Curlow's convictions: A good vintage to be a lender

Awaiting the peak of the rate cycle as inflation and growth start to moderate. The Eurozone, led by Germany, is already technically in recession and recent inflation prints across Europe are starting to show signs of moderating – albeit not universally across the board with the UK proving stubborn. Central bank communications suggest there is yet more tightening to go in Europe and the UK, but in the US the Fed has paused for the first time this cycle. This follows what was an unprecedented rise in terms of both pace and quantum, however, it too is unlikely finished. Property fundamentals have been holding up well on the back of strong economic performance, so the correction thus far remains centred on the capital market and yield portion of the valuation equation. If an economic slowdown were to gather pace, we would expect this rate pressure to subside, and valuations to be more impacted by changes on the income side of the ledger as property fundamentals would likely weaken.

Growing evidence proving the importance of green credentials for both occupiers and investors. There is increasing evidence from office markets around the world highlighting the higher rents, shorter lease up timing and premiums being paid for green-accredited assets. Furthermore, market participants are becoming more sophisticated in their understanding of local rating nuances which are not consistent across the globe and in the continued blurring of real estate and infrastructure, energy sources alongside building specifications are being considered more holistically. There are growing considerations around ‘cold’ vs ‘warm’ rents in the multi-family/PRS space following the spike in energy costs and the cost-of-living crisis facing households.

Transaction levels remain low in a historical context, but values continue to adjust. It has been interesting to note the more proactive approach valuers have been taking this cycle, where they appear to take into consideration deal anecdotes from their capital markets team even if deals do not ultimately complete. This has resulted in the fastest repricing cycle the UK market has ever experienced and should lead to a swifter recovery in deal flow as the bid-ask spread narrows and pricing stabilises. Elsewhere we continue to see values correct but as these declines moderate some investors are beginning to make new equity commitments in an effort to time their capital calls with an anticipated bottoming of the market.

Higher rate environment translates to higher borrowing costs. Real estate continues to grapple with negative gearing – the key exception being Japan. But the lack of interest from banks is leaving a widening gap in the market for alternative funding sources to fill at a good point in the cycle, as values continue to correct, LTVs are lower and lending margins have widened. This is likely to prove to be a strong vintage in terms of collateral performance and risk reward for real asset debt investors.

Banking sector stress and CRE defaults coming in the US, but likely to be more limited in Europe. There are stark variations in commercial real estate lending landscapes across Europe and the US. While the European market continues to be heavily reliant on banks for both their origination capability and lending capacity the overall European banking sector is less exposed to CRE at 7.3% vs 12.6% for large US banks. Furthermore, Europe doesn’t have the same level of leverage in the system, nor the office sector issues that the US banking sector is heavily exposed to. That said, both regions are seeing rising defaults and loan modifications but the situation in the US is expected to prove more significant in terms of ultimate default and losses. Finally, the capital flight which the US regional banks have seen into the larger money centre banks is also not expected to spill-over to Europe as the EU directive to maintain a failing bank as a ‘going concern’ should support depositors.

The office sector is at the heart of the US banking sector struggles. The US office sector is grappling with behavioural changes supported by larger homes, good high speed internet connectivity and long arduous commutes – largely done in an automobile at a time when gas prices have seen a notable increase. These dynamics combined with a strong labour market are what is behind the low US office re-entry rates, which remain amongst the lowest globally at only 40-50% compared to about 70% in Europe and 80% in APAC. The US office sector is also highly exposed to the tech sector, which is seeing particularly low levels of return to the office, and therefore a large amount of office space is being put on the sublease market. When combining this second-hand space with the new supply wave that is expected to continue to deliver through early 2024 across US cities, we are seeing vacancy rates spike in the US, with levels already approaching 20% and unlikely to peak until 2024/25.

We continue to expect the defensive segments linked to long-term megatrends to outperform. Given the expected valuation pressure movement from the denominator (i.e., yield) to the numerator (i.e., income) side of the valuation equation, we continue to focus on segments that are underpinned by demand-side tailwinds. The beds and sheds theme along with emerging niche segments remain well positioned, although affordability considerations are a key differentiator. For example, while both the multi-family/PRS and industrial/logistics segments benefit from strong underlying fundamentals and a supply/demand imbalance that supports strong rental growth pressures, industrial/logistics tenants have a higher propensity to absorb rental growth and inflation indexation because rent payments typically reflect a meagre 3-7% of their overall supply chain costs. By contrast, residential occupiers are seeing rental payments approach, if not exceed, the critical 30% level where affordability becomes a concern – this is before considering the wider cost of living pressures households are facing in the current inflationary environment. While the retail and hotel segments saw a strong rebound in performance during 2022 and H1 2023, we are cautious on the sustainability of that performance given the expected macro-economic headwinds.