Charles Kingston, CEO & Editor, REFIRE Ltd.
Commercial real estate slumps, when they happen, tend to be widespread and slow-moving. It can take a long time for managers to adjust the value of their holdings, particularly when they’re not traded on public markets, and where price visibility is murky. That’s the situation we find ourselves in right now, particularly in the office market, which makes up the bulk of large German funds’ property holdings.
In the US, the colossal write-downs on prominent office buildings have advanced to a stage where it’s not just the lending banks that are rattled, but increasingly the pensioners whose retirement savings are in danger of going up in smoke. The $460 billion Canadian national pension plan admitted that its real estate returns over the past five years have totalled less than 1% annually, while several large US public pension funds have marked down losses of a negative 6% for the last twelve months.
Many of these funds have simply given up on certain of their offices, and are walking away, frequently realising losses of up to 80% or more on what they paid for the building barely ten years ago. In its annual report just published, the Canadian pension fund said its new focus would be less on bricks-and-mortar buildings and much more on infrastructure, such as highways and energy - more established projects, that provide a stable cash yield.
It’s a theme we heard discussed a lot at the MIPIM recently. For many investors, the line between real estate and infrastructure is getting blurrier, and investments in both may now be viewed as interchangeable. Still, it tells us something when giant investment funds are prepared to walk away from office towers and are relieved to be shot of them, pocketing a pittance on their original investment, and just grateful to have nothing more to do with them. Sure, it’s now somebody else’s problem. But the equity losses - if not the bank loans on the assets - are eye-poppingly huge. And every day brings new horror tales. Are we facing the same scenario in Germany, just strung out over several more years?
Direct comparisons between North America and Europe are normally futile, given the structural and cultural differences between the two continents. Nonetheless, some parallels can be drawn, albeit with a modest time lag. It’s clear that in Europe we’re only at the beginning of the Great Reset in valuing offices as an asset category, just as it’s clear that the highest quality offices in the best locations will be in much demand. As for the others - well, with much new capacity still being built, although expected to peak this year, there will be a lot of vacant space available - likely for several years to come.
Soaring vacancy levels won’t help support valuations in certain US cities indefinitely, where industry trends are hard to buck. The crash in values of San Francisco office space has genuinely to do with a 50% fall in the numbers of people in technology companies showing up in their offices since before the pandemic - and their companies more generously permitting them to work from home. But it’s a crash in values, nonetheless.
Apart from offices, investors with deep pockets such as family offices and private equity groups are likely to continue to put a traditional third of their assets into property. They certainly haven’t given up on Germany, despite the gloomy headlines surrounding the country’s political and economic woes. Good news, in the form of a first interest rate cut, should come as soon as this week, while the direction - if not the timing - of future travel for interest rates looks to have been fairly mapped out.
Taken together, lower interest rates and a shortage of supply should work some magic on valuations - at least in residential and logistics. Those with strong nerves and an aptitude for learning about the vicissitudes of eastern German demographics and its implications for elderly care could well find opportunities in the healthcare and senior living sector. That sector has fallen somewhat out of favour, with many operators failing to do their sums properly and ending up in bankruptcy. There are signs that the German authorities are beginning to really address the issue of staff for the sector - as in, how to attract and retain sufficient foreign workers to keep the industry ticking along. It’s an important part of the equation.
The German economy IS stagnating, it is true. There may be glimmers of hope for the construction industry, but by any measure it is still mired in crisis. Housing completions are so far below even modest targets that for the next three years at least, misery will continue for many, and housing rents will rise inexorably upwards. Good for those landlords with index-linked rental agreements, although in residential they are relatively few in number. Resistance by tenants to capricious rent rises is increasing, as is the willingness to resort to any means - fair or foul - to fight back at any excessive landlord profiteering.
Investors in downtown retail have their work cut out for them. The collapse of department store chain Galeria will just add to the ten-year meltdown in high street rents from 2017, amid the whole debate about how to attract high-spending consumers back to the downtown. We’re witnessing the transformation of the big department stores and shopping centres into mixed-use properties. That takes time, while location qualities and rents adjust.
An ongoing shortage of logistics space and new ESG stipulations should support further rises in logistics rents over the coming years, but at a more subdued pace - nothing like the surge in rents in the Munich area of up to €1.50 per sqm over the last twelve months. With little economic growth envisaged, it’s harder to indulge in fantasies of extra capacity, bursting at the seams. Still, with onshoring and supply chain re-invention, there is enough wind to fill the logistics sector’s sails.
But back to offices, and the ever-present ESG. REFIRE spent some time recently talking to Germany’s Sonar Real Estate about everything they’ve learnt about revitalising and repositioning an existing building, to make it every bit as good as a brand new state-of-the-art property - one that’s not even in the Central Business District of Frankfurt. It’s a Herculanean task, but the end-result should be worth it. It’s likely to provide a role model for German business peers and students keen to learn everything there is about burnishing their ESG credentials. Read excerpts of our discussion in this issue of REFIRE.
