- We are close to the end of the interest-rate hiking cycle that has reset global real estate pricing.
- We expect a modest decline in global real estate prices, with markets close to stabilising.
- The macro-economic environment is expected to be subdued over the near-term, so we are focused on tenant strength and income resilience.
MSCI global index returns
Global Real Estate Outlook Chart 1: MSCI global index returns
Source: abrdn October 2023
Global economic outlook
The US economy remains remarkably resilient, with the rate of growth accelerating over the summer. We think robust consumer and business balance sheets and a strong labour market can extend the expansion into 2024. Moreover, the run-rate of headline and core inflation has slowed significantly. We expect further disinflationary pressures from goods and housing prices, even if recent energy price developments may slow this dynamic.
That said, in our baseline forecasts, we expect a US recession to begin around the middle of next year. With wage growth still elevated, a more pronounced slowing in the labour market remains necessary to fully restore price stability. Moreover, bank credit conditions have tightened to levels consistent with a recession, industrial surveys point to weaker activity, and labour demand is slowing. This reflects an increasing drag from earlier Federal Reserve (Fed) tightening that will continue to grow, especially as household saving buffers run out.
In the near term, the combination of strong activity data and soft inflation allowed the Fed to leave rates on hold in September. There is a good chance of a final rate hike in November, given the strength of economic activity and the Fed’s desire to avoid risking the progress that has been made on inflation. But the bigger picture is that the hiking cycle is drawing to a close and there will be a pause in rates for a time. However, we think the Fed will be cutting interest rates from mid-2024. This could be to as low as 2% in 2025, which is below the neutral rate. Beyond the baseline scenario, strong growth and ‘immaculate disinflation’ in 2023 have increased the probability of a US soft landing. This is the biggest upside risk to the global economy and would see interest rates remain higher for longer.
By contrast, the Eurozone economy is very close to, or already in, recession. This is a result of the European Central Bank’s (ECB) monetary policy tightening, an incomplete recovery from the energy price shock, and the weak global industrial cycle that is hurting European exporters. Indeed, Germany’s energy-intensive, goods-exporting, China-orientated growth model is under an enormous amount of pressure. Recent industrial production data is consistent with a significant economic contraction.
Both headline and core Eurozone inflation should fall further as the economy cools and as energy base effects remain favourable. We think the ECB is at the end of its rate-hiking cycle. While the ECB and central banks in all developed markets will signal an extended period of tight policy to keep a handle on financial conditions, we expect an easing cycle during 2024.
The UK economy is also facing mounting headwinds, as the Bank of England’s interest-rate hikes start to weigh heavily on activity. Economic growth seems to have slowed sharply over the summer, with the labour market starting to crack and house prices falling more rapidly. We anticipate the start of a recession later this year.
However, the UK’s unique series of negative supply side shocks mean that, even with growth weak, underlying inflation will remain stickier than elsewhere. After a final rate hike in September, we expect rates to be on hold for some time. However, by the middle of next year, progress on returning inflation to target and broader economic weakness should allow for a sustained easing cycle to begin, albeit slower than in other economies.
Global economic forecasts
Global Real Estate Outlook Table 1: Global economic forecasts
Source: abrdn October 2023 Forecasts are a guide only and actual outcomes could be significantly different
UK real estate market overview
UK real estate pricing has stabilised during 2023, following the significant correction in the sector in late-2022. However, performance has been asymmetric across sectors, with those benefiting from structural and thematic tailwinds proving more resilient in the face of a weaker macroeconomic environment.
According to the MSCI monthly index, all property recorded capital value growth of -1.6% in the third quarter of 2023. The industrial and residential sectors led the way with positive growth of 0.5% and 0.3%, respectively, over the quarter. Conversely, the office sector continues to drag. It recorded capital growth of -5% in the third quarter of 2023, as the sector struggles with changing working habits and a higher-rate environment.
Total return performance has also improved, with All Property recording returns of -0.2% in the third quarter of 2023. The residential sector led the way at 1.8%. Over the previous six months, total return performance has been positive for most sectors. Offices were the exception and recorded a -6.4% return in the six months to September 2023.
While performance has shown tentative signs of stabilising, the investment market has remained muted. Investors have taken a risk-off approach towards the sector. In total, there have been approximately £24 billion worth of UK real estate transactions so far this year (to the end of September), according to Real Capital Analytics. This is 54% lower than the same period a year earlier. It demonstrates slower investment volumes, as investors have stepped back from the market. Investor appetite has remained robust for industrial assets, which accounted for 25% of total transaction volumes. Demand for the living sector continues to grow, making up 21% of volumes so far this year (to the end of September), versus just 6.7% in 2013.
However, a lack of good-quality investment stock being brought to market has helped to suppress transaction volumes so far this year. In many cases, asset holders remain unwilling sellers, given the significant disconnect that exists between buyer and seller aspirations. As a result, investors who are not required to sell at this point are unlikely to do so before an improvement in the wider macroeconomic environment.
Given the market backdrop, there is little indication that activity will substantially improve over the remainder of the year. Greater activity is likely to be prompted by further clarity on the direction of UK monetary policy. However, given the threat of rates staying ‘higher for longer’, and a significant number of debt maturities due in 2024, greater transactional activity may be spurred by pockets of stress forming.
European real estate market overview
Since our last outlook report in July, the real estate market has moved another quarter further through the correction. The current valuation correction entered its 16th month in October and has proven to be more painful than the Global Financial Crisis. As such, European real estate has endured a lot of pain already.
All eyes remain on inflation and central bank decisions. Inflation has cooled to 4.3% as at September 2023. Having increased by 25 basis points (bps) in September to reach a record 4%, the ECB deposit rate is likely to have now peaked. We believe this negative pressure on yields has probably plateaued.
The debate has now shifted to the shape of the rate outlook and whether we will have a ‘Table Mountain’ or ‘Matterhorn’ interest-rate cycle from here. There are some downside risks to rates: inflation is cooling, the Eurozone manufacturing purchasing managers’ index data fell to 43.3 in September, and Germany’s economy is contracting.
With a significant value correction already behind us, the question is when not if sentiment will improve. If growth remains resilient and interest rates are held at 4% for longer, then European real estate should show some resilience. This is because of the strength of underlying cashflows and income growth. If the macroeconomic backdrop weakens and inflation falls, then interest rates should also fall. This would improve the relative attraction of good-quality real estate. The cost of debt should also moderate, but this is unlikely to ease the pre-existing refinancing challenges that are hampering the market. Whichever outcome prevails, the outlook for the asset class is likely to improve during the first half of 2024.
Markets that have lagged the re-pricing are now catching up. Sweden was the weakest market in MSCI’s Pan-European Funds Index for the second quarter of 2023. It had a quarterly return of -5.9%, compared with -1.0% for All Property. Spain and Finland delivered positive returns over the quarter at 0.5% and 0.1%, respectively. However, more current datasets in the third quarter show that these markets are now falling, too. According to CBRE, Finnish yields moved out by 25 bps in August. In Spain, Madrid’s central business district (CBD) and Barcelona’s office yields moved out 25 bps and 35 bps, respectively, in September. Central and Eastern European (CEE) markets, including Poland and the Czech Republic, are also now catching up, with 25 bps increases across their key office markets in September.
There are signs of optimism returning to the markets that have corrected and some investors are already taking advantage of better entry prices. However, broader confidence in where valuations truly lie is taking time to come through. As more fixed-term loans approach the point of refinancing in the coming quarters, better prices will emerge and the gap in expectations will narrow.
As we move through the cycle, the pressures will switch to quality and security of income. We are currently seeing various measures of tenant risk starting to rise, such as insolvencies, vacancy rates or tightening credit standards. This means we expect a greater dispersion in performance between prime and secondary property.
Finally, the one differentiating factor this cycle is the low level of supply coming through in the next few years. After a decade of low activity, renewed developer caution, 20-to-30% higher construction costs, labour constraints, and uncertainty around exit values, the supply pipeline has stalled. Germany reported a 36% year-on-year fall in housing permit issuance in August, UK office development starts hit a 22-year low in the first half of 2023, and the outlook for office completions in Europe is less than 0.7% per annum of existing stock. Insolvencies in the construction sector are spiking sharply in many countries. Even if permits increase, the capacity to deliver new projects in the future is likely to be restricted until the economy picks up. Low supply offers significant upside risk to rental growth expectations, in our opinion.
APAC real estate market overview
The Chinese economic slowdown will have an impact on the occupier fundamentals of most markets/sectors, given the drag on the global economy. We think prime office and retail real estate in Hong Kong, and prime retail properties in Tokyo, may be most vulnerable. This is mainly because of above-average vacancies and the occupier markets’ historical correlation with external growth.
Apart from properties in Australia and Korea, yields in most APAC markets have barely moved since the end of 2021. We expect yields to move out in the next 12-18 months. While logistics properties in many markets will likely see higher yields, the negative impact on capital values should be mitigated by further rental upside.
Following the yield-curve adjustment in July, the market is sensitive to comments from the Bank of Japan and is biased towards hawkish interpretations. While further policy tweaks are possible, our base case is that overall policy settings in Japan are likely to remain accommodative. Consequently, we expect any adjustment in the Japanese commercial real estate market to be gradual, even if the long-term yield rises to 1%.
Occupier market fundamentals guide our market/sector preference and we are most positive about the following:
- Seoul’s offices:occupier market fundamentals remain solid. Vacancy rates remain low amid limited near-term supply and robust leasing demand from domestic information and communication technology firms. While new supply is expected to pick up in the next four-to-five years, we expect vacancy rates to remain tight relative to history.
- Tokyo’s multifamily:the robust rebound in net migration into Tokyo is likely to continue, which should keep vacancy rates tight and support further rental growth. The widening rental premium, based on the building’s age, has strengthened the investment case for value-add investment strategies.
- Australia’s industrial/logistics:record-low vacancy rates of 1% or less in many of the capital cities will support rental growth, albeit at a slower pace. We expect the expanding yields to translate into more attractive entry points for investors as interest rates climb.
North American real estate market overview
As we head into the final quarter of this year, there is some light at the end of the tunnel. We have seen inflation slowing down and we expect another rate hike in November to end the cycle, followed by rate cuts in mid-2024. Although we expect interest rates to remain elevated for a bit longer, yield expansion is starting to slow down across sectors. That said, we are finally seeing valuation data more accurately reflect office assets in the market.
The most recent evidence of the lack of conviction in a full return to the office comes from Chicago’s Aon Centre’s latest valuation. Its value is now $414 million, a 47% drop from when it was first appraised.
Distressed opportunities within the multifamily sector could take a while to play out. But opportunities should be most prevalent where smaller investors, with a value-add focus, have bought over the past two years. This is predominantly the Sunbelt, but traditional gateway markets, such as New York, have not been spared either. After September, seven loans from Emerald Equities’ 28-property portfolio across the Bronx transferred to special servicing.
In the retail sector, we are still positive about strip retail. That said, we are cautious of the near-term risk of falling consumer confidence and consumption, as households brace for the return of student loan repayments.
That said, student loan repayment worries may not have a big effect on the larger economy. More comprehensive measures of household finances, such as cash-in-hand and a rise in home equity, suggest that the finances of many American consumers could be more resilient than expected.
Global market summary – outlook for risk and performance
As we move past another quarter in the real estate market correction, we anticipate there is only a modest decline in prices left to play out. Investment activity remains very subdued, but there are signs that sentiment is improving. This is particularly the case for the industrial, residential and alternative sectors, where the current fundamentals are encouraging. Uncertainty remains high, although it has been exacerbated by ongoing geopolitical concerns. How events materialise from a macroeconomic perspective will be key to the future dynamics in the real estate market. There is an ongoing debate as to whether we will have a ‘Table Mountain’ or ‘Matterhorn’ interest-rate cycle from here. The abrdn Research Institute’s view is that the US will experience a recession in the middle of next year. Rates are likely to fall, as a result, which will help to bolster real estate’s relative pricing.
Global conviction themes and portfolio tilts
In this environment where demand is subdued, tenant strength and income resilience 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. It is becoming more pronounced as investors continue to target good-quality assets with strong ESG credentials, which are likely to meet future tightening environmental standards. Poor-quality assets in sectors with weak fundamentals are expected to bear the brunt of the corrections in value. This includes the office sector or lower-quality parts of the retail sector, where leasing demand is subdued, and vacancies are high and rising. A key risk to our outlook is inflation remaining stickier than the market expects and interest rates having to rise further than we anticipate. This would lead to further price declines for real estate.
Global Real Estate Outlook Chart 2: Global total return forecasts from September 2023
Source: abrdn October 2023
Forecasts are a guide only and actual outcomes could be significantly different.