- Turbulence in commercial real estate (CRE) has increased this year amid concerns about the impact of soaring interest rates on the sector.
- As real estate market ‘corrections’ are a regular feature of the property market, institutional investors may try to seek out cycle-agnostic investment strategies.
Equites headed downward this week as investors braced for further rate rises by the US Federal Reserve to combat inflation. In June, the US central bank kept its benchmark rate unchanged following 10 consecutive hikes. However, the release of the meeting minutes this week indicated further tightening was likely, albeit at a slower pace.1
The pan-European Stoxx 50 index fell 2.9% on Thursday, extending losses this week, while UK blue-chip FTSE 100 dropped 2.17%. Earlier, Hong Kong’s Hang Seng index closed down 3%.2
“With the exception of the handful of names benefiting from the hype and opportunity around artificial intelligence (AI), equities have been in the shadow of fear for much of the last year,” says Lewis Grant, Senior Portfolio Manager for Global Equities at Federated Hermes Limited.
Investor optimism contrasts with growing pessimism towards the macroeconomic outlook.
“Finally, measures of risk aversion started to ease last month. The timing is intriguing: investor optimism contrasts with growing pessimism towards the macroeconomic outlook. A downturn in US output is increasingly likely, with industrial activity weaker than expected and the labour market beginning to slow. The Fed’s June minutes reinforce the possibility of two more rate hikes this year. Investor optimism may be hard to maintain,” Grant says.
“The tighter the Fed turns the screw on rates the harsher the impact on the economy will be, and the harsher the impact the quicker the Fed will need to cut rates. Overtightening would require more drastic action on the easing side, whereas the central banks’ goal now is to find a controlled exit from high inflation with gentle monetary easing on the way out. We don’t yet see fast rate cuts and are preparing for a slow exit but have a keen eye on metrics for overtightening.”
Real estate worries
Turbulence in commercial real estate has increased this year amid concerns about the impact of soaring interest rates on the sector.
HSBC recently announced plans to move its world headquarters from its 45-storey Canary Wharf tower and relocate to smaller premises in the City of London. The demand for office space has also been affected by the rise in hybrid working following the Covid-19 pandemic.3
“The triggers may be different every time, but real estate market ‘corrections’ seem pretty severe every time, and are a regular feature of the property market. Both buyers and sellers are unsure where to value, and certainly where to transact,” says Vincent Nobel, Head of Asset Based Lending, at Federated Hermes Limited, who points out real estate market has long been subject to peaks and troughs.
Figure 1: The ebb and flow of the real estate market
“To avoid being swept up in boom-and-bust cycles, institutional investors must find more cycle-agnostic investment strategies. In the search for more reliable returns, the objective is not to make lots of money in the ‘good times’ but to make decent returns consistently,” he says.
“One way to do this is to find assets that seem likely to generate income throughout a cycle and to have hold-periods that extend well beyond the typical cycle. This changes the underwriting focus to the long-term ability of the assets to attract tenants. Who cares whether the market values this at a 5% or a 7% at any given time?
“Another ‘cycle-agnostic’ strategy is to be a senior lender. Any cyclical market value decline should fall well within underwriting parameters, and therefore should (in theory) not affect the financial returns of senior loan portfolios. This of course depends on the way risk was underwritten, and on whether these cyclical corrections come at the same time as structural decline, such as we currently see in the office market, particularly for tall office towers.”