With relentless Covid-19, the illegal Russian invasion of Ukraine, skyrocketing inflation, supply chain issues and interest rate hikes, not to mention a looming recession, 2022 has seen waves of uncertainty rippling across the entire planet.
As an antidote, we decided to adopt a forward-thinking approach by sharing our long and short-term predictions for the real estate market.
In this two-part series, we will shed some much-needed light on how the broader economy is faring, given that the state of the real estate market is often a good indicator of an economy’s overall health.
Part 1 focuses on our predictions for the real estate market in 2023. In Part 2 we delve into the effects of these uncertainties on different real estate assets.
Part 1: Top Ten real estate predictions for 2023
- Real estate transactions: We continue to see stagnation in the real estate market as a result of cancellations or postponements of transactions. This is primarily due to sellers expecting to maintain or receive higher values for their assets at a time when buyers may no longer be willing to pay the same multiples compared to a year ago. This discrepancy will last until buyers feel a sense of stability within the economy. Real estate transactions, therefore, will likely drop or stagnate at the beginning of next year.
The construction market has taken a hit due to concerns around increasing construction costs which, after hitting a peak, appear to be slowly reducing.
Significant changes in office assets mean that some projects have been (or will be) converted into residential portfolios. Why? Most likely due to the surge in work from home policies, which has led companies to reevaluate the viability of their office spaces. If many employers foresee more working from home going forward, their expectation in terms of office space per employee could increase to enhance employee wellbeing at work. It’s uncertain, therefore, that the demand for office building will shrink.
- Liquidity: Since the beginning of the Covid-19 pandemic, stock market volatility has reached new heights. Many listed real estate funds have blocked the trading of their shares, resulting in redemptions for both open and closed ended fund structures. Furthermore, increasing interest rates have meant that some real estate players are negotiating fixing of loans through interest rate swaps or, in some instances, struggling to refinance some of their existing loans. More leveraged funds are also experiencing cash flow constraints. What’s clear is that monitoring interest payments will be a crucial risk management factor.
More than ever before, cash is king, and it will be critical for market players to properly manage and monitor their liquidity position.
- Financing conditions: Interest rate volatility will likely continue as central banks continue to hike rates to counter inflation. Banks are revisiting their lending conditions and increased margins may compensate certain borrowers’ increased risk profile. Bank covenants and the ability to generate cash are also expected to be a focus for lenders. This period of uncertainty could lead to creative new ways of financing and refinancing with tokenization and retailization as emerging trends to watch out for.
- Investors: Investors are still reviewing and challenging their financial models and profitability assumptions. They are being particularly cautious when it comes to Article 9 type fund structures, as markets do not really consider real estate as an industry that is prepared to fully comply with all the requirements. Due to rising interest rates, return expectations are narrowing because of the external cost of funding. As such, there is likely to be a competitive advantage for equity /deep pocket investors that do not need to borrow.
- ESG always impacts investment decisions. KPMG’s recent article (based on client feedback and market discussions) explores ESG reporting challenges for the sector.
As real estate is responsible for 40% of energy consumption and 36% of GHG emissions in the EU, all eyes have been on the real estate sector during the ESG transformation. These estimations take into account the construction, usage, renovation, and demolition of real estate assets. The sector’s transition to include and prioritize sustainable activities is a key step in achieving Luxembourg and European carbon neutrality targets.
- Valuations: As ever, auditors will need to assess any impact to valuation if external valuation experts include a material uncertainty clause around asset valuation. What appears unavoidable is a sharp decline in some portfolios. On a positive note, the impact of the revised market conditions will already be reflected in the December 2022 valuations instead of being gradually factored in (as we saw during the 2008 crisis). Suffice to say that the beginning of 2023 will prove very interesting on the valuations front.
As for development projects, we see players including inflation clauses in construction projects and/or capping costs before even starting construction. Given current unpredictable cost changes, however, it won’t be easy to value development assets going forward.
- Technology: Technology is proving to be more of a differentiator than ever before. In most of our discussions with market players, digitalization, automation and technology are key aspects to look out for, especially as reducing operating costs is a no-brainer. The concern is that managers may put all their energy into surviving the current market rather than looking ahead and investing in cutting-edge technology to be future-ready.
- Tenants: Over the last few years, tenants have negotiated lease agreements, by requesting extensions for lease payments due to cash flow issues. There has been an increase in sub-letting arrangements with some leaseholders no longer needing all their space (due to remote working).
- Tax: Governments worldwide have authorized massive support packages to tackle inflationary pressure and counter the current economic headwinds (e.g. energy price caps and allowances to support the most disadvantaged households). Given the impact of these measures in terms of budget deficits and public debt, it is probable that some governments will have to review their tax policies to generate additional income in the years to come. This trend has already begun as exemplified in the increase in real estate transfer tax or the abolishment of certain tax regimes.
- Change management: As a result of the pandemic, more people are working from home, and may continue to do so. Operational models are now likely to be challenged and reviewed again to ensure this continued increased efficiency and business continuity.
This article was written in collaboration with Pierre Kreemer.