The coming year is likely to be a challenging one for real estate but should also create opportunities to lock in higher yields and generate long-term value.
Signs of recovery in the wake of higher lending rates could seem elusive in the first half of 2023. Private markets are not as liquid as their public counterparts and, as their pricing trends can lag other asset classes, they may continue to decline over the first two quarters of the coming year. But that will be precisely the period in which purchasers have the greatest negotiating power.
Yields will rise further to reflect tighter financial conditions, but we don’t expect a cycle like that of the 1990s, nor that prices will sink to the lows of the Global Financial Crisis. There are still plenty of buyers in real estate and, given private market investments have become a key part of many well-diversified portfolios, there is unlikely to be a wholesale withdrawal of capital from the space.
A return to rational pricing
Indeed, we should see a fundamental strengthening of terms in 2023. After a long period of low interest rates, during which a lot of real estate seemingly offered the same standardised yield almost regardless of quality, we’re now moving into a period of more rational pricing. This creates the potential for more differentiated returns between sectors, property types, and locations that active real estate investors can take advantage of.
Sustainability premia set to increase
The biggest differential may arise between buildings that are sustainable and those that are not. Not only has the energy efficiency of a building become more important as energy costs have risen, but evolving regulation is continuously ratcheting up sustainability standards. With an alphabet soup of requirements from EPC ratings to Sustainable Financial Disclosure Regulation coming thick and fast across Europe especially, the next few years will bring huge opportunities and risks for those who can get ahead of the changes and those that get left behind.
Instead, we expect the upcoming cycle to be relatively short. If interest rate levels begin to stabilise, we believe that most valuations will readjust by the middle of next year. As the market moves closer to the bottom, there will be some interesting opportunities for investors with long-term capital to deploy.
Some buildings will become stranded as landlords can no longer lease them unless they meet minimum standards. This will increase not only the ‘brown discount’ for non-compliant buildings but also the scope for the most sustainable buildings on the market to attract outsized ‘green premia’ in the near term, especially as buildings with the strongest credentials are in short supply.
An eye on cashflow
Finally, 2023 will be the year that the pricing landscape in the real estate market goes back to basics. After almost a decade of chasing ever-compressing yields due to the increased allocation of capital to the sector, we’re now entering a period where the focus will be on cashflow - maintaining income where you can and growing it where opportunities to pick up higher-yielding assets arise. The focus on delivering alpha will remain but this will be much more a function of the quality of the building, and the ability of the manager to actively manage it, than it will be of past drivers like historically low rates or prime locations.
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