How Interest Rates Are Altering the CRE Outlook

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UBS Asset Management’s Real Estate & Private Markets, one of the largest asset managers of commercial real estate, just released its latest report. The study, which outlines how the change in the global economy has and will impact commercial real estate around the world, points to interest rates as the major player in the forecast.

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As noted in the report, the global growth outlook has weakened as a result of trade hostilities, deteriorating business investment and political uncertainty. And with diminished growth expectations comes diminished demand for real estate. The main source of the altered forecast for real estate centers on interest rates. “The consensus expectation has gone in the last six months from one more Federal Reserve hike to the beginning of an easing cycle. At the same time, the [Bank of Japan, European Central Bank] and Swiss National Bank—they’re looking at how much deeper into negative territory they can go with interest rates,” Paul Guest, lead real estate strategist with UBS Asset Management, said in a video on the report. “All told, central banks seem to believe that preemptive easing is needed to keep growth on track.”

The change in interest rate expectations, he continued, means the risk premium is no longer decreasing and that translates into three possible outcomes for real estate investors, namely, more yield compression, particularly in higher-yielding secondary markets. Additionally, some investors will likely assume additional leverage as a result of low borrowing costs. Finally, in pursuit of higher yield, there could be an uptick in investment activity in such niche sectors as student housing and senior care facilities.

The one common theme among these potential outcomes is the assumption of additional risk. With the risk premia ceasing to narrow, UBS-AM has changed its two- to three-year forecast, going from a prediction of modest capital value erosion to one of flat or positive capital value growth, spurred by downward adjustments in interest rates. UBS-AM’s summary of the real estate market outlook: easing, on the one hand, uncertainty, on the other.

Regional roundup

Looking at the current status of real estate in the Asia-Pacific, UBS-AM found that the industrial sector continued to lead the real estate market in terms of performance in the second quarter of 2019. The office market remained tight, but sentiment went on the downswing. As for APAC retail, low vacancies continued to bolster high rents. UBS-AM’s view on the retail sector was unchanged, with the firm remaining keen on prime retail, tourism-centric high street retail and dominant suburban or regional retail centers.

In Europe, demand remains strong in office and industrial, and supply is largely still constrained. And while investment volume is on the downswing, prices continue to hover at historically high levels. Retail, however, is another story. European retail, but for a few exceptions, is generally plagued with low demand and structural oversupply. Still, prime retail rents were a bit of a mixed bag in the second quarter, holding steady year over year in most major U.K. cities, but decreasing in Brussels, Amsterdam and Barcelona—and increasing in Milan and Naples.

In the U.S. commercial real estate’s status as a solid investment persists; the industry yielded steady returns consistent with long-term expectations in the second quarter. However, there were certain shifts in the sectors. Industrial demand remains high and net rent growth is still robust, but the pace of completions is still elevated, which increases risk in the forecast. In the office sector, returns remained strong in the second quarter, but capital expenditure requirements rose, producing lower cash yields.

In the retail sector, capital requirements increased as a result of the growing emphasis on mixed-use properties. Performance is expected to vary with the ongoing move away from apparel-based formats. Across the sectors, the long expansion—121 consecutive months of expansion, a record not seen in the U.S. since 1854, as noted in the report—is resulting in an increase in capital investment into stabilized assets. UBS-AM cautions investors to keep a sharp eye on the risk-return expectations for incremental capital.