Capital and Debt Markets

Julie Whelan:
So let's continue by talking about the global capital and debt markets landscape. Richard mentioned that we need inflation data to move in the right direction before we can see a meaningful uptick in capital markets transactions. So let's see what our other experts have to say. I'm pleased to be joined by Henry Chin, Head of Investor Thought Leadership, and Darin Mellott, Capital Markets Research. Welcome Henry and Darin.

Henry Chin:
Hey, it's good to join you virtually from Hong Kong.

Julie Whelan:
So comments so far have made it clear that these persistent rate hikes are absolutely having an impact already. So give us an overview as to how deep that impact is across commercial real estate sectors in global geographies. Henry, why don't you start?

Henry Chin:
Sure. Actually, let's start with talking about the investors sentiment. I have to say, global investors continue to be very cautious when it comes to new acquisitions. Major concerns include the availability and the cost of a finance pricing gap between buyers and sellers and negative spread. When we look at different asset classes, fundamentals for logistics and multifamilies remain solid and cap rate expansions is largely due to the higher cost of finance. However, the positive rental growth will continue and somehow can offset the negative impact on the cap rate expansions. Now, when it comes to retail, the cap rate for retail enter the repricing cycle at a higher level this time. Therefore, cap rate expansion could be lower. Some investors are turning their attention to retail assets, particularly in Pacific and Japan. Now let's talk about offices. In terms of a price adjustment, office has been hit the most, particularly in the U.S., followed by Europe.

Henry Chin:
However, capital value in Asia-Pacific somehow remain resilient. The journey of a price discovery has not yet finished. So we all expect you to see further cap rate expansions in offices globally. During this cycle, it's fair to say that the cap rates for commercial real estate has moved out globally, but at various levels, the U.S. has seen the strongest repricing in Europe. There are great variations across countries and property types. I would like to highlight the U.K. has seen the most repricing for logistics in continental Europe; office and multifamily have seen the biggest expansions. Asia Pacific, somehow in general, has seen the smallest movement among three regions. And my colleague Darin will walk you through the cap rate movement in detail across three regions. Darin, over to you.

Darin Mellott:
Thanks, Henry. By the end of the year, we expect that cap rates will have moved out by around 125 bps, across various property types, closer to 200 in office. Importantly speaking, Julie, this is speaking very broadly. We're seeing wide variations across geographies, property types and specific assets. That said, we think the prices will stabilize across most asset classes this year into early next year, with the exception being office, where we may continue to see some movement in pricing into mid-2024. Now, in continental Europe, office and logistics yields have moved out about 120 bps from their lows in early 2022, and retail has moved out by about 70 bps during the same period. We expect that prime property yields in most countries and sectors will continue moving out until the end of the year. Now, like in America, this is speaking very broadly, with variations between geographies and specific assets and property types. In Asia-Pacific, many markets continue to register negative spreads, further cap rate expansion is expected outside of Japan and China, and we expect cap rates to expand in the range of 75 to 150 bps from peak to trough across that region.

Julie Whelan:
Okay, so gentlemen, theme number one seems to be repricing will continue around the globe. And I know when I see sales, I shop more. So hopefully that will be true in this case also. Now, these interest rate hikes have also brought the banking sector into the spotlight, especially small banks. The topic of debt defaults in commercial real estate (CRE) is under a lot of scrutiny. Darin, I know you just wrote a great paper on this. Is this a global topic? Is it isolated to the U.S.? Is it as big a problem as headlines would lead us to believe?

Darin Mellott:
Well, it, it is primarily a U.S. problem, and it stems from issues in the office sector, and that's where challenges in the office sector are most pronounced. So that's where I'll focus my comments, but there's no doubt that we're going to see a significant amount of distress, particularly in office, as I mentioned during the coming quarters. Now, let's put this into a bit of perspective. U.S. banks have about $1.7 trillion in exposure to CRE. However, office debt only accounts for about $340 billion of that. So again, perspective is everything. This is about a percent and a half of the banking systems’ total assets. Also, during the global financial crisis, as you mentioned, some people wonder about wider implications. This was, you know, the global financial crisis was driven by residential real estate, which in 2007 made up 20% of bank assets compared with commercial real estate accounting for closer to 10% of bank assets today, with much more conservatively underwritten loans. Still, we think losses could be substantial.

Darin Mellott:
U.S. banks could see up to $60 billion in losses over the next several years with office accounting for roughly $26 billion of that. Again, for context that's equivalent to roughly 3.5% to 7.5% of total exposure. In the context of total banking assets, losses are within a few tenths of a percentage point of the total. So we think that this is going to be particularly problematic for smaller community banks, but we don't think these losses on their own would destabilize the financial sector. That said, it will create headwinds for our sector, for commercial real estate and the economy as a whole, as the credit flow is restricted.

Julie Whelan:
Well, that is awesome context, Darin and $60 billion does seem like a big number to me, but everything is relative in understanding this in context of the GFC is very, very helpful. So Henry and Darin, let's end our capital markets discussion and leave our viewers with your summary of what they can expect the rest of this year into 2024.

Henry Chin:
Okay, Julie, I do wish I had a crystal ball to predict the future. I think early this year we did expect that the rate high cycle would have come to the end by now, so investors would have resumed their investment activities soon after. However, as Richard has mentioned, due to the stronger than expected service performers and much tighter labor conditions, global central banks have continued to keep the policy rate at the higher levels. But based on CBRE’s, and so many different studies and cap rate surveys, financial-related factors continue to be front and center of investors' mind. Therefore, we do expect global transaction volume to drop by around 34% this year before starting to recover in 2024. I would really want to highlight there are major differences between the three main regions when it comes to investment activities. In where I am, in Hong Kong, in Asia-Pacific, we do expect investment activity to drop by 15% this year, and Japan continues to outperform due to the lower cost of finance and the better and sound fundamentals. Activities in Australia, mainland China, Singapore and Hong Kong all remain muted, and it is worth noting that Korea was the first major economy to hike the policy rate in late 2021.

Henry Chin:
And since the Bank of Korea indicated that the policy rate-hike cycle is coming to the end, so the cost of financing started to trend down. It was 7% in January and it is now 5% as of last week for the stabilized asset. Therefore, we are starting to see signs of a green shoot in the investment activities, particularly in Korea. Darin, your prediction for the U.S. and Europe?

Darin Mellott:
Yeah, so we expect that investment activity will be down, and I'm speaking of volumes here by 37% year-over-year in the U.S., which is close to 2016 levels. We don't expect volumes to pick up meaningfully in the U.S. until 2024. That said, we are starting to see some green shoots, particularly in multifamily, where we expect volumes to pick up notably in the second half of the year. I would say that our expectations for recovery are driven by a few factors. Number one, appetite for real estate investment remains strong, and number two, investors should get clarity with regard to interest rates in early autumn, allowing for more confident underwriting and activity to begin picking up. Now, in Europe we expect investment volumes to decline by about 35%. So that for them, again, that takes us back to volumes last seen in the last decade, of 2013-2014. The major sectors, we expect the logistics to recover first, but residential yields are lowest as rental fundamentals remain strong there. Retail and office are still facing structural headwinds, although the prime segment is more resilient and we expect the northern and western European markets to recover the soonest.

Julie Whelan:
Well, thank you Henry and Darin. The capital markets environment remains tough clearly, but you have reminded us that there are plenty of strong fundamentals that are ready to lead the way as our economic environment becomes more clear.