The writer is chief investment officer of asset & wealth management at Goldman Sachs
Once a decade or so, real property values experience a sizeable reset, typically driven by factors related to overbuilding, interest rate movements, dislocation in capital markets or downturns in broader economic conditions.
The outbreak of the Covid-19 pandemic in early 2020 felt as if it might be this cycle’s re-pricing catalyst, after a long period of expansion following the global financial crisis. But during the highly unusual subsequent period, bank forgiveness, monetary policy easing and the injection of massive amounts of stimulus into the financial system helped ward off disaster.
Instead of what could have been this decade’s signature correction, there was a dramatic upswing in global property markets. With interest rates around the world near zero, asset prices in 2021 — across both public and private markets — soared to peak levels.
Then, after central banks were slow to react to climbing inflation, an aggressive rate tightening cycle commenced. That led to a rapid decline in values across the public Real Estate Investment Trust market in 2022. But private owners were slower to recognise a drop in values, owing to muted transaction volume. And property owners also hoped that continued rental increases in housing, logistics and life sciences would result in sufficient income growth to offset rising capitalisation rates — the yield buyers are willing to accept to acquire property, which is largely correlated to underlying interest rates.
But property markets are now being confronted by multiple negative factors. Interest rates are meaningfully higher, leading buyers to demand higher yields when acquiring property and putting downward pressure on values. Financing for most property (except housing loans supported by the Fannie Mae and Freddie Mac government agencies) is scarce, a result of the US banking crisis and dislocation in debt markets.
Performance across property sectors is uneven. Space needs for offices are evolving with more employees working from home, migration of people and jobs, growing sustainability requirements, and general corporate contraction leading to diverging outcomes across assets. Rental growth is also slowing in the healthiest categories of housing, logistics and life sciences — but weaker demand in the oversupplied office market continues to present the most acute challenges.
These headwinds coincide with more than $1tn of commercial and multifamily rental property loans coming due in the next 18 months. Absent a clear path to replacing these loans — which the bank, bond and insurance markets do not have the capacity nor appetite to accommodate — prices can be expected to reset as loans mature and assets reprice at levels that reflect economic conditions.
Experienced investors in property have seen this before. Following a significant run-up in values, prices reset, wiping out years of gains and leaving the credit markets the battlefield where change in ownership plays out. Every story is distinct, but the plots always rhyme.
This time feels a bit different, though. Not so much from a capital markets perspective; there are structural changes happening in the way tenants use space. A cyclical recovery is unlikely to follow its usual course. There is far greater residual value or obsolescence risk. Lenders will find it harder to extend bad loans to a better day, pretending they are in better shape than they are, given the significantly higher carrying costs and capital needs of most property.
Prices will eventually reset across sectors. New entry points will be established at yields that reflect risk premiums adjusted to this more normalised rate environment. Slowing new deliveries (a result of inflationary pressures on cost to build) will afford landlords pricing power in most sectors.
Sophisticated property investors will seek to enhance yields, over time, as markets recover and new buildings with modern technology, sustainability credentials and excellent locations command higher rents.
The journey to that better day, however, will require price discovery against a very uncertain macro and geopolitical backdrop — and, probably, more than a little hand-to-hand combat between borrowers and creditors.
The near-term opportunity will benefit private markets lenders, who can deliver capital when the industry needs it most. Next will come opportunistic investors seeking “deals” on viable assets. Then momentum investors will pile in and ride the waves of recovery and expansion — until the tide inevitably turns once again.
