Business Post Article with Suzie Nolan, Head of Property Fund Management
Buyers waiting on the sidelines as cost of borrowing increases This article originally appeared in Business Post (subscription required)
December is typically the time of year when there is a race for the finish line to get the last few commercial property deals closed before year-end. However, this year feels a little different. With three ECB interest rate increases already announced since July of this year driving rates up to a level not experienced since 2009 and a further well-flagged increase due in December, the cumulative impact of which has already seen a 2% increase in the cost of debt. The expectation is that the ECB will continue to raise borrowing costs into 2023 in an effort to ensure inflation returns to its target of 2%, albeit at a slower pace, potentially reaching 3% by the mid-year point.
The increased cost of borrowing has resulted in debt-backed buyers waiting on the side-lines as we enter a price discovery phase in the commercial property market. The cash-on-cash return is now getting too tight to encourage leveraged buyers to transact at the prevailing yields. The spread between the cost of debt and yield needs to increase to entice this cohort of buyers back to the table, which is no doubt presenting an opportunity for cash buyers. In addition, the spread between the risk-free rate of return and the yield available on commercial property has also tightened, with 10-year Irish government bonds providing returns in excess of 2.2% compared with a 0% return this time last year. As such, investors are seeking higher yields from property to provide a risk premium given the illiquid nature of the asset class. Between the increased cost of debt coupled with the improved returns on risk free asset classes, there is naturally outward pressure on yields, which in turn is supressing capital values.
However, it is important to remember that real estate remains the only asset class generating positive returns for the 12-month period to end September 2022 and the top performing asset class over a one, three, five, and ten-year period, according to the MSCI Index. While we may be entering a price discovery phase, my view is that it will be gradual and hopefully relatively short lived. The broader economic backdrop in Ireland is robust, with employment at a higher level than it was pre-pandemic, and strong GDP forecasts predicting Ireland to outperform the UK and Europe on a continued basis. Personal balance sheets are also much more resilient than they were in the run up to the global financial crisis.
While yields are beginning to move out, rental levels have remained stable and are even improving in some cases. New lettings and rent reviews in the majority of sectors are proving beneficial for landlords. There continues to be good demand for high calibre office space in sought after locations. In addition, we have seen the occupier base broaden significantly this year beyond the tech and pharma sectors, with active demand from law and aviation firms, financial institutions, international retailers and logistics providers. This increase in the diversification of demand from other sectors has become even more welcome with the news in recent weeks of headcount reductions from some of the big tech firms.
Expectations for 2023
Looking towards 2023, there are a number of factors that I believe will be key to counter-balancing the market-driven yield shifts that are expected to continue, albeit at a slower pace, into the new year. As capital values start to slowly move out due to interest rate hikes, resilient income will be the driving factor underpinning total returns in the months ahead. It is important to have strong landlord and tenant relationships, with open communication particularly as tenants are facing their own challenges at present, including soaring energy costs and increasing labour costs. Landlords must also be willing to adapt to changing tenant requirements, moving with the times into experiential retail, hybrid office working and sustainable built environments.
In addition to the quality of the income or covenant, there is an increased focus on the environmental and social impact of commercial real estate, with the demand now coming from all angles including legislative bodies, investors, and corporate tenants. Landlords need to deliver on these requirements to secure higher calibre tenants as well as attracting a wider buyer pool when seeking to divest. Coined phrases such as ‘greenium’ or ‘brown discount’ are very much playing through in rental levels and yields, with the delta between varying levels of sustainable product expected to widen further in 2023 and beyond. Unlocking embedded value in existing assets will also play a key role in driving value.
There are significant opportunities within the existing real estate backdrop, particularly in major urban locations, to release or repurpose underutilised space and in some instances, create additional space. Proactively engaging with the local authorities early in the design stage can assist landlords in getting an indication as to what is going to be viable and beneficial to the local communities.
The emergence of grey space is expected to continue in 2023. However, the increase in the availability of office space from pre-pandemic, and before hybrid working is manageable, providing tenants with fully fitted, and in some cases shorter term rental options while they work out their future office requirements.
Finally, the year ahead will represent an opportunity for cash buyers, with reduced competition from their leveraged counterparts. I expect the main economic indicators will remain strong and we will continue to attract foreign direct investment and related occupier demand to our shores, housing crisis dependent. The inflation and correlated cost of debt issue will hopefully improve during 2023, resulting in a stabilisation in yields and values.
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