Curlow's convictions: Outlook 2023, learning to live with higher rates

Challenging macroeconomic backdrop: Central bank delays in tightening policy to combat inflation has put them on the back foot leading to a swifter and more significant rate rise. The ultimate terminal rate remains elusive with a growing divergence between market expectations and central bank guidance. While the terminal rate is uncertain, the impact on growth is much clearer: economies are slowing as consumers and businesses digest the impact of higher rates on their finances. All the while inflation continues to bite, and governments lack the fiscal headroom post pandemic to enact growth supportive policies. A potential solution to spur growth could be to accelerate privately funded infrastructure projects given the weight of institutional capital seeking to be deployed into this asset class. In Europe, an accelerated renewable energy push to become less reliant on foreign sources is likely to gather pace.

It all started with a violent rise in the cost of financing: This macro backdrop led to a stark increase in the all-in cost of financing during 2022 which was so rapid in its pace and ultimate quantum that it quickly led to a negative leverage scenario across nearly all markets and sectors. However, the impact on valuations and yields quickly gathered pace in the fourth quarter of last year and should carry through the first half of 2023 before an equilibrium can hopefully be reached and liquidity return in the second half of the year – albeit at a discounted valuation.

Investment volumes fell off a cliff in H2 2022 and will likely remain low through H1 2023: Given the relatively swift and notable rise in the cost of borrowing we have seen a dramatic fall off in real estate transactional activity during the second half of last year. As most market participants expect value declines to continue during the first half of 2023, we are not expecting a notable rise in investment volumes until this valuation cycle runs its course. The most active segments remain those which provide a defensive income stream including logistics, residential and alternatives. This is in part due to investors remaining under allocated to these segments and find the notable rise in yields over the past 6-12 months as an attractive re-entry point. Also notable is the active seller interest to crystallise some of the strong performance these assets have generated over recent years which is further supporting liquidity whilst other segments continue to struggle with a large bid-ask spread. 

Impact on real assets to shift from the denominator to the numerator of the valuation equation: Last year was notable for the swiftest transmission from higher interest rates through to higher lending costs and in turn a direct impact on equity valuations in recent memory. A process which normally takes several quarters seemed to have taken only a matter of weeks given the violent capital market rerate of central bank policy and its impact on margins and yields. As we move into 2023, we expect this denominator pressure to transition to the numerator of the valuation equation – i.e., the income component where prime rental growth performance has surprised in its resilience.

Sector divergence likely to come to the fore rather than geographical: The past number of years has seen a historically wide divergence in performance and pricing between offensive and defensive sectors. However, the rising rate environment has put a disproportionate pressure on some of the defensive sectors given how low yields had become. Furthermore, investors began to question whether the aggressively underwritten rental growth to justify these yields would materialise. Despite the renewed convergence in pricing amongst the defensive and offensive sectors, which has reached its long-term average, we continue to favour the more defensive sectors as we expect their income streams to remain more resilient – even as their pace of growth may slow or pause all together over the short term. We think this sector focus will likely remain more influential to investment performance than geographical considerations as we expect a synchronous economic slowdown in 2023.

Green credentials have become paramount for demand, pricing and liquidity: Both debt and equity is becoming increasingly critical of ESG + HW (health and wellbeing) considerations in their underwriting as more and more data emerges on the higher leasing rates achievable and quicker lease up timings of highly certified office buildings. This is before we consider the raft of regulations which will be taking effect in the coming years. Investment opportunities are likely to continue to materialise in relation to buying standing office assets at or below their replacement or build costs - plus requisite refurbishment - however risks in regards to more obsolete buildings which could become stranded assets must be monitored along with green premiums which could well outstrip replacement costs. Renewable energy sources are benefiting from strong infrastructure investor interest supporting robust valuations.

Swift reprice in traditional equities and fixed income leading to a denominator impact: The traditional lag in real estate valuations has led to a number of institutions finding themselves at or above target allocation levels. However, we are yet not seeing much evidence of active disposals to right-size real estate allocations as investors fully appreciate both the time it takes to build these private market allocations and also anticipate value declines to catch up to the public markets and close this gap. That said, listed real estate – which strongly underperformed the wider market last year – is likely oversold and may offer an attractive entry point for investors who include this market in their investable universe. The overall sentiment remains one of caution as market participants monitor incoming data on the economy, central bank policy response and ultimate impact on valuations. Infrastructure allocations remain well below target and the inflation hedge these real assets traditionally offer should continue to support their place in multi-asset portfolios.

Debt looking more interesting given relative value versus equity: A sizeable debt funding gap should lead to strong refinancing demand for new debt capital over the course of this year and into 2024, before new loan origination volume demand is generated from fresh transactional activity following adjusted valuations. Lower levels of leverage going into this downturn are likely to limit the ultimate quantum of potential distress but the longer these higher rates persist, the higher the risk that refinancing issues arise and distress emerges. More balanced fundamentals in Europe should support more stable market conditions compared to the US market – notably in the office sector where there is a significant geographic discrepancy as the supply response arrived in the US and has led to a spike in vacancy compared to a much more balanced market in Europe. A final consideration, as it relates to deploying capital in the current market context, is that of timing between commitment and capital calls which will make it somewhat challenging to time entry points to perfection.