Invasion of Ukraine, inflationary concerns dampen optimism in global real estate outlook
SINGAPORE (EDGEPROP) – After the disruptive force of the pandemic, Russia’s invasion of Ukraine comes as another humanitarian crisis and massive economic shock that have yet to make their full mark on the world of real estate.
See also: Impact of climate on the future of real estate investing
The huge uncertainty from Covid-19 as an accelerator of major trends in society and business has been the main narrative for the real estate industry for over two years. The invasion of Ukraine — the threat of war escalating in Europe — takes that uncertainty to an altogether higher level.
In some respects, the industry faces a potential re-run of the early days of Covid-19 in 2020 — a cyclical downturn uneasily juxtaposed with long-term structural changes to real estate. That was an extraordinarily difficult year of adjustment, and the industry is still figuring out how those long-term trends will unfold.
If there is a consensus among economists, it is that the Ukraine conflict is unlikely to lead to a global recession although no one is ruling out that outcome. At the very least, however, the effect of the Russian invasion of Ukraine is expected to be a far greater geopolitical risk alongside slower global growth and higher and longer-lasting inflation.
Even that relatively benign macro scenario this year would serve as a major jolt to the real estate industry, which throughout the sharp economic recovery of 2021 enjoyed record levels of investment, almost as if Covid-19 had never happened.
Global volumes for completed sales of commercial properties totalled more than $1.3 trillion in 2021, 59% higher than the 2020 total and 22% ahead of the previous peak in 2019, according to MSCI Real Capital Analytics (RCA). This extraordinary level of activity was driven by worldwide demand for residential and industrial property and in particular a dramatic upturn in the US.
A key factor was the premium between property yields and interest rates, which remains in place across most global markets. This positive capital markets perspective for real estate just about holds good — for the time being. But the uncertainty will inevitably slow the deal-making down, especially in Europe.
It is possible that the industry in Europe may have to deal with the consequences of very swift changes in government spending in favour of defence and energy policies and away from the areas that directly affect real estate, such as infrastructure and housing.
Yet, the invasion of Ukraine also poses bigger questions around the environmental, social and governance (ESG) agenda. The pandemic has already reinforced the importance of ESG for everyone in real estate. If anything, there is even greater concern this year over the capital and operational expenditure as well as the risks associated with making real estate fit for purpose in all aspects of ESG.
Source: MSCI Real Capital Analytics
Mixed macro outlook
With surging oil and gas prices an immediate consequence of the Ukrainian crisis, the focus has been on the short-term inflationary impact. But longer term, will the acute problems of energy security act as a wake-up call to governments about the radical economic transformation they need to implement under the ESG agenda?
The International Monetary Fund (IMF) has forecast that global economic growth will moderate from 5.9% in 2021 to 4.4% in 2022, and slow still further to 3.8% in 2023.
The Ukraine crisis has rapidly emerged as a fresh risk to global economic growth. Forecasts had been scaled down anyway, not least in the US, which RCA says was “the engine of growth for the global property market in 2021”. According to the IMF, the US economy grew by 5.7% in 2021 but is likely to be hindered this year by labour shortages and reduced government support.
Source: MSCI Real Capital Analytics
Real estate leaders are naturally monitoring the global economy alongside the issue of inflation, which was one of the major concerns last year but an even greater concern today as the Ukraine crisis unfolds, at least in Europe and the US. In January, inflation in Europe hit 5.1% and in the US, 7.5%, which is the fastest annual rise there for 40 years.
The full impact on real estate of labour shortages, rising wages and food bills and surging energy costs remains unclear. Last year, disruption to global supply chains, especially in Asia, helped increase inflation rates.
This year, the big unknown is the outcome of the Russian invasion of Ukraine, which has heightened the fears over supply chains, energy prices and the risk of inflation spiralling out of the control of central banks.
Perhaps not disruptive, but an elevated level of inflation remains problematic when it comes to development, just at the point when the industry wants to resume pandemic-delayed projects or advance repurposing initiatives.
Though inflation appears to be less of a concern in Asia Pacific than the other regions, even there it adds to the development challenge. With big caveats over development and huge uncertainty due to the invasion of Ukraine, most interviewees still cling to the traditional view of real estate as a good inflation hedge generally. “Intuitively,” says one global investment manager, “I do think that real assets are better positioned than fixed income, especially, to handle inflation. And levered real assets, which is a lot of the industry, will come out as a relative winner.”
Source: MSCI Real Capital Analytics
Finding late-cycle value
In an echo of those pre-pandemic times, last year’s Global Emerging Trends highlighted a “hesitancy around pricing” of logistics. One year on, logistics has come to epitomise the potential risks and rewards of real estate investment — a sort of lightning rod for bullish and bearish comments about the asset class as a whole.
With a build-up of capital that favours real estate over other asset classes, logistics remains the main draw, alongside residential. That trend shows no sign of stopping, say the industry leaders canvassed for this year’s report, although investment volumes will likely fall in these sectors along with the rest of real estate.
Unsurprisingly, given the greater geopolitical risk this year, the hesitancy over logistics pricing persists. As one sceptic puts it: “A lot of capital is not always smart capital.”
Over the past year, average yields across the major global logistics markets have converged to a relatively narrow range of between 4.25% and 5%, according to RCA. The challenge for investors lies in balancing what looks like late-cycle pricing with the societal, or non-cyclical, shift to e-commerce that has underwritten the growth of logistics since before the pandemic.
While logistics has soared, various forms of retail have struggled, and certainly, the pros and cons around the growth of e-commerce have formed a well-rehearsed storyline for years. Retail has played the part of the real estate pariah and yet some interviewees across all three regions are a little more open-minded now about “value opportunities” arising in the sector, and not necessarily for the sake of repurposing the assets.
Source: Emerging Trends in Real Estate® Asia Pacific, Europe, United States and Canada 2022
Diversification in investment strategies
Many of the interviewees stress the importance of diversification in investment strategies — spreading risk across sectors and geographies. With that diversification in mind, previous editions of Global Emerging Trends highlighted how some global investors were placing their “big growth bets” on Asia Pacific. In light of Russia’s invasion of Ukraine will those capital flows gather momentum this year?
One global investor acknowledges the need to go “much more granular” in Asia: “We are already present in the region, but we are trying to understand it beyond the main markets where everyone is playing and focus more and more on the smarter economies in South-east Asia, even if there is less liquidity.”
At the same time, a big theme in Emerging Trends Asia Pacific relates to both the office and retail sectors as “currently oversold”. Indeed, one investment manager based in Asia Pacific and interviewed for this global edition stresses the importance, still, of “relative value” and therefore “the opportunities in the traditional spaces” such as retail and offices.
It is accepted that the office sector in Asia is not facing the same existential crisis from remote working as in Western markets
After all the changes to business strategies and worker lifestyle choices over the past two years, it is remarkable that the investment ebb and flow of real estate can appear much as it did before Covid-19. But the simplicity of that observation masks the fact that the pandemic has dramatically altered expectations of how people will use properties in the future.
Despite overall resilience, some sectors and markets have experienced upheaval, leaving many assets obsolete and needing to be repurposed — a theme that to varying degrees runs through all three regional reports. Repurposing initiatives have been gathering pace over the past year, but again the likelihood is that the momentum here will stall as part of the greater market uncertainty and ongoing supply chain disruptions.
The need for repurposing does not go away, certainly not in the office sector, which has long been the foundation of commercial real estate portfolios. But Covid-19 has dented that hegemony, reinforcing a long-standing trend for remote working to such an extent that it has become a permanent option for millions of office workers, at least in North America and Europe. It is accepted that the office sector in Asia is not facing the same existential crisis from remote working as in Western markets. In Seoul, for instance, office investment in 2021 was well ahead of previous years, according to RCA.
By contrast, office deals last year accounted for less than 20% of the total invested in US real estate for the first time. It is a startling decline, given the sector’s past status as a bedrock component of real estate portfolios.
Two years on from the outbreak of Covid-19, there is still no clear direction here. A disconcertingly broad range of industry perspectives exists about how some form of hybrid working model will affect office demand. But in any conceivable outcome, companies will be leasing less space in the future. New hires and added space required for social distancing are unlikely to fill the resulting vacancies.
The running debate about the future of the office is also inextricably linked to ESG, which is a narrative thread that is only growing in its influence over real estate, including finance.
There is arguably an element of industry self-preservation here because increased tenant focus on healthy buildings is accelerating the obsolescence of older buildings with outdated ventilation systems and floor layouts. Demand for this product will decline among tenants and investors alike as a “flight to quality” draws tenants to newer construction.
Another US investor points out that the only segment of US office stock that has seen positive net absorption over the past year is supply completed since 2015, everything else is negative. “It’s not that it’s just new, it’s that it is more sustainable, it is greener, and it is more efficient. And I think for those who are making new decisions, if their employees are coming back to the office, if they are going to be in that environment, they’re going to want to be in the right environment.”
Source: Emerging Trends in Real Estate Asia Pacific survey 2022
Beyond the mainstream
Between them, the business disruption from Covid-19 and the strictures of ESG have forced the industry to broaden its scope beyond mainstream property sectors and think more about the overall role of real estate in society.
The pandemic has certainly reinforced the trend of investors targeting contra- cyclical sectors, such as life sciences and data centres, which profit from megatrends and therefore generate resilient income.
In effect, as one Asia Pacific player puts it, the industry is “buying into the new generation, new economy sectors where the underlying business growth is coming from digitisation, wellness or healthcare because those are just tenants that are growing”.
For several years, Global Emerging Trends has signalled the move into these sectors as part of a fundamental shift into more operational and service-based real estate although such investment comes with challenges. In Europe, the lack of availability of life sciences and data centre deals has been a problem. In Asia Pacific, one interviewee refers to the need to understand the “ecosystem” around data centres. “The tenant concentration is massive in the space. And so, if you don’t create an asset at the right price point that can have some pricing power against that demand, you’re going to struggle.”
Challenges aside, operational real estate has won wide and growing support across the industry. It remains to be seen whether demand for such assets will become even stronger during the economic fallout from Russia’s invasion of Ukraine. As one European interviewee points out, operational real estate usually comes into its own during a period of higher inflation. “Anything where you can add a service component can be quite helpful in terms of an inflationary environment because you can increase the price of your service, or you have the optionality to do it.”
Report on “Emerging Trends in Real Estate® Global Outlook 2022” by Urban Land Institute (ULI) and PwC