EMEA commercial property values have been undergoing the “great recalibration” since 2022, caused by fast increases in interest rates and high inflation, Fitch Ratings says.
Some real estate sectors face adverse prospects, which could prolong this period of adjustment, although the peak-to-trough fall in values will settle when the interest rate and inflation environments are clearer. Industrial and residential-for-rent sectors have strong fundamentals, retail has been through its trough, while secondary offices may deteriorate further.
Industrial and logistics have favourable longer-term growth fundamentals, including on-going demand for efficient space, increased on-shoring and automation investments, the benefits of new energy-producing buildings and constrained land availability. Similarly, regulated residential-for-rent assets have future inflation-linked increases in rents, and supply and demand dynamics support positive longer-term prospects.
Secondary offices face the most challenging prospects, weakened by remote working practices, non-prime locations, rising vacancy rates and the need for green re-investment to secure successful re-leasing. We expect this asset class’ valuations and rentals to decline, and some buildings to become obsolete.
Recent companies’ results have been affected by this recalibration. Valuation yields in industrial and logistics, one asset class that previously had high values due to investor money pouring into it, had shifted towards 4.5%-5.0% by end-2022 from as tight as 3% in 2020 and 2021, particularly in continental Europe. Some industrial and logistics property companies’ year-on-year valuations have included a 15%-20% shift in yield, but net of contractual CPI or market-supported increases in rent of nearly 10%, the valuation decline is limited to 8%-15%.
For all these sectors, these capital-intensive asset values have to change because they are now costlier to finance, and capital deployed may not be fully compensated by higher rental values. This also depends on each real estate owner’s funding structure. For, example, residential-for rent assets, which are valued at low yields, are more likely to be funded by debt levels quantified by resultant interest coverage, rather than loan-to-value conventions.
In a low interest-rate environment, Fitch-rated property companies had raised long-term debt with low coupons, mostly at fixed rates with only small exposure to variable rates, as shown in EMEA Real Estate – The Adverse Effects of Rising Interest Rates published in November 2022. As debt is scheduled to be refinanced at higher rates, dividends will decrease and, for some issuers, interest cover ratios will gradually decline to just above 2x by 2026 – levels last seen before the global financial crisis. However, many companies had mitigated imminent refinancing risk concerns.
Some companies had previously lowered their targeted loan-to-value (LTV) thresholds, aware that low interest rates and high real estate values were going to change at some point. Other companies now want to quickly de-leverage, which could be difficult at a time of little transaction activity and where values are recalibrating. De-leveraging may include raising fresh equity and asset disposals. Forced disposals create distressed sales, and cloud market valuations. However, rational purchasers will consider such assets’ longer-term attributes during this period of resetting.
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