Investment Market

Short review of 2023

In the second half of 2022, the central banks’ interest rate hikes suddenly changed the familiar playing field in which real estate investors had been operating in previous years. Persistent inflation forced the ECB to abruptly slow down demand for consumption and capital in the EU. This led to an unprecedentedly forceful interest rate policy from the second quarter of 2022 to well into 2023. Partly due to offsetting wage increases, the requisite interest rate hikes in 2023 turned out to be higher than expected, which in turn affected pricing, dynamics and confidence in the Dutch investment market.

Ultimately, weak dynamics and declining prices led to a significantly lower investment volume at €8 billion – representing a decline of 53% compared to last year. As was the case in previous years, most of the investment allocation went to logistics real estate (30%), followed by residential investments with a 24% share. Sitting at 16%, the share held by office real estate remained historically low, while the allocation to retail space remained relatively stable at 12% of the overall investment volume.

Whereas CBRE initially assumed that the market would be more dynamic from autumn 2023 onwards, this virtually failed to materialise, especially as far as larger transactions were concerned. Many organisations normally operating in this market are still cautious when it concerns their acquisitions or sales. However, the bidding processes undertaken reveal that liquidity has already increased significantly compared to the end of 2022 and the beginning of 2023.

This applies mainly to the market for less than €50 million. For amounts exceeding that, it is traditionally the institutional organisations who are active, and at the beginning of this year they were still suffering from what is known as the denominator effect. This has since continued in ‘redemption requests’, which involve withdrawing some capital from real estate funds. As far as this is concerned, international outflow seems to be greatest for office space funds, as well as for residential funds in the Netherlands. This goes against the trend in Europe: on our continent in particular, there is still – on average – a great deal of interest in all kinds of residential investments, and this is spreading from the more traditional housing product to operational housing products, such as student housing, care homes or affordable housing, and/or making housing more sustainable by those who have impact funds.

Major transactions are not taking place due to reticence on the part of the sellers in particular. Only those who were forced to sell due to significant capital outflow or private equity organisations wanting to focus more on other markets were active in the market. This led to a considerable decline in the overall investment volume. Whether and to what extent this outflow from the real estate market will continue depends mainly on two factors: interest rate movements and the extent to which the risk ratio between the bond market and the initial returns on real estate normalises. Risk premiums for real estate investments fell considerably in 2023 compared to, say, 10-year government bond yields. So much so, that it was more lucrative for investors to allocate their investments to products like government bonds rather than less liquid and low-yielding real estate investments.

What we are witnessing is that the current spread between net initial returns and 10-year government bonds has now grown to a level that can be described as a healthy, long-term risk premium for various real estate typologies. This is partly due to the sharp fall of the capital market interest rate at the end of 2023. With this, it seems as though a period of write-downs is heaving into view sooner than expected. Taking lagging and smoothing into consideration, which is not unusual in the valuation world, it is fair to say that book values and actual pricing in the market will converge in the first quarters of 2024.

Whereas 2023 held investors in the grip of further interest rate hikes and the associated write-downs, 2024 could become a clear tipping point in this. In fact, the expectation is that capital value growth could resume in several real estate categories towards the end of the year. That said, the reason for this capital value growth does differ depending on the sector.

For instance, the reason for capital value growth for the prime buildings in the office market is linked to several factors: a slight drop in initial returns towards the end of the year; an improvement in the prospects for rises in rentals, partly driven by a tightening of the ESG-proof office market; and an actual increase in market rentals. The reasons may also be along these lines for logistic buildings. In the retail market, however, the increase is mainly driven by falling initial returns, while the rental prospects are stabilising after many years of decline. For residential properties, legislation has capped rental growth, so capital appreciation due to rental growth is limited. However, market rents are rising excessively partly due to the many housing units being sold off individually, which is prompting a further tightening of the rented housing market.

Outlook for 2024

As was the case last year, interest rate movements will be a deciding factor for the investment climate. Only this time the focus will be on the reverse: in 2024, all eyes will be on the lookout for a possible cut rather than on a rise in interest rates. Yet the sharp interest rate hikes of the past eighteen months will have a tangible aftermath – they are still leaving their mark on the sales dynamics in the investment market this year. On the one hand, this is a consequence of refinancing challenges, and, on the other, it is due to redemption requests. This is forcing funds to partially convert to cash to meet these redemption requests.

It is clear that the current situation in the market – after a thorough price review – would be an interesting time for investors to take the plunge. That said, the capital available for investment in real estate is significantly less compared to previous years: -39.7%, While available capital remained relatively level for opportunistic (-21%) or value-add strategies (-41%), it fell significantly for core or core-plus strategies: by -51% and -54% respectively.

Deterioration of the relative risk-return ratio prompts capital outflow

The principle cause of the reduction in available capital is the relative deterioration in the risk-return ratios for real estate relative to other investment products. For instance, at 4.01% the 10-year government bond yield in the United States is at an extremely competitive level compared to core real estate investments. Mainly because of this, asset/liability management (ALM) models are prescribing fewer allocations of investments to real estate than they did in recent years, when interest rates were very low. This also explains why requests to exit open-ended funds are currently the order of the day. The last time a similar outflow balance lasted at least three consecutive months was in 2010. With caution, one could refer to this as a reversal in the trend.

The repercussions of this will not be major in the first instance. But if this capital outflow persists, it may eventually cause some of the fund to have to be liquidated. The ‘redemption requests’ on the desks of relatively many investment managers can be offset by:

• raising new capital
• financing part of the fund
• selling fund assets

Because the market for new capital and funding is challenging, some of the redemption requests this year will be paid for by selling real estate.

From an international perspective, the biggest capital outflow so far seems to be coming from office real estate funds. A combination of factors is playing a role in this. The overall allocation to real estate is falling and, of this allocation, investors are more and more inclined to shift their interest to logistics real estate and residential real estate of all types. So office real estate is being affected more by reallocation within the various real estate sectors. Despite this, the expectation is that – if the return/risk ratios in the office market become more attractive – this will automatically prompt higher allocations to the market for office space in the medium term.

In addition, the increase in fund allocations to operational real estate is striking. More and more capital is shifting to hotel properties, student accommodation and housing for the elderly, long-stay/short-stay hotels or holiday parks. In addition to this, CBRE is seeing a growing interest in impact funds amongst institutional organisations. These impact funds are funds that focus mainly on affordable and sustainable housing or housing (including care homes) that can be made more sustainable, in an effort to contribute to the Netherlands’ broader housing targets through these investments.

This trend towards investing in impact funds is in stark contrast to the number of redemption requests currently in investment managers’ in-trays in the Netherlands. A conservative estimate puts this at more than €2 billion. Unfortunately, this claim has to be viewed against the background of all the regulatory risks that have been strewn across the residential investment market in recent years. And this is quite apart from the impact that the twice-increased transfer tax had and continues to have on raising capital for the built environment in the Netherlands.

Refinancing issues will boost sales in 2024

Besides the outflow of core capital, higher interest rates are clearly still affecting the financing market. Many of the financing deals concluded between 2018 and 2020 are due to expire in the foreseeable future And that is when refinancing will be challenging. The sharp change in the loan-to-value (LTV) ratio combined with the stricter funding policies set by banks and other providers for the LTV ratio are forcing investors to inject more of their own equity when refinancing, or to look for (more expensive) external capital. If neither option is a good alternative, then selling the asset may reasonably be the only remaining option. This largely explains why refinancing challenges will force more buildings on to the market this year. And, with the sharp drop in value in the office market, this issue seems to be concentrated around this segment in particular.

Yet this is nothing new: there are always refinancing risks in the housing market. Take property developers: they always run the risk of ending up in default when they get involved in housing developments. This is particularly the case if they have to finance their projects at higher interest rates while there is no income coming in to offset them. This is certainly true if these projects are heavily financed with short-term loans and/or if government measures hit them hard. The consequence: developers decide not to proceed with projects that may end up underwater when refinancing costs are high. These projects are expected to be put on the market at a significantly reduced residual price, after which they may be able to get off the ground more easily. This is less likely to be the case in the retail market, with far fewer forced sales as a result. In recent years, financing has been much more conservative in this segment. Moreover, this financing has often been accompanied by a redemption obligation, which has mitigated LTV risks. The main risk appears to be in supermarket investments. However, recent high inflation in that market has cancelled out the increase in initial returns considerably.

Investment volume is increasing due to forced (or partly forced) investment products on the market

The overall investment volume in 2024 is expected to rise compared to 2023 through a combination of:

• stabilised market prices;
• the anticipated slight reduction in the capital market interest rate; and with that
• more accurate and better forecasting of the exit yield;
• a larger pool of investors that will be forced to sell.

Based on the current situation, CBRE is assuming an investment volume of €9.5 billion in 2024. That is 19% more than in 2023, but is significantly less than we were accustomed to in the period between 2017 and 2021. As long as the interest rate does not fall to the unprecedented low level of those days (0%), we are unlikely to see a return to those volumes.

Logistics will be the biggest investment category for the fourth year running

Logistics will continue to be the largest asset class in 2024, although the interest rate hike also affected this market. Not only in terms of changes in the value of real estate – interest in the occupier market also declined in the wake of a reduction of consumer spending. Despite this, the allocation of capital to this segment is relatively high. Partly because of this expanded mandate, CBRE expects investors to scale up strategically, both geographically and in terms of the types of product. All things considered, CBRE expects an investment volume of €2.75 billion for this category. This is way less than in the peak years of 2021 and 2022, which can mainly be explained by hesitancy in the core segment and the significantly reduced new-build pipeline.

Residential investment market continues to face headwinds

Many asset classes can look forward to having the wind back in their sails this year; this includes the residential investment market, albeit with some delay. Reduced capital values are still hindering the sale of many new-build complexes to investors. Another factor is that many of them do not have enough liquidity to buy new housing complexes. This is evident from withdrawals from this asset class by some pension funds and insurers.

This means that property developers are relying heavily on housing associations, private owners and a handful of foreign entrants when selling new-build houses. The dynamics in the residential investment market will therefore largely be driven by the sale of existing complexes. This year, too, these complexes are likely to land in the hands of organisations that intend to sell off the complexes as individual units on the owner-occupied market, partly because of the substantial difference in value when selling off individual units as opposed to a strategy involving holding the properties and managing them. The biggest opportunities for new builds is the growing number of impact funds. This may ultimately encourage some investors to enter the new-build investment market. Ultimately, CBRE expects the volume in the residential investment market to reach €2.5 billion, which is more than in 2023, but at the same time very limited in light of construction targets.

Investment market for office space is gathering momentum thanks to refinancing challenges and redemption requests

Since CBRE started recording investment volumes in the office market, the last time the volume was at a similar low level as last year was in 2011. 2024 is also unlikely to be a prosperous year for this segment, even though this market is gathering momentum. Refinancing challenges and the growing number of redemption requests are putting pressure on investors to sell office real estate. Nevertheless, this market remains challenging. The impact of hybrid working is still affecting the office space market, which is putting a dampener on the enthusiasm to invest in this segment. Having said that, the renewed risk-return ratios should start contributing to reviving interest in the office market amongst a larger group of investors by the end of the year. All in all, the investment volume is set to rise to €1.6 billion, which from a historical perspective is still very low, but at 30% it is a significant increase compared to 2023.

Retail investment market gaining ground after years of a shrinking market share

The retail investment market also struggled last year under the weight of interest rate hikes, although it was considerably more dynamic compared to other sectors. Due to the higher proportion of own capital and the significant presence of long-term investors, there is more liquidity in this market than in that of offices or logistics real estate, for instance. Despite greater challenges in the occupier market, this year CBRE expects more dynamism, particularly in the high street retail market. Many institutional and private investors are increasingly focusing on the top six cities, and even on the top 15. An important underlying factor in this is stability: these retail markets have proved that they can produce sound returns on investment, even when facing financial headwinds. Added to this, demand for convenience remains strong, which is honing the definition of this retail product even more. Aligning the retail mix with the primary target group is also becoming an increasingly important issue in the acquisition of these types of shopping centres. All things considered, CBRE expects the investment volume to grow to €1.2bn, partly due to an increasing willingness to (re-)invest in the retail market.

Healthcare investment market: investors and healthcare operators’ ambitions are aligning

It seems as though investors, property developers and healthcare institutions in the healthcare investment market are joining forces to achieve their high expansion and sustainability ambitions. Furthermore, the growing number of impact funds is enabling institutions to work together towards agreeing on rental levels that will not impede the exploitation of healthcare facilities. This is creating opportunities for high standards of care, expansion of high-quality and efficient healthcare real estate and making it more sustainable. Despite the rapprochement between the various players in the healthcare market, the investment volume remains relatively limited at €550 million. The feasibility of projects continues to be a major, and especially time-consuming, challenge. As a consequence, the volumes required to meet the serious national targets will not be achieved any time soon.

Exploitation of hotel real estate will awaken interest and benefit pricing

The corona pandemic is still affecting the hotel investment market. Many institutional investors and private equity organisations are still searching for the right risk perception for hotel real estate. Meanwhile, hotels are operating full steam ahead, as never before. The significantly higher RevPAR and the more moderate increase in operating costs are rendering hotel operators’ position in terms of EBITDA extremely strong. Given this development, it is apparent that the risk of investing in hotels is being overrated. However, investors are expected to recognise this risk more in the coming year, and offer and ask prices could converge slightly again. Partly because of this, CBRE anticipates a considerable growth of the investment volume, up to as much as €500 million.

Overall, it is fair to say that the market will pick up momentum in 2024, particularly in the second half of the year. This forecast depends in part on the lowering of interest rates, which will drive dynamics in the real estate investment market and create more opportunities for capital value growth and higher allocation of money in real estate.