Chart: MSCI global index returns
Global economic outlook
Getting a clear read on the state of global activity is challenging at present. Economies are normalising after the Covid pandemic, and data is providing mixed messages around the current conditions and future direction.
On balance, growth is more resilient than anticipated in the face of a significant and widespread tightening in monetary policy over the past year. As such, near-term recession risks have declined.
In contrast to developed market (DM) resilience, China’s vigorous reopening rebound has proved more fleeting than hoped, and activity is now running at relatively subdued rates. Meanwhile, headline inflation is softening on the back of easing energy and food pressures, but underlying price pressures have been sticky. This reflects sustained excess demand across several sectors and economies.
Central banks have been hawkish in response to this cocktail of solid growth and robust underlying inflation. More interest rate hikes are coming in most DMs, even if we are approaching the end of tightening cycles.
This large and ongoing monetary tightening cycle will ultimately generate recessions in the major DM economies and parts of emerging markets (EMs) too. However, we think the timing has changed and that recessions will begin later, around the turn of the year.
These downturns will engineer a relatively rapid retreat in inflationary pressures. This paves the way for deep interest rate cuts across DMs through 2024, comfortably in excess of current market pricing.
Policymakers in China are already loosening at the margin and could act more aggressively as DM downturns unfold. Other EMs will launch their own cutting cycles once it becomes clear that the Federal Reserve (Fed) has decisively turned.
A scenario approach is critical, given the conflicting signals we are seeing around growth and inflation. Resilient activity could widen the path for a soft landing, especially if accompanied by a recovery in the supply side.
However, there are risks to the downside, too, especially if this resilient growth is accompanied by even stickier inflationary pressures. This would force central banks to tighten even more and engineer deeper downturns to stamp these out.
Table: Global economic forecasts
Source: abrdn July 2023 Forecasts are a guide only and actual outcomes could be significantly different
UK real estate market overview
The UK recorded a significant correction in real estate pricing during the second half of 2022 and into the first quarter of 2023, as the weaker economic backdrop and higher rate environment weighed on performance. However, pricing began to stabilise in the second quarter of 2023, particularly in those areas of the market that saw the greatest capital declines.
According to the MSCI Monthly Index, all property capital value growth fell again in June 2023 by 0.5%. This followed a flat reading in May 2023, and rises of 0.1% and 0.2% in April and March 2023, respectively. Industrials was the only sector that recorded growth during the month at 0.3%. The residential and retail sectors recorded negative capital growth of 0.1% in June 2023. Offices continued to drag on performance, with capital values declining 2.2%.
Total return performance also improved during the second quarter of 2023, with all property posting a total return of 1% in the three months to June 2023. The residential sector led the way with a return of 3.9%. This was followed by the industrial and retail sectors, which posted returns of 2.4% and 2%, respectively. On a three-month basis, all sectors (except for offices, where returns dropped to -2.8%) recorded positive total returns.
While performance improved, transaction activity remained muted in the second quarter of 2023, as investors took a more cautious approach to UK real estate. Transaction volumes were £5.6 billion in the second quarter, down 64% on the same period a year earlier and 63% below the 10-year quarterly average. Limited good-quality investment stock has come to market so far in 2023, which has suppressed transaction volumes. A gap between the pricing aspirations for buyers and sellers remains. Given lower conviction on asset pricing on the back of a weaker macroeconomic environment, we are likely to see a further slowdown in activity during the summer months.
European real estate market overview
We estimate that the European real estate market has seen a peak-to-trough fall in values of roughly 20%. Interest rates set by the European Central Bank (ECB) are now broadly expected to peak at the end of 2024. The ECB is expected to hike a further 25-50 basis points (bps), taking the cumulative hike to between 4.25% and 4.5% since mid-2022. This leads us to believe that we are around three quarters of the way through the yield revaluation phase, and that this pressure will subside as we move through the second half of 2023.
Some markets seem to be lagging the correction, relative to their market risks. We believe Sweden, Finland, Poland, and the Czech Republic will need to see a stronger correction in values from here for pricing to reflect risk.
Our expected turning point for continental European real estate has been pushed back to the turn of this year. This is because of stickier inflation and the higher peak level of interest rates. We are also receiving mixed signals from the listed market. Steep discounts to net asset values (NAV) are taking longer to erode than previously anticipated and debt refinancing issues are weighing on the outlook. Furthermore, fixed income yields seem to have peaked out in this cycle (at 4.2% for BBB-Eurozone corporate bonds, 3.2% for AAA-rated corporate bonds and 2.3% for German long-term government bonds, as at 29 June), but they have not contracted as we had expected. This means spreads have further to widen to restore fair value.
There are signs of optimism returning to the market and some investors are already taking advantage of better entry prices. However, transparency around where valuations truly lie is taking time to come through. We believe that as more fixed-term loans approach the point of refinancing, there will be more willing or forced sellers. We believe there will be another 5-10% fall in asset values in the second half of 2023, taking the total decline to over 25%, in aggregate.
As we move into the weaker economic environment, the pressures in the real estate market will switch to focus on the quality of income and those asset types that are more closely linked to economic trends.
Weaker occupier trends in the sectors most linked to the economic cycle are clear. Logistics and office take-up fell sharply in the first quarter of 2023. Retail has held up above expectations in the face of the cost-of-living crisis, but eurozone retail sales turned negative in May and consumer confidence indices remain close to record lows. Higher mortgage and household loan costs will continue to limit disposable incomes, while excess savings are running lower. As expected, demand in the living sector and supply fundamentals remain strong, with high occupancy rates helping to support consistent cashflows.
Finally, we are monitoring a significant increase in regulation. Firstly, residential rent regulation has increased further. We have also seen revisions to the Plan Local d’Urbanisme (PLU) bioclimatique in Paris, which will significantly affect office holdings in certain areas. Furthermore, the introduction of the European Commission’s Energy Performance of Buildings Directive and the broader European Green Deal will act to accelerate obsolescence. Discussions around the regulation of energy supplies for German residential property, as well as the expropriation laws tabled in Berlin, are back under the spotlight.
APAC real estate market overview
Besides a relatively more benign interest rate outlook, APAC’s office occupier market also appears to be in better shape, compared with its Western DM peers. This is a result of a faster return to office post-Covid (with the exception of Australia). The better outcome in terms of workers returning to the office is mostly to do with structural factors, such as smaller living spaces per person, and a more affordable and efficient office commute in Asia’s key cities. That said, our analysis suggests vacancy risk remains a threat in several office markets over the next three-to-five years. Seoul, Singapore and Mumbai may be the exceptions here.
Property yields in Australia and Korea have risen the most in APAC, especially for warehouses and offices. Investment sentiment is cautious and prices have adjusted, especially in the case of Sydney and Melbourne’s central business district (CBD) offices, and for logistics in Greater Seoul. Yet, recent transactions do not suggest there is widespread distress. In the case of Sydney and Melbourne’s CBD offices, some of the wider discounts to book value transacted could be attributed to asset-specific issues, such as low occupancy and the building’s age. This supports our thesis that a faster price correction in secondary-grade assets will create opportunities for environmental, social and governance (ESG) upgrades.
Occupier market fundamentals guide our preferences, and we are most positive about certain aspects of the market. These are highlighted below.
Seoul offices: Occupier market fundamentals remain solid, with record-low vacancy rates amid limited near-term supply and robust leasing demand. Domestic information and communication technology firms have been particularly active in leasing additional space. While the supply pipeline is expected to pick-up in four-to-five years’ time, we expect vacancy rates to remain tight relative to history, even by conservative assumptions.
Australia’s industrials and logistics: Record-low vacancy rates in many cities, at 1% or less, will continue to support rental growth, albeit at a slower pace. We also expect expanding yields to translate into more attractive entry points for investors as interest rates continue to climb.
Singapore’s industrials and logistics: Limited near-term supply and robust demand for modern ramp-up facilities are supportive of further rental growth, despite a weak external environment for trade. This remains one of the few markets where the yield still offers an attractive positive carry to borrowing cost, even though it comes at the expense of a shorter land tenure.
North American real estate market overview
Since our last outlook at the start of April 2023, the North American real estate market has continued to deteriorate. As at the time of writing, transaction volumes year-to-date are down 61% year-on-year. This now outstrips the period of decline at the beginning of the pandemic. Activity fell during the pandemic because of uncertainty, but it’s now falling because financing is restricted.
In light of higher-for-longer interest rates, we also expect further cap rate expansion from the more tightly wound sectors, such as industrials and multifamily.
Transaction-based cap rates for these sectors rose on average by around 30 basis points (bps) quarter-on-quarter, with the most significant yield shifts coming from Inland Empire industrials and Los Angeles industrials.
This is not a surprise as the West Coast has lost a significant amount of ship and freight traffic because of union negotiations at ports. Most distributors have shifted inbound shipments into the Gulf and East Coast ports, given fears of disruption or a potential strike. This has boosted demand in the port markets and surrounding logistics hub markets, such as Atlanta and Dallas.
Research from Real Capital Analytics suggests that we are also about to see a substantial amount of distress from the US real estate market, especially in the office sector. We are expecting around $42 billion of potential distress in offices. This is followed closely by the retail sector (mostly malls) and the multifamily sector, with around $30 billion of potential distress. This pressure is unlikely to be alleviated through refinancing, so sales at discounted prices are anticipated in the second half of 2023.
Distressed opportunities within the multifamily sector might occur in select areas. In a scenario where refinancing interest rates for interest-only loans increased to 5.5%, the Washington-Arlington-Alexandria and New York-Newark-New Jersey areas have the highest percentages of multifamily properties going under a 1.25% debt-service-coverage ratio (at 43.7% and 28.9% of loans, respectively).
In the retail sector, we are seeing a streak of positivity in terms of strip mall retail. Demand for retail space has outpaced net deliveries for eight consecutive quarters so far and supply does not seem to be picking up to levels that will satisfy demand. Vacancies are now at record-low levels within small- to mid-sized strip centres and freestanding single-tenant properties.
Global market summary - outlook for risk and performance
Performance in the global real estate market remains challenging as prices continue the correction that started in the middle of 2022. Prices have been declining in response to the rapid increases in global interest rates that were consequently put in place at the start of last year to help dampen inflation.
In the current environment of declining real estate prices, investors are taking a cautious stance towards the market and there remains a gap between buyer and seller expectations. We are beginning to see some signs of positivity in the market, though – particularly for the industrial, residential and alternative sectors, where the current fundamentals are more resilient.
We anticipate that we are approximately three quarters of the way through the current correction. We expect a broader market recovery towards the end of the year, when the central bank tightening cycle is likely to have run its course and policy makers are expected to reduce interest rates.
In this environment where demand is subdued, resilient income and tenant strength will be the focus as recession hits demand. We aim to target good-quality occupiers with a strong credit rating in this phase of the cycle. Polarisation between good- and poor-quality assets remains elevated and is becoming more pronounced as investors continue to target good-quality assets with strong ESG credentials. Poor-quality assets in sectors with weak fundamentals – such as the office sector, or lower-quality parts of the retail sector where leasing demand is subdued and vacancies are rising – are expected to underperform.
A key risk to our outlook is that inflation remains stickier than the market currently expects and that interest rates rise further. This would lead to further price decreases for real estate than we currently expect.
Table: Global conviction themes and portfolio tilts
Chart: Global total return forecasts from June 2023