Clarion Partners explores the challenges and opportunities within real estate, noting that commercial real estate has seen favorable performance during past periods of rising interest rates. ClearBridge Investments shares its outlook for infrastructure—which is still facing COVID-19-related impacts—in light of rising inflation and bond yields.
Tim Wang, Ph.D.
Head of Investment Research
Clarion Partners
Bruno Berretta
Vice President, European Market Research
Clarion Partners
Tim: As the Fed aggressively tightens financial conditions to curb inflation, we believe 2023 will be challenging, given high interest rates and the risk of a recession. There are still significant positive tailwinds, however.
Consumer spending, labor markets, business activity, corporate balance sheets, and the banking system have all continued to be relatively healthy, with much lower leverage than before the GFC. Depending on how quickly inflation responds to the Fed’s tightening, several possible economic scenarios could play out over the next year or two. Nonetheless, we do not believe that the coming downturn will be as severe as the GFC.
Moody’s Analytics’ baseline forecast for US economic growth is generally positive, with an estimated 6.6 million new jobs from 2022 to 2024.
Historically, US commercial real estate (CRE) investment performance has reacted favorably in periods of rising interest rates. Because of strong job growth and overall demand for commercial space, property cash flows have remained relatively healthy. While some property sectors, such as office and mall, have not fully recovered from the pandemic impacts, other property sectors, like industrial, apartment, life sciences and self-storage, have reported sizable ongoing rent growth.
In addition, there is a manageable level of new supply, especially since elevated construction costs and supply chain disruptions present additional headwinds for new development projects. Geographically, high-growth markets with 18 Global Investment Outlook: Finding opportunities in 2023 after a (un)forgettable market year thriving industries, business-friendly policies, and strong
demographics have also seen robust investment performance, given the strength of underlying demand fundamentals. Steady migration and corporate relocations have led to outperformance in many “sun belt” metros and select, premier suburban areas. Of course, not all sectors or markets will experience strong performance, so knowledgeable guidance is imperative.
Tim: We believe that the combination of higher inflation and rising interest rates will likely have a material yet varied impact on the US CRE market in 2023. There have been some disruptions across real estate debt and equity capital markets. Ten-year financing costs have risen by approximately
200–250 basis points (bps)19 year-to-date (through mid- November 2022), and higher financing costs, along with tighter lending standards, have added some upward pressure
on capitalization (cap) rates and downward pressure on property values. Clarion Partners expects cap rates to expand; the magnitude, however, will depend on various factors. The risk profile of individual assets (sector type, market and lease terms) will matter significantly. High-quality assets with strong net operating income (NOI) growth should fare relatively better.
There is a substantial amount of “dry powder” on the sidelines that seeks to be invested in CRE. At the same time, most property owners are not over-leveraged and are under little pressure to sell right away. For these reasons, we believe that it is likely that the transaction market will remain slow and repricing will not be as severe as during the GFC. The pace of property NOI growth (a positive) and cap-rate expansion (a negative) will determine property value adjustments.
Tim: Looking into 2023, Clarion Partners believes that investors should take a long-term view during this period of uncertainty. The current macro risks and market dislocations may create attractive buying opportunities over the next 12–18 months. In the long run, we believe that, for many investors, an adequate allocation to CRE makes sense, as it has proven to be an effective inflation hedge historically and can offer portfolio diversification benefits.20 As CRE transitions into the next market cycle, we also think positioning portfolios for better risk-adjusted performance is important, with an overweight to property sectors and markets that have strong pricing power and can grow cash flow over time.
Bruno: In 2023, the disruptive social, economic and financial events that dominated 2022 will manifest themselves through various channels and various degrees in the European commercial property market. The sharp increase in interest rates aimed at tackling rising inflation resulted in a 325–350 bp increase in the cost of debt financing for prime property between the fourth quarter of 2021 and third quarter of 2022, triggering a correction in property yields and values. We expect values to continue to adjust during 2023 until the market finds a new equilibrium.
The yield shift is likely to impact low-yielding sectors more proportionally. However, ultimately, the extent of the correction will depend on the risk profile and NOI growth prospects of each individual asset. With inflation expected to remain elevated in 2023, the Consumer Price Index indexation most European commercial leases have written into contracts may partly offset the negative impact of rising cap rates on values.
The increased chances of recession weigh negatively on the European occupational market outlook, but there are reasons to be cautiously optimistic. The European corporate sector is generally in better shape than it was pre-GFC, for example, and most European countries are expected to experience only a mild technical recession during 2023. Sector-wise, property types such as logistics continue to There is a substantial amount of “dry powder” on the sidelines that seeks to be invested in CRE. At the same time, most property owners are not over- leveraged and are under little pressure to sell right away. For these reasons, we believe that it is likely that the transaction market will remain slow and repricing will not be as severe as during the GFC.
Global Investment Outlook: Finding opportunities in 2023 after a (un)forgettable market year boast excellent market fundamentals and to benefit from numerous structural tailwinds. Across the board, elevated construction costs and rising exit yields are challenging new development projects, curtailing the amount of new supply that will come to market over the next year or two. This may help prevent oversupply even if demand faltered. That said, we believe a weak economic outlook is only likely to exacerbate pressures on sectors like Grade B offices and non-essential retail—adding to the existing challenges of changing shopping and working patterns.
For all the above-mentioned reasons, 2023 is likely to be a challenging year for European commercial property. Yet, we believe the ongoing repricing will present attractive buying opportunities for investors ready to deploy capital.
Source: gio-4q22-1222-a.pdf (widen.net)
