Inflation has peaked, and interest rates will soon reach a crescendo

Inflation has peaked, and interest rates will soon reach a crescendo.

Sound familiar? That’s because there is a sense of déjà vu in the economic backdrop; since the beginning of this year, the narrative underpinning the global economic outlook has remained broadly consistent.

Economic growth has proven to be resilient this year, and incoming data has consistently beat expectations. But this is supporting ‘sticky’ inflation, forcing central banks to ratchet up interest rates in response. Expectations of the terminal rate have risen too, such that we are no closer to the peak than we were at the beginning of the year.

This is weighing on sentiment across real estate markets; investing in illiquid asset classes requires a level of conviction in the future that simply isn’t possible in the current environment. It’s no wonder that many investors are choosing instead to sit on their hands, and so capital markets remain in stasis. Total global investment dropped by -55% YoY in the first half of 2023.

Offices

Much of the negativity is focused on the office sector. In the US, distress is beginning to build in a market that is awash with empty space. This is seeping into the psyche of investment committees around the world; what happens in the US often leads the rest of the world. Office transaction volumes declined by 60% YoY in the first six months of the year.

Global prime office yields, Q2 2023 (as at end-June)

Source: Savills Research and Macrobond

And yet, while the evidence points to a broad-based slowdown in occupational demand globally, there are important differences in the supply-side of the equation that’s provides more nuance elsewhere.

In Europe for example, there remains a dearth of good quality office space, and new development is unlikely to be a significant drag on rents, with speculative space in the pipeline representing less than 3% of total stock in major markets. In the City of London, deal activity is constrained by a limited sales pipeline, with many investors showing renewed interest in a prime yield of 5%.

In Asia Pacific, while excess supply is a concern in Hong Kong and mainland China, in some markets the tightness in supply is providing a cushion for landlords, including Sydney, where a flight to quality is driving a material divergence in rental growth across property grades. Seoul also stands out as markets where supply constraints accentuate the squeeze at the top end of the market.

Logistics

While sentiment has clearly shifted on offices, investors have not wavered in their conviction for logistics through this cycle. Instead, many metrics across both capital and occupational markets are broadly comparable to pre-Covid levels, suggesting a normalisation in activity. While investment in the global logistics sector was around 41% down on the year, it was nearly 10% above the equivalent Q2 value in 2019. Investors remain bullish on the long term prospects for the sector, suggesting bust will not follow boom in the next 12 months.

Global prime logistics yields, Q2 2023 (as at end-June)

Source: Savills Research and Macrobond

Indeed, some markets are again piquing the interest or major investors. A yield of around 5% in the US, Australia, and UK is beginning to look attractive again, given prospects for more stability in interest rates in the second half of this year, and continued upward pressure on rents as supply remains tight.

As evidence of this bottoming out, several major portfolio deals involving some of the largest asset managers in the world should help act as a catalyst for more activity in the second half of the year; where the big players go, others tend to follow.

Across both the logistics and office sectors, it is too early to call the bottom, and the rest of this year is unlikely to see a significant uptick in investment volumes. And yet there are some tentative signs that investors are emerging from hibernation. In some cases, they are merely window shopping. But conditions for dealmaking will eventually improve. Inflation has peaked, and interest rates will soon reach a crescendo.