Q3 2023 Public REIT Market Recap
Higher for Longer Rates
In 2023, Global REITs underperformed global equities, primarily because interest rates have continued to rise, and the market’s perspective has shifted towards the expectation of rates staying higher for a longer period.
Since the start of the year, 10-year government bond yields have risen by 85 to 100 basis points in North America, ~75 basis points in the U.K., ~40 to 50 basis points in Australia and Japan, and ~25 basis points in Continental Europe. These higher interest rates have negatively influenced the transaction market, causing bid-ask spreads to widen and real estate values to decline.
The Impact on New Supply
While the ‘higher for longer’ narrative is what captures the attention of news headlines and the market is fixated on real estate valuations, what gets missed underneath the surface is the impact higher interest rates are having on new supply.
There are two sides to the fundamental coin, demand, and supply. Currently, demand for residential and commercial real estate remains strong across most property types and geographic locations, except for office and life science properties. This sustained demand is due to the global economy’s resilience, supported by ongoing job growth.
What’s not getting talked about enough is how much new supply is forecasted to decline in 2024 and 2025, due to the rise in construction costs from higher inflation over the past 18 months and the significant increase in the cost of construction financing over the last 12 months from interest rates being higher for longer.
We frequently meet with companies and brokers who point to a supply shortage starting the second half of 2024 and 2025.
U.S. industrial sector - Developers are experiencing tighter financial conditions, including higher recourse requirements and loan rates, which have made many projects economically unfeasible. According to CBRE, industrial construction started declining to 59.6 million SF in Q2 2023, decelerating for three straight quarters, and down 50% compared to 2022. Prologis, on their second quarter earnings call, spoke to how new construction starts in Europe are also down 50%. We believe a declining supply backdrop combined with steady demand for space, will result in a more sustainable rent-growth environment over the next few years.
Senior housing sector - According to Cushman and Wakefield, construction starts as a percentage of total inventory in Canada, is anticipated to decline to 1.5% of existing stock in 2023, the lowest amount in seven years, and down from 2.2% in 2022 and 3.4% in 2021. New supply deliveries peaked at 5.6% in 2017. In addition, Cushman and Wakefield is forecasting national senior housing occupancy rates will continue to rise and match prior peak highs in 2025 and 2026. We believe a moderating supply environment combined with higher occupancy rates will embolden operators to push rents, leading to strong same store net operating income growth.
Office - According to Green Street, new office supply in Europe as a percent of existing stock, is anticipated to decline to 0.7% in 2024 and 0.6% in 2025. These levels are some of the lowest in over 20 years. Demand for office space in Europe remains strong, especially for high quality buildings with attractive environmental, social, and governance characteristics. Back-to-work trends in Europe are strong, with most employees in the office at least four days a week, making the European office sector significantly more vibrant than its U.S. counterpart.
Multifamily sector - According to Vonovia, completions of new communities in Germany and permits to build new projects is forecasted to decline in 2024 and 2025, leading to a 700,000-unit demand/supply imbalance by year end 2025. We believe, this imbalance should lead to stronger fundamentals and the prospect for higher rents for years to come. In Canada, high costs of project financing, supply chain disruptions and a complicated and protracted municipal approval process has dissuaded many builders from breaking ground on new rental housing, resulting in a significant shortfall for rental housing across Canada. According to the latest estimates from Statistics Canada and the Canada Mortgage and Housing Corporation, the total supply deficit is more than 300,000 units.
Data centre sector - According to UBS, data centre development is forecasted to decline by 4% globally in 2025. Higher debt and land costs, and power constraints are contributing to making data centre development a more challenging endeavor, especially in markets like Singapore, Hong Kong, Japan, and parts of Europe and the U.S. We anticipate that demand for data centre space will be robust over the next five years, driven by artificial intelligence generative requirements. The combination of a modest contraction in new supply and steady demand, should lead to a favourable rent growth period for the industry.
Lodging sector - According to Smith Travel Research, new supply in the U.S. in 2024 is forecasted to be slightly more than 1%, which is nearly 2x below the long-term average of 2%. Historically, hotel occupancy rates rise in periods of lower construction starts, providing owners with a pathway to raise average daily rates with less new supply to compete with. We believe demand for lodging, especially from group business is on strong footing and that, combined with significantly less supply over the next 12 months compared to pre-pandemic years 2015 to 2019, may result in stronger than anticipated rate growth.
In all the examples provided, along with countless others, we believe a ‘higher for longer’ interest rate environment will have a meaningful, positive impact to the supply side of the equation over the next two to three years, and when combined with steady demand for space, we believe pricing power is better than expected resulting in real estate fundamentals being more resilient than feared leading to stronger rent growth in the coming years.