The direction of capital values is a tug of war for now
There are four distinctive yet interconnected factors to consider when we estimate where we are in the capital value cycle: the gap between appraisals and transaction values, (long-term) interest rates, leasing market fundamentals and market sentiment.
We know that appraisal and transaction values can become disconnected, especially when fundamentals, such as interest rates, change quickly. The UK appraisal methodology focuses more on updating valuations so that they reflect potential transaction prices, while eg, German appraisers have the tendency to change appraisal models slowly. The latter creates a smooth valuation trend, which is welcomed by many long-term real estate investors, compared to the potentially sharp valuation corrections that are more often observed in the UK.
But smoothing valuations over time risks creating a wedge between transaction prices, which are a function of what potential buyers consider the fundamental value of real estate to be eg, interest rate levels, and valuations. At the same time, potential sellers anchor themselves at the appraisal value and are very reluctant to sell assets below it. If they are not forced to eg, due to limited need to de-lever portfolios, the number of transactions drops. This is indeed the situation in many European office markets.
Low transaction volume affects sentiment: many market participants want to see at least a normal level of transaction volume to have the confidence to enter markets. Weak market sentiment can cause the number of prospective investors to drop, which affects transaction values as fewer investors bid against each other on the assets that are sold. This can cause a pressure on transaction values, which then, with time, feed onto valuations as appraisers consider sales comparables when they estimate properties’ values.
In our last commentary from November 2023, we discussed how common it is to see interest rates drop by ~150bps over the next two years after their cyclical peak. We penciled in a target of seeing the 10-year Bund and the 10-year Gilt around 2.3% and 3.5% respectively around the end of 2024 and, if history is any guidance, around 1.5% and 3.0% by end of 2025.
While we recognize the upside risk of policy rates staying higher for longer – see previous discussion – we see nothing that fundamentally changes our view regarding the longer end of the yield curve. We will need to see a few more negative inflation measures before we change our minds. Until then, however, our view from November on the interest rate influence is largely unchanged.
The same goes for the leasing market fundamentals. The key trends are: contraction of office demand but a simultaneous shift towards central and high-quality assets creating a wedge between prime and secondary rental growth; moderating but healthy logistics demand where increased supply reduces pressure on rental growth towards its structural trend; shortage of life sciences and residential housing driving rents where regulation allows and; weak but persistent rental growth recovery in the retail sector. There are few signs in leasing markets, bar secondary-quality offices and ESG non-conforming assets, that spell serious trouble for investors.
It is the first two factors – weak market sentiment and the gap between valuations and transaction values – which are heavy weights on European real estate markets. The other two, interest rates and leasing fundamentals, are however neutral or supportive by now.
Consider the following. As interest rates rose in 2022, so did risk-adjusted required returns across all real estate investment strategies. Higher required returns call for a) lower going-in price or b) stronger rental growth. Where rental growth was inadequate, values dropped and net initial yields rose. This is what happened in Paris CBD offices (see Figure 4).
However, now that yields have corrected and leasing fundamentals are sound, the gap between yields and market-risk driven yields has narrowed. This is the time when one should be investing in a market as values have largely corrected and the cyclical peak in yields – accompanied by the cyclical trough in values – is near. There is a tug of war happening between the first two factors, delaying the capital value recovery, and the fundamentals, which point to rising capital values.
