Alex Jeffrey, chief executive, Savills Investment Management
How would you describe the 2022 real estate year?
As the past year has shown, even the best-laid plans can go awry. We entered 2022 feeling relatively optimistic, but global economic and geopolitical developments have changed the macro environment. In many real estate markets, risk-off sentiments have intensified, putting pressure on capital values and occupier performance.
That said, unlike previous property cycles, the current one has not been characterised by oversupply, and occupier markets generally remain tight. Thus, even if vacancy does rise as occupier markets weaken, it seems unlikely that there will be a long period of excess supply as higher construction costs and interest rates constrain near-term development, supporting future rental growth in supply-constrained markets.
2022 was challenging, but there were also several bright spots. Some market segments emerged stronger from the pandemic, which is a vindication of our convictions around these fundamental investment themes. The non-discretionary feature of the living sector was bolstered by demand-supply imbalances and increased institutional participation. We saw the resilience of urban industrial assets and we believe this will continue, as competition for land intensifies in urban centres around Europe.
The squeeze on household incomes from rising rates and inflation will likely lead to a cutback in discretionary spending, which continues to be supportive of essential retail. Real estate debt is well placed to step in where banks take an overly cautious view, which creates significant opportunities for alternative lenders.
What are the main challenges facing the sector and your company in 2023?
A general repricing of some real estate assets has already started in some markets as the world faces up to rising interest rates, recession risks, and historically high inflation. Lenders and investors will become more risk averse, leading to lower transaction volumes and potential difficulties in refinancing.
Investors with high levels of debt and those needing to refinance will feel the greatest pain from higher interest rates. In the UK, for instance, around £75 billion of outstanding loans will need to be refinanced over the next two years. This could result in various points of market stress as much of this refinancing will be at higher interest rates.
‘We believe in our time-tested approach of sticking to fundamentals and adapting our strategies accordingly. Arguably, there is no single best strategy.’Alex Jeffrey, Savills Investment Management
Investors and occupiers demanding more robust ESG credentials will increase the risk of obsolescence. Across all asset classes, occupiers quite evidently want more energy efficient and operationally suitable buildings. This will widen the performance gap between prime and non-prime, and will support values and growth in the former, but punish investors unable to maintain quality.
All said, while the operating landscape looks to be more challenging this year, these challenges could also present themselves as good opportunities.
What are likely to be the chief positive influences on strategy in 2023?
At Savills Investment Management, we fundamentally believe in the importance of a ‘top down’ contextual macro and capital-markets framework. But we also firmly believe our investors should be served by specific understanding of the wide variation within our markets. Real estate investment is always very easy in theory. The top-down picture looks a lot less messy than the bottom up one. However, knowing where to allocate your capital is only half the battle. How you invest it is just as important. To sum up:
- Macro fundamentals are just our starting point, thematics matter too.
- In this challenging environment, it is vital to focus on quality assets with strong fundamentals, ESG credentials, and the ability to generate rental growth. Failure to maintain focus on these essential qualities could easily result in exposure to stranded assets and difficulties in refinancing.
- Be wary of ‘sector myopia’ as the range of returns within, rather than across, sectors provides much more variation over time. Focusing on the best sub-sectors within any broader property segment has the potential to produce much greater risk-adjusted returns to investors.
Where do you see the best value and what will be the best strategy in the year ahead?
We believe in our time-tested approach of sticking to fundamentals and adapting our strategies accordingly. Arguably, there is no single best strategy. In fact, we see value across many markets and sectors that we operate in.
We see opportunities in upgrading large parts of the current property stock in urban locations, creating significant value-add potential through upgrading measures, repositioning strategies and active asset management to create best-in-class, ESG-certified space.
The push for net zero means that buildings that do not have adequate green credentials are suffering from a ‘brown discount’, which raises the risks of stranded assets for those that do not have other redeeming qualities such as high-demand locations. That said, the brown discount is also an opportunity, since it provides scope for retrofitting, upcycling, and consequent capital growth and rentability for suitably located assets.
Compared with the US market, where non-bank lending is 50% of the real estate debt market, the landscape is adolescent in Europe and Asia. Increased regulatory oversight and a reduction in risk appetite by commercial banks have created a significant opportunity for non-bank lenders. This supply-demand differential allows real estate lending to achieve higher income returns for investors while taking on less property risk, given the equity cushion demanded by lenders.
Real estate debt managers with discretionary capital will be in a good position to take advantage of potential volatility in the markets, as banks pull back once again and focus on other areas in their portfolios.
Looking back at 2022, what has given you the greatest inspiration for this year?
We saw first-hand how real estate markets and investors made excellent strides towards greater stewardship. Even as the macro backdrop felt vulnerable at times, the push for more responsible and sustainable investing in the built environment has only become more entrenched. The real estate industry is now taking ownership of the fact it is responsible for around 40% of all greenhouse gas emissions globally.
There is also an increasing focus on the S in ESG, as investors want to influence social impact through initiatives such as affordable housing. This is filtering through to every market participant and stakeholder, from financiers to developers, investors to tenants. The US, UK and APAC may pursue different ESG solutions as we are at varying stages of this ESG runway, but 2022 was definitely an important pivot point in mindsets and actions.