In a research note issued this week by RBC Capital Markets, primarily on the merits and risks of UK Real Estate Investment Trusts, the Canadian bank considered the age-old issue of cyclicality in commercial property markets.
Various factors, it said, suggest cyclicality is today less of an issue, although it has not been eliminated. The absence of overdevelopment this decade is one major factor. The other is the more conservative financial gearing applied in property deals, compared with before the last crisis.
In such volatile times, with Brexit unfolding and political disquiet across other European Union countries, market players cannot rule out a black swan forcing a more abrupt end to the cycle than most expect. Indeed, RBC added that a shock that leads to tenant demand disappearing is quite plausible. However, with development and debt in check this time around, two of the major in-built factors that historically cause real estate bubbles seem less of a threat.
Full-year 2018 investment figures have emerged showing Europe’s commercial real estate markets boomed last year. For example, German investment volumes reached an all-time high, with €61.5 billion transacted, a 6 percent year-on-year uplift, according to BNP Paribas Real Estate data. Overall, CBRE hailed 2018 as a record year for European real estate investment, with €312 billion clocked up, a 0.3 percent increase on 2017.
While there seems no end in sight to demand for commercial real estate in this extended cycle, investors and lenders active today need to consider that the markets in which they operate have become more complex.
There are several reasons for this. The weight of capital focused on prime, core property has forced investors and their debt providers in tandem to look at asset classes once considered alternative, including hotels, care homes and a variety of leisure uses. With many of these types of asset run by operators, lenders need to take an informed view on the ability of a company to run the property optimally.
More fundamentally, the world of commercial real estate is experiencing structural change. Take retail for example. In previous cycles, shopping space was a mainstay of most portfolios. Times have changed, and investors and lenders need to bet on whether an asset ticks the many boxes to ensure it remains relevant as more people shop on their phones. Lenders to offices can no longer count on a traditional lease in the building, as co-working occupiers make their mark across Europe’s cities. Those funding residential development, meanwhile, need to analyse whether a for-rent model is sustainable for a new apartment block in a given location.
Investing in, and lending to, commercial real estate in this elongated cycle takes a level of due diligence and analysis beyond previous cycles. Capital providers – both equity and debt – need to ensure their investments are on the right side of major trends, including demographics and the use of technology.
As RBC pointed out, structural changes create big challenges, but also big opportunities. While the risk of obsolescence has increased, emerging sectors are creating a need for liquidity of debt. The later we are into this cycle, the more important it is that lenders back trusted sponsors with an understanding of the fundamentals shaping the sector.
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