Year of the Rabbit
Rabbits communicate using facial muscles: signs you wouldn’t notice if you weren’t looking out for them. Much like the buck, Fiver – the deuteragonist in Watership Down – forecasters have painted an alarming outlook for the real estate sector in the Year of the Rabbit which begins on January 22nd. Fiver had the ability to intuit the future, and we attempt to summarise major Banks real estate forecasts in this note who attempted to do the same.
Forecasts from Oxford Economics were not cataclysmic, commercial property in the U.S. is expected to produce an average total return of -2.2% in 2023 and in the UK of -3.0%, although these figures are lower than the 4.2% and -2.2% returns respectively in 2022. There are also some relative bright spots, with U.S., retail and hotel property expected to generate positive returns of 1.8% and 1.2%. Residential property is expected to see the most negative returns in both countries at -5.0%.
Much will depend on whether investors with firepower decide to enter the market. Peel Hunt estimate that European private equity firms have around €270bn of capital ready to acquire London-listed companies this year, provided the debt markets are supportive. They are adamant that “the sheer weight of dry powder, following a period of record fundraising, demands the deployment of capital” the broker said. Elsewhere we note however the LSE raised 90% less in 2022, raising just ￡1.6bn, compared to ￡16.3bn in 2021, so find this thesis slightly optimistic, and which also likely explains the explosion of convertible bond instruments last year, which allows companies to borrow at lower interest rates than a traditional bond, without immediately diluting existing shareholders’ stakes through the sale of new stock.
With many listed companies having traded at substantial discounts to net asset value for a prolonged period, the sector is certainly in the spotlight, but Credit Suisse advocate prudence in the face of a ‘fundamental reset in macroeconomics and geopolitics'. They prefer listed real estate in the USA to Europe where valuations reflect the challenging outlook for property markets. With Property Market Analysis expecting property values to fall between 15% and 20% across all sectors by the end of 2023, investment opportunities may only emerge in 2024. They highlight the undemanding valuations on Swiss real estate funds, with their premia to NAVs now down to levels last seen during the Global Financial Crisis.
Wells Fargo are not keen to get back into the REIT sector whilst there is a recession on the horizon and Treasuries are at attractive yields. Selected sectors are favoured: self-storage, retail and data centre REITs; with unfavourable ratings on residential (apartment, single family home and manufactured homes), office and health care REITs.
HSBC are anticipating further real estate capital declines on top of the 10-15% fall in the US and Europe in Q3 2022 reported by Green Street Advisers. As the spread with bond yields remains historically low, despite the rise in property yields, they fear further declines in property values.
The sharpest corrections so far have been recorded in sectors that used to be the most sought after, where property yields were the lowest and which still have the strongest long-term outlook for rental growth and occupancy. This is most apparent for the logistics and residential sectors as strong competition between investors for the best assets often implied record low yields and the use of leverage.
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Deutsche Bank also expect the real estate sector to go through a rather ‘fragile transition period’ that will potentially last one to two years but see ‘interesting opportunities’ in the logistics segment.
Citigroup concur on logistics, citing no end to the e-commerce revolution. They estimate that global e-commerce sales have increased 133% over the past five years. As online transactions require three times the warehouse space of traditional retail. They estimate that as much as 2.1 billion square feet of additional e-commerce-dedicated logistics space will be required globally over the next five years to support the growth of internet sales. They conclude that whilst the industrial market is not immune to increased financing costs, nor to slowing growth, the long-term outlook for the sector remains positive.
In the bed sector, ING expect markets to correct in 2023 due to aggressive rate hikes from the European Central Bank, with prices only stabilising at the end of next year, but low unemployment, fixed-rate mortgages and housing shortages are expected to limit the decline in prices to about 5-10% which would still leave prices well above the pre-pandemic level.
The inverted yield curve (when interest rates on long-term bonds fall lower than those of short-term bonds) points to weakness ahead, but whilst Morgan Stanley believe that they indicate that a slowdown will occur at some point in the future, they do not believe that they are a good predictor of when a slowdown will occur. Timing the recovery in the market is therefore difficult, which is crucial as U.S. REITs have historically underperformed U.S. equities during periods of large interest rate increases but have outperformed three, six and 12 months after a significant rise in interest rates.
They have a bearish stance on offices, citing uncertainty over future office absorption due to work-from-home policies and increased layoffs and hiring freezes. A recovery in credit and lending markets is anticipated, with roughly $400 billion of undeployed capital on the side-lines. They also expect to see an increase in M&A activity, which may be favourable for REIT investors. Companies without a sufficient capital expenditure plan devoted to sustainability projects are expected to struggle with the sector heavily impacted by business, government and investor goals to achieve carbon neutrality by 2050.
Barclays conclude that cash will be the real winner of 2023, with US front-end yields likely to go to 4.5% or higher and stay there for several quarters. The ability to earn over 4% while taking virtually no risk is a factor that is likely to drag on all investment markets next year.
Apollo (the only non-bank referenced in this note) predict that 2022 sounded the death knell for the classic 60/40 portfolio split between equity and bonds and that investors will turn to private markets in 2023. They see a ‘historic entry point in private credit and attractive opportunities in private equity for investors able to be providers of capital in a time of stressed and distressed markets’. Prices of real estate and infrastructure “should retain support as investors continue seeking inflation hedges.”
"Rabbit holes are inevitable. It's how you hop over them that will define your success" Anthony Scaramucci writes jarringly honestly in his biopic Hopping over the Rabbit Hole published shortly before entering the White House. Clearly the Year of the Rabbit will require investors to spring over the economic potholes expected in 2023, but one can’t help thinking there are still secular tailwinds buoying certain sectors, and capital will return to private markets.