A recession is avoidable

The report ‘Where Do European Property Values Go From Here?’ presents an economic outlook for Europe that has turned more dismal with downside risks increasing. Signs of the market reacting to a changing economic outlook and elevated levels of uncertainty are beginning to emerge. Uncertainty surrounding inflation, persistent labour shortages, the Russian invasion of Ukraine, and the risk of an ECB policy error are some of the challenges investors are having to navigate. To help you think through the implications of the shifting macro environment, Cushman & Wakefield has modelled how property values across sectors will perform under four unique economic scenarios across Europe.

“For each scenario, we model and present forecasted values for the following: net operating income (NOI), yields, total returns, and thus property values for the office, industrial and retail sectors. Uncertainty surrounding inflation, persistent labour shortages, the Russian invasion of Ukraine, and the risk of an ECB Policy error are some of the challenges investors are having to navigate. These headwinds are likely to persist, which has implications for property values. That said, real estate is a long-term investment and will continue to provide healthy cumulative returns. Additionally, market volatility creates opportunity, so now is precisely the time for you to revisit real estate strategies and consider options to diversify and maximise returns,” said Mark Freeman, the Poland head of valuation and advisory at Cushman & Wakefield.

A severe recession is unlikely

Although a recession looks inevitable it is likely to be ‘relatively mild’ largely due to the resilient labour market and the anticipated fiscal measures. Moreover, healthy corporate and bank balance sheets will help contain widespread job losses, which is why we don’t expect a profound hit to activity and employment. However, as the region remains highly vulnerable to disruptions in oil and gas markets, the risks are skewed to the downside.

Economic indicators all point to weakness, with the chances of a recession in the euro area rising. In its baseline scenario, Cushman & Wakefield
now assumes a mild recession beginning in Q4 2022 with three quarters of negative growth, before returning to moderate growth in the second half of next year. In this scenario, Cushman & Wakefield estimates that all property values will decline by approximately 18 pct next year, ranging from 10 pct to 20 pct depending on the product type.

Will the difference between property yields and 10-year government bond yields return to levels that are closer to historic averages?

Government bond yields have moved significantly higher in 2022, from hovering just above 0 pct to the mid-2 pct range, says the report. Given the historical relationship between bonds and real estate (which typically move in tandem), we assume that yields will eventually follow government bond yields higher to bring the spread back into a range that is more consistent with the historic norm. As NOI growth slows due to the recession, this will place downward pressure on property values.

What are the bright spots?

Market volatility creates opportunity. Now is precisely the time to revisit real estate portfolio strategies to diversify and maximise returns. We offer investment themes towards the end of the report.

What’s next for CRE?

Cushman & Wakefield’s report also highlights possible scenarios for commercial property values and their probabilities. The most likely scenario, with 50 pct probability, assumes that persistent inflationary pressures push the ECB to raise interest rates more aggressively, stalling business investment and consumer spending. The eurozone economy enters a mild recession in Q4 2022 with three-four quarters of negative growth, before returning to moderate growth in the second half of next year. Other scenarios assume a soft landing, upside growth or stagflation, albeit with lower probabilities.

The possible scenarios are: economic growth slows or radically accelerates; the economy plunges into a severe recession.

According to Cushman & Wakefield the most likely scenario assumes a mild recession with a 50 pct probability. The assumption is that persistent inflationary pressures push the ECB to raise interest rates more aggressively, stalling business investment and consumer spending. The eurozone economy enters a mild recession in Q4 2022 with three-four quarters of negative growth, before returning to moderate growth in the second half of next year. NOI growth for offices turns slightly negative for the next two years with high-quality products outperforming. NOI growth in the retail sector also turns negative, resuming positive growth in 2024. Industrial NOI growth slows but remains positive. Given the recent rise in interest rates, yields will drift higher through 2023 by 60 to 100 basis points (bps) depending on the asset type. Property values will fall by 10-20 pct with moderate growth returning in 2024, with the exception of offices returning to growth in 2025.

Will economic growth slow?

In one of Cushman & Wakefield’s scenarios, economic growth slows but a recession is avoided. Bond yields stabilise near their current levels. The probability of this scenario is 30 pct. NOI growth remains relatively flat but positive for offices and retail in the short term. Industrial NOI growth continues to pick up. Given the recent rise in interest rates, yields will drift higher through 2023 by 30 to 80 basis points (bps) depending on the asset type. Property values will fall by 4-16 pct in 2023 and begin growing again in 2024.

The most dismal scenario is least probable

Two least likely scenarios with 5 pct probability each assume upside growth or stagflation. With upside growth, virtually all risk factors quickly abate, allowing NOI growth to gather momentum across all asset types. Given the recent rise in interest rates, yields under this scenario will drift higher through 2023 by 10 to 70 basis points (bps) depending on the asset type. Property values will fall by 0-14 pct and begin growing again in 2024.

The stagflation scenario assumes a failure to curb inflation which accelerates amid slower economic growth and rising unemployment, and a severe recession begins in 2024. Further, NOI contracts for several years for office and retail, says Cushman & Wakefield. Industrial NOI growth does not turn negative but slows materially in 2025 compared to other scenarios. Higher interest rates push yields out over the entire forecast period, by 110 to 170 basis points (bps) depending on the asset type. Under this scenario, property values will fall by 18-32 pct over the entire forecast period.

Summary

Although a recession looks inevitable, it is likely to be ‘relatively mild’ largely due to the resilient labour market and the anticipated fiscal measures. Moreover, healthy corporate and bank balance sheets will help contain widespread job losses, which is why Cushman & Wakefield does not expect a profound hit to activity and employment in the eurozone. However, as the region remains highly vulnerable to disruptions in oil and gas markets, the risks are skewed to the downside.

One of the key assumptions in the report is that spreads, more specifically, the difference between property yields and 10-year government bond yields, will return to a level that is closer to their historical average. Government bond yields have moved significantly higher in 2022, hovering just above 0 pct to the mid-2 pct range. Given the historical relationship between bonds and real estate (which typically move in tandem), we assume that property yields will eventually follow government bond yields higher to bring the spread back into a range that is more consistent with the historic norm. As NOI growth slows due to the recession, this will place downward pressure on property values. In its baseline scenario (mild recession), Cushman & Wakefield estimates that all property values will decline by approximately 18 pct next year. Market volatility creates opportunity. Now is precisely the time to revisit real estate portfolio strategies to diversify and maximise returns.

Investment ideas and opportunities

With supply and interest rate risks lower than in other sectors, food-centric/grocery-anchored retail is likely to outperform. Key aspects include F&B (food and beverage), health and fitness, and medical retail.

Demand in e-commerce remains strong, but logistics is the most exposed to the rising cost of capital, meaning that investors may want to monetize some low yielding core assets and keep their capital dry awaiting cap opportunities as debt maturities increase.

“Unlike in some past global recessions the Polish investment market is already feeling the impact of the changing economic outlook. Some investors have paused their activity until the extent of the market shift becomes apparent, while others are already attempting to price in some of the likely value loss. During such situations, opportunities always arise. While the industrial and office sectors appear likely to suffer the most, they also exhibit the most potential for future growth,” concludes Mark Freeman.

For the full report: https://cushwake.cld.bz/European-Property-Values

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About Cushman & Wakefield

Cushman & Wakefield (NYSE: CWK) is a leading global real estate services firm that delivers exceptional value for real estate occupiers and owners. Cushman & Wakefield is among the largest real estate services firms with approximately 50,000 employees in over 400 offices and approximately 60 countries. In 2021, the firm had revenue of $9.4 billion across core services of property, facilities and project management, leasing, capital markets, and valuation and other services. To learn more, visit www.cushmanwakefield.com or follow @CushWake on Twitter.