LOOK AHEAD 2018: Time to reassess risk

As we enter a new year, real estate markets are changing fast and lenders should reconsider assumptions about property fundamentals, writes Yolande Barnes, head of Savills World Research.

Many new forces and factors are having an impact on global real estate markets, ranging from physical and climate changes to new ways of living, working and playing in the technological age. On top of this, the nature of money and investment has changed. In 2018 and beyond, real estate lenders need to consider this shifting landscape.

Investing institutions, which have been used to taking savings from baby boomers since the 1960s, now have to pay pensions to the same people, and will do so for decades to come. Demand for fixed-income assets has therefore soared. The downward path of global interest rates was inevitable under these circumstances, with or without central bank interventions. Little wonder, then, that all assets, including real estate, are scrutinised for their income-generating qualities.

If the quality of the income is the major consideration, it changes everything. Mixed-use, fine grain, flexible accommodation for living, working, playing, staying and shopping is in high demand and should be reassessed. It might be tricky to underwrite in the short term (though new technology should help here), but such property will provide long-term, stable and diversified income.

In these circumstances, the reassessment of the nature of real estate risk and a recalibration of property classes is natural. Locations once considered secondary or tertiary are rivalling old bastions of prime, while previously ‘grade A’ workspace is less popular among some occupiers than co-working and co-creation spaces. Asset classes once considered ‘alternative’ are on institutional shopping lists. This is not late-cycle desperation, but something longer-term.

It is sensible for lenders to ponder what constitutes a ‘quality’ covenant. Is a corporate office on a 25-year lease really a better risk than a tatty building let on short leases to a deep pool of local businesses, for example?

The likely prognosis is that global interest rates will remain much lower than during ‘the great inflation’ of 1965 to 1995 and may settle nearer the norm of the century prior to that – around 4 percent. Any asset that produces a net operating income at around this rate will be viewed favourably. There will be further yield compression between sectors and asset classes, where previously risk differentials had been assessed as greater.

World yields are at or near their nadir so there will be no capital growth without rental growth. We have to understand occupiers, of all types, in order to understand investment performance.

On the subject of debt, regulation has meant less capital flowing into new projects compared with the recovery stage of other cycles. While this means less danger of real estate oversupply, capital is tied up in assets and is not being used to drive new development. So, real estate rents may hit ceilings based on economic growth and productivity but have little scope to adjust downwards while supply is constrained.

In a wider sense, the risk posed by global debt is worth pondering. The rise in Chinese debt has alarmed, but 95 percent of it is domestic rather than external – so the scope for global contagion in the event of defaults is limited. When it comes to household debt, there is $4.7 trillion outstanding in China, while in the US, outstanding household debt is $14.8 trillion. In the UK, the figure is $2.1 trillion and in Germany just $1.8 trillion and France $1.3 trillion. Most countries have good asset cover, theoretically at least, with residential property values in most countries at three to four times household debt. In the US, the figure is just more than two times, while in China, it is more than eight times.

Older generations in advanced economies have large amounts of equity tied up in real estate, while younger generations have not accumulated real estate capital and unsecured debt levels have risen.

A credit squeeze in the unsecured sector could be just as drastic as a classic banking crisis, especially if it results in low consumer confidence. There may be few mortgage repossessions and forced sales driving prices down in these circumstances, but there would be little investment activity or rental growth to drive prices up. Real estate markets do not crash in these circumstances, they stagnate.