail sector, although rapid population growth is supportive of some sub-sectors. While the structural changes of hybrid working and environmental, social and governance (ESG) are ongoing, the strong labour market offers some comfort for office demand, especially for best-in-class assets. In logistics, ecommerce and on-shoring continue to drive demand.

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For the private residential sector, affordability will be challenged by the increased cost of borrowing even with the new mortgage-lending rules, making rental a more viable option. However, supply now becomes an even bigger policy headache with the ever-increasing cost of delivery making most schemes economically unviable.

In the meantime, the prevailing interest-rate environment is challenging the investment market, particularly in pricing with everything starting and ending with the “risk-free rate”. The favourable financial conditions that existed from 2009 – 2021 are unlikely to return anytime soon, as the perceived economic risk moves from deflation to inflation. This comes down to higher interest rates, far more upward pressure on long-term bond yields with alternatives emerging to test the previously unchallenged relative value appeal of real estate.

Against this economic and financial backdrop, the outlook for real estate pricing and therefore returns has changed considerably, across all sectors of the market

While equities and bonds reprice in real time via an organised exchange, real estate is traded by negotiation between a buyer and seller, and therefore takes longer. Consequently, the market will enter a “grey” period of price discovery over the rest of this year and into early 2023. For real estate, this represents not just a price correction but should establish new market norms. The outcome for real estate investment is quite clear: a short-term reduction in transactional volumes over the remainder of 2022 and inevitably into early 2023 while these new norms find their equilibrium.

Against this economic and financial backdrop, the outlook for real estate pricing and therefore returns has changed considerably, across all sectors of the market. In the near term, BNP Paribas Real Estate is forecasting increases in real estate yields across all sectors. With the exception of some segments of retail, where the cost of living crisis presents another challenge for occupiers, demand for space in the other sectors, particularly for prime assets, remains strong. For this reason, we think real estate will remain relatively attractive giving investors what they crave – cash flow stability. But cycles change, markets move on and investors will have to accept a lower level of total return than they have been used to in the past decade or so.

Kenneth Rouse is managing director and head of capital markets at BNP Paribas Real Estate Ireland

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