This article was publish in BDO M&A Horizons magazine 2022 - Issue 4
The world has seen more change over the past 24 months than most would expect to experience in a lifetime. The financial hardships and supply chain disruptions caused by the pandemic pushed central banks to inject massive amounts of liquidity into the financial system, mainly through quantitative easing and government backed loans. As a result, in the US, Fed fund rates were decreased to zero per cent between March 2020 and March 2022, similar to UK rates while Eurozone rates were kept negative until July 2022. Now interest rates are increasing faster than any time in recent history.
In the Real Estate market, values and rents increased in most markets and for most asset types. Multifamily and logistics properties were the top dogs of 2021-2022. While this was cheered by long-time owners, these skyrocketing values rapidly resulted in bidding wars for prospective owners and pushed some prospective renters out of some markets.
The liquidity oversupply, coupled with the supply chain issue, caused dramatic inflation. It has now reached levels not seen since the 1980s. While the US started facing abnormal inflation rates in April 2021, followed by the Eurozone and the UK in October 2021, the authorities first considered it to be temporary and arguably acted too late.
THREAT OF INFLATION LOOMS LARGE
Central banks have now adjusted their stances by increasing their interest rates. While the US has increased the interest rates by 300 basis points in six months and the UK by 225 basis points in nine months, the Eurozone has so far been slow to follow with only a 75 basis point overall increase. The fight against inflation is a perilous one, with on one side the threat to push the economy into recession by cutting liquidity access and on the other the threat of letting inflation stay. Central banks seem to consider the latter option to be the one to avoid at all costs, despite the growing risks of recession.
So far this rapid liquidity tightening has not resulted in any substantial observable direct impact on the commercial Real Estate market. But what really lies ahead?
Historically, the relationship between interest rates and capitalization rates has been an intricate one. While the cost of borrowing is a highly regarded component by market participants in their bidding wars for assets, investment strategies are also guided by supply inventory, expected rent growth and overall demands. These factors result in contractions or expansions of the spread between interest rates and capitalization rates. For instance, the explosive growth of online shopping led to an increasing demand for warehouses and logistic assets, resulting in a massive contraction of capitalization rates between 2006 and 2022. In some markets, this contraction is twice as high as contractions observed for office and multifamily properties.
Overall, the Real Estate market appears to be receiving mixed signals depending on the asset classes. Interest rates direction, supply chain issues, geopolitical stability and the flexibility of the property types will all be influential and help to determine the strengths and weaknesses of each asset.
The BDO Real Estate and Construction group has set up a global Real Estate Valuation network to address the valuation challenges associated with these complex problems, allowing it to work on several different markets and maintain an overall market view of Real Estate. The BDO Real Estate and Construction group provides impairment testing analysis, financial reporting as well as feasibility studies and publishes outlooks on the individual asset classes.
OUTLOOK FOR REAL ESTATE ASSET CLASSES
Recent history: The explosion in demand associated with customers’ shifts to online shopping, coupled with the attractiveness of long-term triple net leases and relatively low management fees, made industrial/ logistics assets the most preferred asset class for investors. Capitalization rates for logistics assets have exhibited an impressive contraction over the past 10 years. Prime capitalization rates were around 6.00% for UK assets in 2011, while they are sub-4.00% as of 2022. Similarly in the US, they went from 6.00% back in 2010-2011 to slightly above 3.00% in mid-2022.
Expectations: On the demand side, while supply chain volatility made a nice run for the bulls over the past few years, operators have recently showed slowing revenue growth. Amazon has posted its slowest growth in over two decades and has recently frozen hirings. eBay and Walmart both showed decreases in revenue year‑over-year.
Revenue growth forecasts for these main market participants have also decreased, which appears primarily to be due to the combination of inflation and rates increases, which are both already eroding and are expected to further erode consumers’ purchasing power.
From a supply perspective, most markets appear to be undersupplied, as evidenced by record-low vacancy rates and strong net absorptions. Rising construction costs may have delayed some projects, further strengthening the current market undersupply.
While some woes are starting to be seen, investors’ appetite remains healthy, and the asset class is viewed confidently by market participants. However, peaks of values are certainly near, as financial feasibility will be even more scrutinized with debt service weighting on – if not already largely exceeding – attainable
cashflows in certain markets.
Historically, the three main drivers that made multifamily a booming asset class during the pandemic were low supply driven by a historically lagging Real Estate market and high-barrier entry points due to zoning and legal requirements; high demand driven by population growth, net-in-migration and work-from-home policies; and recent liquidity easing.
Expectations: Prospective tenants may be at risk due to inflation eroding tenants’ capacity to afford rent. As a prudent reaction, collection losses are likely to show an uptick in future underwritings. Operating expenses, typically born by the landlord, have seen large increases compared to two or three years ago. The rise in operating expenses has – so far – been passed down to tenants, mostly through rent increases. But for how long?
With prime capitalization rates going as low as sub 3.00% in some markets across the world, the financial feasibility of some projects is definitely at risk. Investors’ appetite remains relatively strong and healthy but this mostly depends on the location. Some markets are still red-hot like Boise in Idaho, USA while some are uncertain like Atlanta in Georgia, USA.
The European markets also currently benefit from a very favourable position for US‑based or Chinese investors who can take advantage of favourable currency exchange rates.
Recent history: The pandemic and associated work from-home policies have dampened the office market since early 2020. Market participants have remained quite optimistic with regards to employees returning to the office, but recent months have shown that the market is still in employees’ favour. While some institutions such as major retail banks have asked their employees to return, the labour market is so fluid that employees can easily and safely move to more work-from-home friendly companies. It has become so much of a concern that the tax collection revenues of hub cities such as New York or Los Angeles have decreased – whether these are Real Estate taxes or sales taxes from the sale of ancillary goods or services provided to workers on a day-to-day basis.
Vacancy rates have soared to concerning levels and rent growth was in the red until late 2021 but the first half of 2022 has seen some improvements, with positive growth, and a gradual return of employees to offices.
Expectations: The situation seem to have improved since late 2021, with positive growth and better occupancy rates. Lower incentives to tenants have also given a breather to landlords. However, work from-home or flexible employee schedules look like they might be here to stay, and inflation is eating away profits, especially in markets where the expenses are born by landlords. Interest rates going up will also certainly slow down employment, resulting in further decreases in the need for office space. As the Real Estate market is a lagging industry, the market has not yet reacted. However, the market sentiment is mixed, if not negative, on offices. Partly as a result, the financial feasibility of converting offices for other uses is increasingly being explored by developers.