Curlow's convictions: 2024 shaping up to be a good vintage

Long awaited rate cuts to arrive: Financial markets have responded aggressively to central bank guidance that the peak of interest rates is likely behind us. This comes amidst a macro backdrop of slowing inflation and softening economies. While the timing and quantum of rate cuts vary between the two, consensus has been reached that rate cuts are forthcoming with financial markets seeing a notable repricing of the yield curve in December 2023. While we anticipate an easing of rates to begin by mid-2024, we are more closely aligned to the Fed's guidance of 75bps compared to the 150bps expected by the market. Regardless of where we ultimately end up, this is welcome news for real assets as subsiding rates will support values whilst the mild economic slowdown shouldn't significantly disrupt the generally healthy fundamentals. 

Property value correction nearly complete: A softening in rates should support a stabilisation in property values from mid-2024 following the notable pricing declines we have seen over the past 12 to 18 months. The correction in pricing has been swiftest in the UK and Continental Europe, where yields reached the lowest levels, but there are encouraging signs of positive leverage returning to parts of Continental Europe which support pricing equilibrium being reached. We expect this stabilisation in European real estate values to be reached by mid-2024. In the US, the correction in values is lagging due in part to the stresses occurring in the US office sector where market pressures are most acute, and both borrower and asset level distress is growing but limited transactional evidence is stifling price discovery. As property prices complete their value correction and equities and fixed income markets recover on the back of the softening in monetary policy, we expect the denominator effect pressures that many multi-asset class investors faced in 2023 to subside and renewed investment allocations to the sector will further support a rebound in deal flow.

US office sector is focal point of distress: Most property markets and sectors entered this cyclical correction from a position of strength with balanced underlying fundamentals. Occupier demand for high quality assets remained strong and availability relatively modest. The key exception is the US office sector where the nuanced dynamics have pushed vacancy rates higher. Limited office re-occupancy post COVID combined with a more active speculative supply pipeline have been exacerbated by sublease space coming online from tech occupiers, leading to a spike in the vacancy rate north of 20%. This dysfunctional occupier market combined with higher leverage is leading more and more asset owners to default on their mortgages and give the keys back to lenders who are not yet equipped with the human capital to manage these loan workouts. The US office sector is therefore likely to be the prime hunting ground for distressed investment opportunities this cycle.

Sector nuance coming to the fore: Stabilising yields should see property performance become more driven by the numerator of the valuation equation (i.e., income) than the denominator (i.e., yields) - the latter of which having been the dominant force over the past few years. This performance dynamic amidst a softer economic backdrop will place sector nuance under greater focus as rent growth and net operating income resilience is likely to become the key performance differentiator. We anticipate the defensive and alternative/niche sectors which are underpinned by long-term thematics (i.e., digitalisation, decarbonisation, urbanisation, etc) to continue to outperform given their demand side tailwinds. That said, the significant correction which the more pro-cyclical retail and hospitality sectors have undergone during the pandemic means they will be well positioned to ride the road to recovery should this cyclical slowdown turn out to be short-lived. Strong underlying operational performance over the past few years must not be ignored as we may see attractive re-entry points emerge in these recently challenged sectors. Diversification may prove important to manage the risk of these combating thematic narratives.

ESG, health and wellbeing considerations remain key: Occupiers and investors (debt and equity) alike have seen ESG, health and wellbeing considerations catapult themselves up the priority list for both space planning and investment decisions. As more data emerges, it is becoming clear that a higher rent is achieved, less lease up time is required and better pricing applied by investors for accredited assets. What is less quantifiable but anecdotally clear is also the greater level of interest, and therefore liquidity, as more occupiers require certifications for buildings to be considered for occupation and both lenders and equity investors insist that either certifications are in place or capital expenditures under-written in order to consider investment. Improving the growing level of obsolescence in existing stock along with new ground up development to cater to this change in occupier requirements will provide a wave of investment opportunities over the coming years but also be a drag on some legacy assets where cap-ex reserves were not adequately funded. 

Sweet spot to be a lender but transaction volumes likely to gather pace through 2024: We are currently in the sweet spot of the property cycle to be a lender. The repricing of assets, combined with more modest loan-to-value ratios and wider lending margins means lenders are currently benefiting from outsized risk-adjusted returns. Furthermore, the more limited competition means debt investors have an opportunity to be more selective when choosing which investment opportunities to pursue and can also dictate stricter lending terms. The listed sector has also been a chronic underperformer relative to the wider equity market but it looks well positioned to recover and outperform on the back of more accommodative monetary policy. As valuations bottom out and positive leverage returns, we would anticipate a recovery in direct equity transaction volumes to gather pace through 2024. The current lending opportunities which remains centred on the much-publicised loan maturity wall is likely to be expanded to include growing demand for new originations as equity transactions gather pace over the course of the year. 2024 is likely to prove to be not only a good vintage for property lending but also the turning point in equity investment performance.