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LaSalle’s Brian Klinksiek and Eduardo Gorab, and JLL’s Matthew McCauley discuss real estate transparency and its effect on investment decision making.

GRETI on jll.com

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One of the most important factors we consider when deciding where to invest capital is the transparency of a real estate market. This encompasses the transparency of market fundamentals and investment performance, as well as:

its legal and regulatory transparency,
the prevalence of listed vehicles,
the transparency of transactions processes, and
the transparency of reporting on sustainability factors.

During times of heightened uncertainty, transparency is more important than ever as a foundation that allows real estate occupiers, investors and lenders to operate and make decisions with confidence.

Our latest ISA Focus report, Transparency and Strategy, explores these factors and their implications for real estate investors. We release this report alongside the Global Real Estate Transparency Index (GRETI) for 2024. GRETI is a joint publication between LaSalle and our parent company, JLL, which is based on a global survey of our extensive network of real estate market experts.

Important notice and disclaimer

Last year, we released the inaugural edition of LaSalle’s ISA Portfolio View, where we discussed the art and science of portfolio construction and why it matters most when market conditions change suddenly. That was certainly true at the time of last year’s release and remains so today.

In this year’s edition, we cover the five foundational concepts of portfolio management below, and how they should be considered alongside an investor’s objectives and values to devise a strategy for their portfolio.

Why real estate lays out the case for property exposure in a multi-asset context?
Why global considers the benefits of expanding horizons beyond an investor’s domestic market?
Why be sector smart tries to make sense of the recent changes in relative sector performance with an eye to building resilient portfolios?
Why be quadrant smart addresses the interplay among the “four quadrants” of real estate?
Why manage risk explores the importance of—and our approach to—managing investment risk?

For 2024, we have also updated ISA Portfolio View to include the most recent available data, and added new sections on:

long-term real estate returns relative to stocks and bonds,
debt returns’ correlation to other assets, and
the effect of leverage on both risk and returns.

The speed and unpredictability of market changes over the last few years highlights the importance of not only planning ahead by thinking carefully about how to create real estate portfolios that can be expected to be resilient, but also working with an asset-class expert who understands the nuances presented by real estate.

Download ISA Portfolio View 2024

Important Notice and Disclaimer

PropertyEU spoke with LaSalle’s Ryu Konishi and Adam Donohue about the drivers of and challenges to sustainable investments around the world at Expo Real 2024.

Learn more about how LaSalle is building pathways to a more sustainable future below.

LaSalle’s Eduardo Gorab, Chris Battista and Matt Sgrizzi discuss the outlook for REITs and ask if listed real estate is about to enter a new “golden era”?

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Listed real estate investment trusts (REITs) have faced a tough two and a half years, driven by the rapid tightening of financial conditions (see LaSalle Macro Quarterly, or LMQ, pg. 13). Sentiment towards REITs has been weighed down not only by the higher interest rate environment, but also by constrained bank lending, a barrage of negative headlines about commercial real estate and REIT underperformance relative to the broader equity market. But, as the saying goes, it’s often darkest before the dawn.

The modern REIT period has seen three “golden eras” of REIT investing (see chart below).¹ These have been characterized by either a dramatic growth in the REIT market or outsized investment returns versus other asset classes, or both. The Savings and Loan (S&L) crisis spurred what is often considered the birth of the modern REIT era in the mid-1990s. During this period, the number of REITs increased by nearly 50%, while the market cap of that group grew nearly seven-fold. Following the Dot-com bubble, a period where REITs had been significantly out of favor, the REIT market endured a multi-year run of strong absolute performance in which it cumulatively outperformed broader equity markets by more than 300%. The period following the Global Financial Crisis (GFC) saw the rise of dynamic new property sectors in the public market, and another period of outperformance in which REITs led broader equities by 50%.

While each golden era was unique, our analysis finds that each period was preceded by challenging circumstances with four common elements (see LMQ pg. 14). These are:

dislocation of bank lending to real estate;
broad-based negative sentiment around real estate;
underperformance versus broader equities which leads to attractive relative valuation and the potential for renewed outperformance; and
an easing or reset of financial conditions, potentially aided by a central bank easing cycle.

Recent history, marked by a post-pandemic recovery followed swiftly by the Great Tightening Cycle (GTC), presents important similarities to these historical periods of severe market challenges. For instance, real estate bank lending is dislocated. An AI-driven tech frenzy and fears of a generalized “commercial” real estate malaise mean REITs have underperformed compared to equities (see LMQ pg. 22). Meanwhile, signs of an easing or stabilization in financial conditions and a potential global monetary easing cycle are becoming more apparent (see LMQ pgs. 9, 10 and 30).

While history does not repeat itself, it does often rhyme. The presence of those elements in today’s market environment, and the potential for those concerns to flip to opportunities, may foretell the next REIT golden era. We discuss each of these factors in turn.

Challenged real estate lending represents an opportunity for REITs. The past two to three years have been characterized by a significant retrenchment in bank lending to real estate. According to the US Senior Loan Officer Survey (see LMQ pg. 16), the net balance between demand for loans and banks’ willingness to lend points to the widest undersupply of credit in the past ten years, except for during the depths of COVID-19. The shortage is evident in all styles of borrowing, from riskier construction loans to mortgages backed by traditional, defensive apartment assets.

This circumstance presents an opportunity for REITs given their strong financial positions and access to the capital markets. Having learned a painful lesson from the GFC, global REITs went into the GTC with their lowest leverage levels on record (see LMQ pg. 16), and nearly 90% of their debt on fixed rates and an average remaining term of seven years.² Looking specifically at the US market, the overwhelming majority of REIT borrowing – nearly 80% – is from the unsecured market, at rates that are today almost 100 bps lower than a traditional mortgage. This relative advantage in both access and cost of capital positions REITs to potentially play the role of aggregator and to take market share.

“Commercial” real estate negativity is office-focused, but all real estate is not office. Headlines proclaiming the demise of commercial real estate usually involve a misleading generalization. Professionally managed, income-producing real estate generally should not be conflated with office specifically. It is well known that hybrid work and other factors have harmed office values. Office fundamentals are expected to remain relatively weak,³with the sector’s growth outlook trailing nearly all other REITs globally. Office landlords will likely need to invest capital aggressively to maintain competitiveness.

These challenging office sector dynamics have unfairly cast a shadow over the broader real estate and REIT universe. In reality, office has over time become a smaller portion of the real estate landscape, especially in the public market; as of the date of this paper, only about 6% of global REITs by market capitalization are office focused (see LMQ pg. 20).⁴ The public market now offers a diverse sector menu comprising a wide range of dynamic sectors. These include industrial and logistics; forms of rental residential including multi- and single-family rental, manufactured housing and student housing; various formats of healthcare property; and exposure to tech-related real estate in the form of data centers and cell towers. Sectors other than office comprise the overwhelming majority of the public REIT market,⁵ and many of those sectors have growth outlooks that are forecast to produce earnings growth that is in line with or better than broader equities.⁶ That growth outlook is underpinned by a combination of secular demand drivers and declining supply levels, the other side of the higher interest rate coin.⁷

Media coverage naturally tends to focus on the national and trans-national arenas, but local political developments can be especially impactful for real estate investments. Such issues can fly under the radar, especially given many of the most relevant ones are only of interest to a specialist audience. For example, changes in policy around topics like the planning process, property taxes and transfer taxes (a.k.a. stamp duty) can have direct, measurable and immediate impacts on property cash flows and thus values. The distraction of the bright shiny lights of global geopolitics should not be allowed to excessively overshadow the critical local issues that impact real estate.

Underperformance may set the stage for a return to outperformance. The negativity around lending or financing concerns and the “death of office” have weighed on both the absolute and relative performance of REITs. The chart below shows the rolling one-year relative performance differential between REITs and equities; it indicates that REIT underperformance has reached its typical peak historical level before starting to reverse. Periods of underperformance have historically tended to reverse, and this instance is likely no different; indeed, the performance gap is already narrowing.

The start of a global monetary easing cycle. Real estate is a capital-intensive business that exhibits significant sensitivity to changes in financial conditions, an observation that holds for both directions of interest rate change. The downside of this dynamic was evident for much of 2022 and 2023, but the upside is likely coming into play. A global monetary easing cycle is now decidedly underway, heralded by the Fed’s 50 bps rate cut on September 18 (see LMQ pg. 31). REITs have generally performed well in periods leading up to and following a central bank easing cycle, as the chart below shows.

Over the past 25 years, REITs have produced total returns of 8% per annum, with 4-5 percentage points of that return coming from income. LaSalle’s base case underwriting for the next three years is for the REIT market to produce total returns of 9%, slightly above historical averages, with roughly four percentage points of that coming from income. That base case forecast incorporates today’s fundamental outlook and interest rate levels. Should any further easing in financial conditions occur, even only in the amount of 50 bps or 100 bps, those return expectations increase to 13% and 18% per annum, respectively, in line with previous “golden eras.”

LOOKING AHEAD >

Pattern recognition is a useful approach that can help in predicting regime shifts in market conditions. Our study of historical periods of listed REIT under- and outperformance identifies a clear pattern. Namely, there are four common factors that have driven REIT strength after a period of challenges: dislocated bank finance, weak sentiment, underperformance versus broader equities, and the start of an easing in financial conditions.
We also identify three historical “golden eras” for REITs — all of which were preceded by periods characterized by those four factors. These periods are those immediately in the wake of the S&L crisis, the Dot-com bust and the GFC.
The current environment resembles the set up for these historical golden eras, suggesting that the REIT market may be on the cusp of its next golden era of investment, according to our analysis.
Many of the factors supporting the REIT market’s upbeat prospects are also positives for real estate as a whole. For example, an easing in financial conditions has historically been a driver of strong forward REIT returns, as well as those for private equity real estate.
That said, some of the dynamics are more specific to listed real estate markets. For example, REITs’ strong balance sheets and the cost of capital advantage of their unsecured borrowing options versus conventional mortgages positions listed players to seize opportunities.

Footnotes

¹ This analysis based on LaSalle Securities analysis of historical macroeconomic, capital market and listed market trends. Source for the REIT performance data cited below are the FTSE Nareit indices.
² Source for debt pricing comments in this paragraph: S&P Global Market Intelligence, Green Street Advisors, company financial releases, company research and market analysis conducted by LaSalle Securities.
³There is considerable global variation in office performance, and there are certainly exceptions to this generalization, especially in select Asia-Pacific markets and the higher end of the European office quality spectrum. For more discussion of global office trends, see our ISA Outlook 2024 Mid-Year Update.
⁴Source: LaSalle Securities. Percent of companies classified as office focused within the global listed universe defined as the constituents of the S&P Developed REIT, FTSE EPRA Nareit Developed and Nareit All Equity Indices. Sector classifications determined by LaSalle Securities.
⁵As measured by market capitalization. Source: LaSalle Securities. Global listed universe defined by the constituents of the S&P Developed REIT, FTSE EPRA Nareit Developed and Nareit All Equity Indices. Sector classifications determined by LaSalle Securities.
⁶As based on LaSalle Securities proprietary modelling and consensus earnings forecasts for the Bloomberg World Index, a proxy for broader equity markets.
⁷Higher interest rates mean development proformas use higher exit yield assumptions and more expensive development finance. When interest rates are high, all else being equal, the rents required to justify development are higher.
⁸Based on proprietary internal LaSalle Investment Management modeling of securities returns. There is no guarantee that such forecasted returns, or any other returns referred afterwards, will materialize.

Dave White, Head of Real Estate Debt Strategies, and Brett Ormrod, Net Zero Carbon Lead for Europe, discuss the current and future state of green lending across Europe.

While lending volumes across the market remain volatile, data shows one continuously increasing metric: the demand for green loans, which is being driven by the ever-growing sustainability requirements from both investors and sponsors.

Dave White and Brett Ormrod discuss the challenges that borrowers and investors are facing, and how we at LaSalle are navigating these dynamics. They discuss how green loans are impacting the European real estate market, what they can mean for investors’ bottom lines, and the overall opportunity not just for green loans, but for greener assets in investors’ portfolios.

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This article first appeared in PropertyEU’s State of Logistics report

LaSalle’s Petra Blazkova recently joined Property EU’s State of Logistics 2024 conference in Amsterdam to present the firm’s inaugural Paths of Distribution Score research, which gives the ability to compare logistics locations at a micro, market, country and pan-European level.

LaSalle identifies top logistics locations in Europe

Paris and the surrounding Île-de-France region are the top micro-locations for efficient logistics distribution in Europe, according to a new study by LaSalle Investment Management.

The Paths of Distribution study considered over 150,000 micro-locations across the UK and EU, scoring them based on factors like manufacturing output, consumer spending, infrastructure, and labour costs. It also took into account the location of Amazon warehouses and analyzed data from REITs and other real estate databases.

Presenting the results at the Amsterdam logistics event, Petra Blazkova, Europe head of Core and Core-plus Research and Strategy, LaSalle Investment Management, pointed out that the data provides valuable insights for investors seeking the most efficient and attractive logistics locations with the greatest potential for long-term rental growth.

Want to read more?

LaSalle’s Paths of Distribution Score

PropertyEU’s report

A prudent person sees trouble coming and ducks.
A simpleton walks in blindly and is clobbered.
— Proverbs 22:3

King Solomon’s words of wisdom have been passed down to us for 3,000 years. They still resonate, especially in this modern translation,¹ even though the “trouble” is no longer invading Assyrians or Babylonians but the type of danger we bring on ourselves through an all-too-human combination of ingenuity, hubris and ignorance.

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Watch any movie from the 1930s to the 1960s and you will see actors inhaling tobacco smoke with abandon. We know better now. Like the generational awareness of the harm caused by tobacco products, real estate owners have gradually become aware of the dangers lurking in certain building materials and contaminated soil. Starting in the 1960s, societies have spent fortunes cleaning up “miracle products.” Asbestos, PCBs, dry cleaning solvents, herbicides and lead pipes were all considered state-of-the-art technologies at various points in human history. None of these inventions were designed with the intention of killing people. They all started with a noble purpose – whether suppressing catastrophic fires, insulating transformers, cleaning wool suits or producing a pleasing nicotine buzz that also curbed the appetite. The “externalities” associated with societal damage from the use of these products took decades to discover and billions to eradicate.

Greenhouse gas emissions share a common ancestry with these miracle products. Heating buildings with diesel fuels, running gas lines through city streets, producing electricity with coal-fired plants—these were all logical, economical, and sensible solutions to the problem of bringing energy to homes, businesses and buildings of all types. The industrial revolution accelerated the growth of cities and raised the quality of life for millions of people by dragging them out of rural poverty. As we now know, society’s dependence on fossil fuels creates new problems which must be dealt with.

The recognition that miracle products can carry hidden (or not so hidden) dangers follows a predictable pattern. Here is what the step-by-step process often looks like:

Evidence and awareness. An environmental problem often requires decades of scientific study and mountains of evidence to convince people that a change is necessary. Even as this evidence accumulates, vested interests organize counterattacks to convince society that the problem is non-existent or over-stated. Eventually the harm to human life becomes so obvious that denial becomes a “fringe position.”

Market demand. In many cases, the process of partial “market adjustment” can begin ahead of government action. Voluntary data collection and industry-led reforms start the slow process of change. In the case of greenhouse gases, the marginal contribution of each emitter is so small, and so embedded in society, that government interventions sometimes lag market-led shifts (e.g., the adoption of LED lighting or heat pumps).

Regulatory response. Yet, government interventions are almost always needed to accelerate and complete behavioral change to truly eliminate harm to the environment and to human life created by “externalities.” These regulations and policy responses often get pushback as competing outcomes are debated in the political arena. Economists agree that putting a price on carbon would be the most efficient and effective solution, but a market mechanism for carbon pricing requires government intervention — in the form of a carbon “tax” or to set up an emissions trading scheme.

Benchmarks and best practices. Eventually, the rise of data benchmarks and peer group comparisons begins to shed light on who, where and how successful “treatments” are applied to any environmental problem. Engineering and laboratory science helps inform this stage of the process, as does public health or industry group data. Integration with market investment processes and decisions leads to a focus on reversing years of damage to the environment and compliance with new regulations and guidelines. At this stage, market-driven and regulatory-driven changes start to converge.

Price integration. Feedback loops are established where type 1 errors (false positives) and type 2 errors (false negative—or overlooked problems) are exposed.² In loosely regulated situations like climate change, the efficient market hypothesis (EMH) takes hold as the change process gets partially or fully priced by consumers and producers. Economists and policy analysts favor the practice of placing a “price” on an externality to compensate society for the harm. In practice, though, compensatory payments to offset environmental damage are often decided through the courts and litigation.

Continued market and regulatory evolution. The enforcement of tighter regulations also follows its own trajectory depending on the governance structure of a particular country or urban jurisdiction and the toxicity of the problem. The discipline of epidemiology, using population data and public health analysis, is especially helpful at this stage of refining the policy solutions.

The Transition from “Data” to “Wisdom”

For the de-carbonization of buildings, various markets and countries are well into Step 3 (Regulatory Response) and Step 4 (Benchmarks and Best Practices). In Europe the “theory of change” is focused more on EU-wide or national policies to promote energy disclosures through top-down regulatory solutions. In the United States, the emphasis is based more on voluntary pledges, market solutions and regulations that are based on specific local jurisdictions. In most developed countries, steps 5 (Price Integration) and 6 (Market and Regulatory Evolution) are underway, but both have a long way to go.

The rise of real estate sustainability benchmarks (like GRESB) has accelerated in recent years. In many cases, they have expanded to include social factors and tenant well-being alongside environmental metrics. The next hurdle, though, is to establish materiality tests that infuse meaning, and determine financial impacts based on the volumes of reporting that the industry has started to produce and disclose.

Reading through ESG reports often reveals the triumph of reporting and public relations over salience or relevance. The conjoint challenges of reducing building emissions alongside improving the well-being of building users and the surrounding communities can be obscured by data denominated in less familiar metrics like tons of CO₂ or Kilowatt hours. In time, and with experience, the emphasis will shift to what truly moves the needle on all elements of the “sustainable investing” paradigm—and which metrics give off misleading or meaningless “virtue” signals.

Financial metrics align most closely with the “fiduciary duty” of an investor. Moreover, stakeholders have decades of experience analyzing and interpreting financial data. It will take additional time and effort to convert environmental data into financial terms or to simply raise the consciousness of how to interpret energy and emission data in its own right. (LaSalle’s work on the “Value of Green” synthesizes studies of the evidence linking sustainability metrics and financial outcomes. An update on this work is below.)

In writing Proverbs, King Solomon gathered centuries of wisdom based on experience. In the modern world, we often believe that the steps to wisdom are built on a foundation of knowledge, information, and data. The famous “DIKW” hierarchy has been a mainstay of information sciences since the 1930s. Sustainability wisdom is still in the process of being formulated and likely requires more time to make progress. Fortunately, the foundations of this wisdom are already being put in place—first through data (the modern way to refer to many, many experiences), then information (organized and analyzed data), eventually leading to knowledge (patterns are identified and the “what” and “why” questions are answered) and finally reaching the status of accumulated wisdom (how to respond). This is a path that humans have traveled before. More lives are at stake this time around and the wisdom may not be easily agreed upon by all industries, countries and stakeholders. Nevertheless, the search for sustainability wisdom must continue and time is of the essence.

Revisiting LaSalle’s “Value of Green”

In September 2023, LaSalle published our ISA Focus report What is the value of green? Looking at the evidence linking sustainability and real estate outcomes. The report presents a framework on how sustainable attributes of properties can be viewed as both as drivers and protectors of value, along with showcasing findings from the broader literature. We continue to maintain a Value of Green tracker, monitoring research on this subject as it is produced. Some of the findings that have surfaced since the release of our initial report are worth highlighting:

In early 2024, CBRE reported in their UK sustainability index that efficient properties outperformed inefficient properties by close to 2% per year in terms of total return, over the course of 2023 across three major property types. The efficiency of buildings was delineated through EPC ratings.
UBS reported in late 2023 that a green premium of 28% and 19% in price per square foot was in evidence in the New York and London office markets, respectively, when comparing office transactions based on LEED/BREEAM certifications. This premium was also established in cap rates, showing a 36 and 27 bps premium for New York and London respectively.
MSCI published a report on price premiums for green buildings, and how they have changed over time. Looking at offices in Paris and London, a clear trend emerged from 2019 onwards showing a growing sale-price gap between offices with and without sustainability ratings. In the case of London, the gap was close to non-existent before 2019 and had since grown to 25% as of the latest reported data point in late 2022.

Beyond the direct links between sustainability and historical investment performance in terms of return, rent and value premiums, more signals are emerging as available data on the topic grows, and becomes increasingly forward looking:

In 2024, JLL published in their “Green Tipping Point“ report on how the supply/demand balance is shifting in favour of sustainable offices across the globe, as tenant demand evolves. JLL projects a 70% unmet demand across 21 global office markets.

Beyond results based on backward-looking data, detailed case studies of investments into sustainable initiatives are being published. The JLL report “Future-Proof Your Investments“ showcased opportunities for sustainable New York offices; another example is CBRE’s report “The impact of on-site rooftop solar on logistics property values.”

Tobias Lindqvist
Strategist, Climate and Carbon Lead, London

Sources:
CBRE (March 2024) UK Sustainability Index Results to Q4 2023. CBRE
P. Torres, G. Bolino, P. Stepan (2024) The Green Tipping Point. JLL
T.Leahy (2022) London and Paris Offices: Green Premium Emerges. MSCI
P. Torres, J. del Alamo (July 2024) Future-proof your investments. JLL
D. Marina, J. Tromp, T. Vezyridis, O. Bruusgaard (July 2023) The impact of on-site rooftop solar PV on logistics property values. CBRE
O. Muir, Y. Chen, T. Metcalf et.al (Dec 2023) Green premium: Study of New York and London Real Estate finds strong evidence for a ‘green premium’. UBS

What can we learn from simulations?

The de-carbonization of buildings is taking place in a complex and ever-changing environment. It is a multi-dimensional problem replete with uncertain outcomes, regulatory change, shifting societal norms and markets, and the politicization of sensitive issues.

At the June 2024 MIT World Real Estate Forum, Professor Roberto Rigobon unveiled a “sustainability simulation” game patterned on his pathbreaking work on social preferences for the European Commission. The technique shows how the traditional economic conceit that we make “resource trade-offs” does not accurately capture how humans make decisions when faced with multi-dimensional choices.

In the simulation, the audience was given nine choices for different retrofit projects for a commercial building. Each choice resulted in simultaneous movement across three metrics that the audience had already established that they cared about — changes in NOI (profitability), CO₂ emissions, and tenant satisfaction/well-being. The cost of the projects was amortized into the NOI calculations and the other metrics were also calibrated based on actual data from the US.

The simulation showed that a knowledgeable real estate audience rarely solves just for “pure profits” at the expense of tenant well-being or CO₂ emissions. The simulation also mimicked reality—where sometimes profitability moves in synch with reduced CO₂ emissions and other times it moves it moves in the opposite direction. The simulation was designed to show how the co-movement depends on the local market and the type of de-carbonization project. Tenant well-being and CO₂ emissions could be implicitly linked to revenue when and if participants believe that occupancy, rents and capital raising are all interconnected.

Through their choices, the audience tried to optimize across all three priorities at once — leading to an interesting result that revealed their average willingness to “pay” to reduce a ton of CO₂ emissions of about $200 ton. Yet, if asked directly how much they would pay to reduce a ton of greenhouse gas coming from a building, it seems unlikely that many would have volunteered to pay that much. This finding also shows how the language of profitability and returns is much more advanced than the metrics and concepts associated with either decarbonization or tenant satisfaction. And that all these metrics are linked, but not fully integrated in the minds of real estate professionals.

Only a few participants in the game focused only on reducing CO₂ (at the expense of decent profits). And just a few focused exclusively on profitability at the expense of tenant satisfaction or CO₂ emissions. This seems like a reasonable facsimile of what enlightened investors will do — especially when they know that their actions are being disclosed. As we learn more from these simulations, it is possible that policy makers will be able to refine the mix of incentives and regulations that govern the real estate industry.

Jacques Gordon
Cambridge, Massachusetts

LOOKING AHEAD >

As we advance through the six stages of market wisdom, sustainable features in real estate move away from purely “virtuous” and toward increasingly meaningful drivers of investment value. As noted in our ”Value of Green” report the challenge for investors is understanding where, when and how sustainability is driving performance, which is highly variable across markets and sectors. Given LaSalle’s global reach, we are well positioned to observe, learn and act to enhance and protect asset values for our clients, and gain and share wisdom in the process.
Markets are shifting towards wider alignment with a more sustainable future, new data and findings are continuously published. At LaSalle we also focus on the data generated within our walls, linking our own initiatives driving sustainability with their associated investment outcomes, bringing our own data and experience into the DIKW hierarchy.
Recognizing the importance of meaningful benchmarks to drive decision-making (Stage 4), LaSalle has been leading an industry initiative to develop an improved solution for decarbonization pathways in the US and Canada, which could be adopted by CRREM and others globally. More meaningful decarbonization pathways will help investors properly measure transition risks and set targets, setting the industry up to make real progress in decarbonizing the built environment.
Evolution over the Six Stages will likely be uneven over time, geography and investor type. This unevenness could provide investors at more advanced stages an advantage over less progressed investors. For instance, an investor who has incorporated a carbon business case into their investment process is at an advantage to appropriately price opportunities. For example, it should help investors identify attractive brown-to-green strategies.

Footnotes

¹ The Message, translated from the Hebrew scriptures by Eugene Peterson (1993-2002).

²These are all part of the learning that occurs with any “treatment hypothesis.” The science of public health provides solid evidence to weigh whether the “treatment” is helping, hurting or having no impact on the eradication of the underlying disease. In real estate, a good example of this is the gradual discovery that with certain types of asbestos, it is more dangerous to remove it than to “encapsulate” it in an existing structure. The science of “decarbonization” is still being established to determine whether, for example, the mass production of lithium batteries does as much harm as the burning of fossil fuels. For real estate and climate change, the “treatment” will likely focus on energy efficiency/ decarbonization interventions that are a combination of government penalties/incentives and voluntary actions. The effectiveness of these treatments will depend on compliance, market response, and how well interventions find acceptance through the political process.

Important Notice and Disclaimer

One of our key conviction sectors for real estate investment over the last few years has been logistics. It has been a particular focus of our research, as we seek to identify investment opportunities in prime locations. But with continued uncertainty around variables such as energy prices and supply chains being disrupted, cost uncertainty is high across the continent for logistics providers.

Location, however, is a key variable which distributors can still control, and so it is more important than ever: optimising your choice of location can help minimise exposure to these other risks and protect your supply chain.

LaSalle’s Paths of Distribution Score 2024

LaSalle’s inaugural “Paths of Distribution Score,” focuses on the geography of the European logistics market. This innovative, granular new research gives us the ability to compare logistics locations at a micro, market, country and pan-European level, with extensive flexibility for understanding, benchmarking and ranking locations – and opportunities to deploy capital – at both micro and macro scale. As investors in the sector, this new insight into the most resilient logistics markets in Europe informs our portfolio composition and asset management.

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At LaSalle, we are often asked what investors in real estate debt and what borrowers of our credit solutions can expect from us.

For investors, knowing that their investment manager has successful, long-term relationships with their borrowers is a strong sign that those interactions will continue, and that attractive investment opportunities will remain available. This dynamic allows us to remain both disciplined and selective in the areas where we choose to invest capital.

For borrowers, recognizing that their credit provider has a wide range of capital solutions, and can offer competitive terms backed by certainty of execution is paramount to our success. Further, this is what drives such a high repeat borrower base and the ability to foster long-term relationships with our borrowers.

As one of the largest providers alterative credit solutions in Europe¹, we find ourselves in the enviable position of being able to truly understand how important both borrowers and investors are to the whole equation. This dynamic allows us to remain active investors in this market, highlighting our expertise in the sector.

What can real estate debt investors expect from LaSalle?

What can real estate debt borrowers expect from LaSalle?

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Learn more about investing in European real estate debt

Source: Real Estate Capital Europe, Summer 2023 issue

Brian Klinksiek, Jen Wichmann and Dominic Silman discuss global real estate debt markets.

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While traditional banks’ appetite for providing commercial real estate loans has declined, other lenders (including investment management firms such as LaSalle) have moved in to fill the funding gap. As a result, we have recently seen increasing interest from institutional investors in real estate debt.

But what is it about real estate debt that makes it a compelling investment? As the second largest of the “four quadrants” of real estate, it has a value in the US and Europe alone of approximately US $4.5 trillion, representing an enormous opportunity. Real estate debt historically has produced competitive risk-adjusted returns in addition to showing low correlation to other assets.

In our latest research, we examine the three-part case for investment, including:

Real estate debt’s place in institutional portfolios,
The role of non-bank lending, and
The debt opportunity today, which takes advantage of a looming debt funding gap and attractive pricing.

Important notice and disclaimer

LaSalle is one of Europe’s largest and most established investors in real estate debt, offering a variety of loan types across sectors. Learn more about this dynamic asset class, and LaSalle’s capabilities from Dave White, Head of European Debt Strategies here at LaSalle.

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Learn more about investing in European real estate debt

Dave White, Head of Real Estate Debt Strategies, Europe discusses the market in 2024 and where we are seeing opportunities for investors.

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Brian Klinksiek and Eduardo Gorab (L-R) discuss how the investment landscape as we reach the halfway point of 2024.

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“You take the blue pill—the story ends, you wake up in your bed and believe whatever you want to believe. You take the red pill… all I’m offering is the truth.”

– Morpheus to Neo, The Matrix (1999)

We published the global chapter of the ISA Outlook 2024 on November 14, 2023, just before euphoria about a potential ‘V’-shaped property market turnaround emerged. Interest rates fell quickly as financial markets priced in several US Federal Reserve (Fed) rate cuts in 2024. For a time, it looked as though our prediction that it would take a little longer for markets to digest a renewed spike in rates would not age well.

In this Mid-Year Update, however, we look back to find an outlook with an uncanny resemblance to that of six months ago. This is not because nothing has changed, but because the mood has gone full circle. The landscape remains characterized by interest rate volatility, soft fundamentals in some markets, and gaping quality divides, but also by pockets of considerable strength. Another factor that has not changed is that financial conditions (i.e., interest rates) remain the dominant driver of the market, and that political and geopolitical uncertainties are in focus in many countries (see LaSalle Macro Quarterly, or LMQ, pages 4-6).¹

In this report, we discuss five themes we see driving real estate markets for the rest of 2024 and beyond. At our European Investor Summit in May, our colleague Dan Mahoney argued that—like Neo in the Matrix—we should take the red pill and endeavor to see the market as it is, not as we’d like it to be. Taking the red pill requires a realistic view on property values. It reveals as unlikely a return to an environment of ultra-low interest rates or uniformly benign fundamentals in the “winning” sectors.

But it does not mean that there will not be attractive investment opportunities. Unlike the bleak dystopia of The Matrix, there are many reasons for optimism, as well as signs that the coming months will come to be seen as a favorable investment vintage. That said, investing successfully will require a balance of big-picture perspective and granular discernment, and a mix of patience and willingness to take risk.

Interest rates – Still no map to the trail

Over the past year, we likened the interest rate path in most markets to a strenuous mountain trek: the relentless climb (2022), the range-bound altitude of an alpine ridge line (H1 2023), the unexpected upward turn in the trail (Q3 2023), and the mountain meadow of cooling inflation and expected rate cuts (Q1 2024). More recently, there have been upward turns in the interest rates trail whenever there have been signs of sticky inflation in the US and other key countries.

One thing is for sure: No map exists for this trail. While interest rates have big consequences for real estate capital markets, they are extremely difficult to predict. We continue to caution investors against overconfidence in their ability to forecast the path of long-term interest rates.

Mercifully, falling rates are not a necessary condition for a robust recovery in real estate transaction activity. Despite interest rates remaining elevated, property markets are already showing signs of finding their footing, such as renewed US CMBS issuance and resilient deal volumes in many markets and sectors.² A key reason for this is that wherever interest rates have spiked over the past two and half years, especially Europe and North America,³ real estate prices have by now adjusted downward significantly. The relativities between expected returns for real estate and those for other asset classes now look more appropriate than they have in many months; in other words, more of the market is at or near fair value.⁴

That said, while lower rates are not necessary for real estate capital market normalization, greater stability in rates than we have been seeing would no doubt help. Interest rate volatility is the enemy of a smoothly functioning private real estate transaction market. Excessive movement in borrowing costs during due diligence periods can lead to dropped deals and re-trades. Moreover, when rates are volatile, the conclusions of fair value models are also volatile, impacting both buyers’ and sellers’ assessments of appropriate pricing. Looking at recent trends in the MOVE index,⁵,⁶ interest rate volatility appears to be gradually easing but is still elevated relative to recent history (see LMQ page 13).

Increasing stability in rates is welcome, but for now it is reasonable to expect continued strains in real estate capital markets that create both challenges and opportunities. Such conditions can represent favorable entry points for debt investors (lenders), distressed equity players and core investors seeking entry points below replacement

Macro – Deciphering divergence

Over the past half-year, interest rates have been increasingly influenced by widening divergences between near-term growth, inflation and monetary and fiscal policy outlooks. Most notably, the bond yield gap between the US and other markets, especially the eurozone, has widened. US growth and inflation have surprised on the upside, in the face of softening or stability elsewhere. Markets currently expect only one Fed rate cut in 2024, down from up to four earlier in the year.⁷ Meanwhile, in early June the Bank of Canada became the first G7 central bank to cut rates since the great tightening cycle began, with the European Central Bank (ECB) following shortly after (see LMQ page 7).

Regional groupings can obscure divergences within them. The key driver of eurozone softness is Germany (see LMQ page 23), owing to its reliance on manufacturing exports and past dependance on Russian energy. Meanwhile, the Spanish economy remains strong due to healthy consumption and tourism. Within North America, Canada’s economy is underperforming the US because the structure of its residential mortgage market makes it more exposed to higher rates.⁸ These intra-regional variations may have a range of impacts on property markets, for example by shifting the relative short-term prospects for demand and value.

Japan and China represent long-standing divergences that persist.⁹ In China, a loosening bias remains in effect as inflation hovers at around 0%.¹⁰ In Japan, monetary policy is gradually normalizing, but so far without triggering a big increase in interest rates (at least compared to elsewhere). In March, the Bank of Japan (BOJ) abandoned negative interest rates and ended most unorthodox monetary policies, though it has since held policy interest rates at around zero. Japan’s economy becoming more “normal” is generally a positive, but interest rate differentials have pushed the yen to a 34-year low against the US dollar (see LMQ page 14), creating upside risks to inflation.¹¹ But notably, Japan remains the one major global market in which real estate leverage remains broadly accretive to going-in yields.

Aside from reinforcing the potential benefits of diversification, what do these divergences mean for investors? Mechanically, any unexpected relative softening of interest rates should, all else equal, be beneficial for relative value assessments of real estate in that market. But firmer rates in the US have predictably come alongside a stronger US dollar. This points to practical limits to global monetary policy divergences; central bankers are keenly aware that weaker currencies come with inflationary risks. Moreover, it is worth asking how persistent macro divergences will be; current divergences are rooted in timing differences of expected rate cuts, rather than an anticipated permanent disconnect.

Renewed cyclicality — Ride the (supply) wave

For several years, secular themes and structural shocks have dominated the trajectories of global property markets. But there is a clear cyclical pattern reemerging in the form of a pronounced upswing in vacancy across global logistics markets, and in US apartments. The return of cyclicality in those favored sectors is having significant impacts on their near-term prospects.

The softening trend is not new. In the ISA Outlook 2024, we identified hot sectors “coming off the boil.” Part of this was down to normalizing demand levels, but elevated new supply was also a key driver. As expected, the softening we observed has continued to deepen, leading to outright rent declines in certain markets, especially for apartments in US sunbelt metros.

Softening fundamentals are not to be ignored, but we recommend investors to have the conviction to “ride the wave” of excess supply. Wide variation in supply levels at the market and submarket level means that investors with granular market data and the discipline to incorporate it into their market targeting processes should be positioned to select the most attractive markets and submarkets.

Moreover, the forces that create cycles sow the seeds of their own reversal; we expect the current supply wave to moderate soon, as evidenced by sharply falling construction starts (see LMQ page 25). Many of the projects being completed today broke ground when credible exit cap rate assumptions were several hundred basis points lower than today. Higher interest rates upended development economics; far fewer new developments can now be justified on today’s mix of land prices, construction costs and financial conditions.

Finally, investors should be prepared to think about cash flows in both real and nominal terms. When cooling nominal rental growth comes alongside cooling inflation, as it does today, it is possible for that to be consistent with solid real rental growth, depending on the relative magnitude of each.

The next chapters in secular change

Beyond the reassertion of supply cycles in some markets, there is an evolving mix of secular stories that deserve attention. Some of these are so long-standing that they could almost be considered constants. These include structural shortages of housing in most of Europe, Canada and Australia, as well as the widespread changing definition of core real estate in favor of more operational niche sectors and sub-types.¹² We continue to be strong advocates for investment in undersupplied living sectors, and for participating in the institutionalization and growth of niche sub-sectors such as single-family rental (SFR) and industrial outdoor storage (IOS).

More dynamic themes that deserve a closer look include the stabilization of retail real estate and divergent office investment prospects:

Rebalanced retail — In much of the world, the various sub-sectors of retail are on firmer ground than they have been in years. This owes to a nearly decade-long process of rebalancing, supported by normalizing post-pandemic demand trends and the removal, through demolition or irrelevance, of uncompetitive retail inventory. We have found retail assets to be some of the most stable performers in our portfolio in recent quarters. While the consumer mood is bifurcated between healthy higher-end households and lower-income households struggling with inflation’s hit to real spending power, physical retail has proven its enduring role in serving both convenience and experiential shopping. We are constructive on selective investment in several retail sub-types, particularly European outlet centers, top Canadian regional malls, and select open-air centers in the US.

All-over-the-map office — The office sector is quite literally “all over the map”, with huge variation in outlook depending on geography, ranging from Seoul, South Korea, where office market conditions are currently tighter than nearly any other market/sector combination globally, to the many North American office markets where vacancy rates are well into double digits. We stand by our long-held views¹³ on the widely varying prospects for global office markets, with Asia-Pacific markets (ex-Australia and China) having the best near-term outlook, US markets having the worst, and Europe in between. One office sector theme that deserves special mention is the increasingly compelling case for investment in super-prime offices in a handful of key European central business districts. We see the conditions for a substantial shortage of top-quality space several markets, which should lead to substantial rent spikes for the best positioned assets.

Other key secular themes driving investment opportunities today include the implications of artificial intelligence (AI) adoption for data center demand, student mobility for student accommodation in Europe and Australia and aging for senior housing.

Don’t wait for the “all clear”

Past experience of real estate cycles suggests that the best investment opportunities tend to arise in periods marked by significant uncertainty, volatility and pessimism, but also when early signs of improvement and stabilization are present—in other words, moments similar to today’s environment. Experience also reinforces that it is nearly impossible to time the market, so it is best to be selectively active throughout the cycle. By the time the “all clear” signal is sounded after a market crisis, it is too late to achieve the best risk-adjusted returns.

That said, “red pill” thinking means we must recognize that the coming capital market rebound is unlikely to be as sharp as it was after the Global Financial Crisis (GFC), given that central banks are unlikely to usher in ultra-loose policy. Seeing the market as it is requires accepting the likelihood that interest rates could remain sticky, and a realistic view of near-term fundamentals as a wave of supply impacts some sectors.

LOOKING AHEAD >

Strategies for both new and existing investments must take a realistic stance on interest rate uncertainty, with duration exposures aligned to an investor’s goals and risk appetite. Using real estate as a vehicle to place bets on bond markets is as inefficient as it is misguided. We continue to recommend that investors be largely “takers” of bond market signals, and today those are pointing to interest rates remaining high for longer in the US and several other key markets.
Upended development economics in many markets and sectors means that assets can be bought well below replacement cost, suggesting rents will need to rise and/or land prices will need to fall to justify incremental supply. While buying below replacement cost can be one indicator of a potentially attractive acquisition opportunity, we are cautious about using replacement costs in isolation as an investment decision-making tool. It is essential to adjust for the capital expenditure required to truly equalize the market position of a new asset versus an old one. Often a building is worth less than the cost to build a new building simply because it is old and uncompetitive.
The anchor of “replacement cost rents” only operates when there is a fundamental need for additional space. In heavily vacant markets, such as US offices, it likely will be years before this mechanism kicks in. Investors acquiring below replacement cost in heavily unbalanced markets must be prepared to wait a long time for that discount to close, and the extended passage of time to monetize a discount is mathematically deleterious to IRRs. A focus on markets working through short-term challenges such as a wave of new supply, but characterized by long-term strength, may generate the best risk-adjusted returns.
Market bottoms are hard to see in the moment, and only tend to become obvious in retrospect many months down the line; it is hard to see today whether we are fully clear of the lowest point in prices. But we have a least moved from a period of relentless upward movement in rates to volatility around a pivot point. Moreover, challenged capital stacks built before the great tightening still need repair. Both observations point to potentially strong opportunities to invest today across real estate debt and equity.

Footnotes

¹ Also see our ISA Briefing, “Elections everywhere, all at once: Geopolitics and risk”, April 2024. In that note, we highlighted the various sources of political uncertainty this year and outlined how we recommend investors consider these risks. At the time of writing, political developments are particularly salient for short-term movements markets in France and the UK, given elections that have been called in those countries.
² Source: MSCI Real Capital Analytics and Trepp
³ Japan and China are key exceptions that we cover in greater depth under the “deciphering divergence” header.
⁴ Of course, there is considerable variation embedded in this and any assessment of fair value. As always, the devil is in the detail on the assumptions that go into expected and required returns; at LaSalle, specific fair value inputs and conclusions remain a proprietary output.
⁵ The Merrill Lynch Option Volatility Estimate (MOVE) is a market-implied measure of volatility in the market for US Treasuries. It calculates options prices to reflect the expectations of market participants on future volatility. Observation made as of June 24, 2024.
⁶ Source: Bloomberg as of June 26, 2024.
⁷For more discussion of the Canada-US divergence and the consequences of mortgage rate resets, see our ISA Briefing, ”The impact of residential mortgage resets”.
⁸ For more detailed discussion of the unique factors in the Japanese and Chinese macro environment, see our ISA Briefing, “Key economic questions for China and Japan”.
⁹ Source: Oxford Economics; Gavekal Dragonomics as of June 26, 2024.
¹⁰Economic theory suggest that weak currency may contribute to inflationary forces because it pushes up the cost of imported goods.
¹¹See our PREA Quarterly article on “The Changing Definition of Core Real Estate” for a discussion of how the characteristics considered desirable in core properties is moving from traditional metrics like lease length, to observed qualities like the stability of cash flows. This shift elevates the appeal of niche sectors sub-sectors versus traditional sectors such as conventional office.
¹²See our ISA Focus report “Revisiting the future of office”, published March 2023.

Important notice and disclaimer

LaSalle’s Brian Klinksiek and Tobias Lindqvist (L-R) discuss how changing climate risk should be viewed by investors.

Recognition has grown substantially in recent years that climate risk can shape real estate investment outcomes. This owes to an increasing frequency and severity of loss events,¹ surging insurance premiums,² improving data availability and a mounting reporting burden driven by regulations.³ Investors have had to move quickly from acquiring basic climate risk literacy, to sourcing good quality climate risk data, to most recently, leveraging that data into improved investment decisions. There is a clear and rising likelihood that investors on the lagging edge of this process may underperform.

At LaSalle, we have sought to share insights from our own climate risk journey, combining that with broader analysis of our industry’s climate risk challenges and opportunities. In 2022, we partnered with the Urban Land Institute (ULI) on a report, How to choose, use, and better understand climate-risk analytics, which addressed the difficulties in selecting and evaluating climate data from an ever-changing and increasingly crowded—and sometimes contradictory—data provider landscape. In April, we released a new report with ULI, Physical Climate Risks and Underwriting Practices in Assets in Portfolios, which looks at how investors are taking these data and seeking to make better-informed buying, selling and portfolio construction decisions based on them.

While the joint ULI report takes an industry-wide view, this ISA Briefing looks at the topic through the lens of LaSalle’s own investment process. We present three case studies of our evaluation of climate risk on a regional, market and asset-level scale. These examples – one each from each of our global investment regions – illuminate how we are taking account of climate risk and lay out our views on issues investors should be thinking about.

A broader regional view: wide-scale impacts

In 2023, the US recorded 28 weather/climate disaster events for which losses exceeded $1 billion, the highest recorded number of distinct events exceeding that threshold.⁴ But of course, these events were not uniformly distributed across the country. To better understand the geographic predisposition of parts of the country to these hazards, LaSalle’s US Research and Strategy team developed two separate climate risk indexes, evaluating current and future climate risk. The indexes encompass a range of climate hazards, such as heatwaves, floods and wildfires, with earthquakes added as a non-climate threat. The current climate risk index harnesses machine learning to scrutinize hyper-local data from the Federal Emergency Management Agency (FEMA). Meanwhile, the future climate risk projections rely on data from the Rhodium Group data set, as analyzed by ProPublica and assuming an RCP 8.5 scenario.⁵

LaSalle US Current Climate Risk Index – Source: FEMA, LaSalle analysis

Looking at climate risk at a regional scale has been useful in several ways. First, it can accelerate analysis of new opportunities by acting as a “yellow flag,” directing resources early in the underwriting process toward deeper analysis into asset-specific climate risk issues that may turn out to be red flags. Second, regional climate risk can be integrated into market-targeting tools, weighing it alongside other factors that influence real estate performance (for example, demographic variables such as population growth and real estate variables like the prospects for rental growth). To this end, LaSalle has embedded these climate risks scores into our proprietary Target Market Analyses (TMAs). Thirdly, it can help frame inquiry into how metro-level performance factors, such as migration patterns, can interact with climate risk over time.

On that last point, the map appears to beg a question about recent migration trends that have favored the Sunbelt.⁶ Are people disproportionally moving to at-risk places, and if so, why? An important follow-on question that is germane for investment strategy is whether climate change may eventually cause a reversal of recently observed migration patterns. Indeed, we do observe a discernible, moderately positive correlation⁷ (+29%) between climate risk exposure and increased migration over the past five years. This pattern holds, and even intensifies, when considering population growth projections for the next five years (+47% correlation).⁸

The implication is that regions facing severe climate challenges continue to draw new residents. This suggests that environmental risks may not yet be so widely recognized as to shape behavior. That said, a mere 8% of market value within the NCREIF Property Index’s (NPI) apartment asset base is situated in markets we classify as high-risk.⁹ This suggests the impact in the near-term on institutional real estate investors will be limited, at least until climate change is severe enough to routinely impact markets in the next less risky band, which encompasses 16% of total NPI apartment value.¹⁰ Either way, investors looking to the long-term would be wise to consider how people will respond to growing climate hazards in high-risk markets. If a major reaction is that Sunbelt denizens relocate back to the Rustbelt, that could have significant implications for regional economic growth and real estate market prospects.

A market-level view: Evaluating mitigating infrastructure

Below the regional level, it is at the scale of an individual metro area where different degrees of exposure to climate risk can be evaluated with more granularity. It is often at this level where both in-place and planned efforts to mitigate the potential impacts of climate hazards can be identified. As we discussed in our 2022 ULI report, such measures can confound traditional climate risk data if they ignore its impact.

For example, when overlaying LaSalle’s global portfolio with raw data from our climate risk providers, Amsterdam and its broader ‘Randstad’ region stand out as especially exposed to sea-level rise. Not considering any protective infrastructure, we estimate that 52% of Amsterdam and 38% of Rotterdam commercial property would have a significant exposure to severe flood.¹¹

Dutch primary flood defenses

Thankfully, the Dutch have been building dams and levees to protect their low landmass from flooding for centuries.¹² Modern infrastructure investment accelerated in the wake of the 1953 North Sea flood – a combination of a severe European windstorm and high spring tide that caused the sea to flood land up to 5.6 meters above mean sea level.¹³ The ‘Deltawerken’ (Delta Works), now complete, consists of a set of storm surge barriers, locks and dams mainly located in the south of the country. But the Dutch flood defense program extends beyond the Delta Works,¹⁴ encompassing almost 1,500 constructed barriers, including more than 20,000 kilometers of dikes, enough to encircle the country over 15 times. In fact, the Delta Works program has evolved into the Delta Programme, a continuous project that take future effects of climate change into account, with a target of 100% of the Dutch population protected by floods not exceeding a 1 in 100,000-year event by 2050.¹⁵

The presence of these flood defense programs is of imperative importance when considering the Dutch markets for investments. We find that many climate risk data providers do not adjust for the Netherlands’ formidable stock of anti-flood infrastructure investment which mitigates much of the risk. Investors who act as uncritical “takers” of unadjusted climate risk stats may thus excessively underweight the Dutch market.

An asset-level view

Below the regional and market level, the asset level is where the outcomes of climate hazards have the most direct impact on a building’s structural integrity or the ability to access and operate a property. An asset manager’s actions can directly influence a building’s capacity to withstand climate-related hazards. This tends to be the most impactful when such interventions are made during the design phase of the development.

For example, take the case of a LaSalle logistics development in Osaka, Japan, a city that has historically been vulnerable to flooding due to its geographical location, with much of the urban area made up of flat lowlands that make natural drainage a challenge in the event of tsunamis and heavy rainfall.¹⁶ The local city planning assesses the maximum level water could rise above sea level by submarket in the event of a flood. The flood height varies by location while considering additional factors such as the city’s infrastructure (i.e., floodgates and seawalls) and the overall elevation of the submarket. In the case of one of LaSalle’s Osaka Bay logistics developments, the subject warehouse is at a site where water levels could rise to three meters above sea level in the case of a flood.¹⁷

Seawalls, ranging in height from 5.7-7.2 meters protect the asset from extreme floods coming from the sea. To further mitigate the flood risk in the case of extreme rainfall or failure of the sea walls, the warehouse is designed with an elevated floor plate that puts the ground level 1.4 meters above mean sea level, and places key building equipment on the second floor, minimizing potential damage to the asset in the event of flood. This effort resulted in a 4.4 meter clearance above sea level (i.e., sea level + 1.4 meter buffer + 3 meters = 4.4 meters), which is above the required 3.5 meters above sea level (i.e., sea level + 1.4 meter buffer + 2.05 meters = 3.45 meters) for the location. In addition, the property management team has been trained and equipped to minimize flood damage on the first floor by closing the doors and shutters and placing sandbags in any gaps. By incorporating considerations to mitigate flood risk when designing the warehouse, the asset is well positioned to support tenants’ business continuity plans in the event of a flood.

Looking ahead

The impacts of an evolving climate need to be considered through multiple lenses, from country or continent spanning impacts, down to the level of individual assets. At all levels it is necessary to understand the interplay between the impact of climate on people, how governing bodies are responding to it, and how asset and investment managers have opportunities to better safeguard their portfolios against climate-related risks.
Investors should use climate risk data, but apply an overlay of judgement, particularly concerning factors that climate risk data providers generally do not incorporate well. A key example of this is the impact of protective infrastructure. Investors should ask: What mitigating infrastructure is currently in place? Over what time horizon is this accounted for in the present time? Are the plans to strength, expand or enhance local infrastructure in the future? Are these initiatives being appropriately funded, to ensure that plans become a reality?
While our collaboration with ULI on two reports is rooted in a desire to help the industry adopt best practices, standardization need note – and indeed should not – be the central goal. In the future, we expect an increasing share of real estate transactions to be at least partly motivated for buyers’ and sellers’ disagreement on the climate risks faced by a property.¹⁸ With increasing severity and intensity of climate-related loss events and surging insurance costs, it is our view that players that get climate risk right are likely to outperform those who do not. Having a differentiated climate risk process could lead to differentiated investment outcomes.

Footnotes

1 Source: National Centres for Environmental Information of the National Oceanic and Atmospheric Administration (NOAA). See Billion Dollar Weather and Climate Disasters

2 Source: The Climbing Costs to Insure US Commercial Real Estate, MSCI, November, 29 2023

3 The TCFD framework which has now been absorbed by IFRS’ ISSB, serves as the framework with which other international reporting standards setters seek to align such as the US SEC who voted in favour of The enhancement and standardization of climate-related disclosure, or the UK Government and the Sustainability Standards Board of Japan who will align its disclosure standards with ISSB.

4 According to the National Centers for Environment Information (NCEI). $1 billion threshold adjusted for inflation in historical periods. See https://www.ncei.noaa.gov/access/billions/.

5 RCP refers to Representative Concentration Pathway, a standard for modeling future climate scenarios of greenhouse gas concentration in the atmosphere. RCP 8.5 represents an extreme case scenario. See this Intergovernmental Panel on Climate Change (IPCC) glossary for more detail.

6 For more discussion on this trend, see our recent ISA Briefing, US migration trends and (U)rbanization.

7 Cross-sectional correlation between the LaSalle current climate risk index and the population change in the top 45 US metro areas between December 2018 and December 2023.

8 Cross-sectional correlation between the LaSalle future climate risk index and population change in the top 45 US metro areas between December 2023 and December 2028 based on Moody’s forecast as of February 2024.

9 Source: LaSalle analysis of data from NCREIF, FEMA.

10 Source: LaSalle analysis of data from NCREIF, FEMA.

11 Source: LaSalle analysis of MSCI data.

12 Source: The Dutch experience in flood management: A history of institutional learning

13 Source: The devastating storm of 1953, The History Press

14 Source: Dutch primary flood defenses, Nationaal Georegister

15 See Delta Programme 2024

16 See Osaka city – Flood disaster prevention map outline from the Osaka City Office of Emergency Management.

17 Estimates of maximum flood depth are based on historical records of natural disasters such as earthquakes, river floods and tsunamis that have occurred as reported by Japan’s Ministry of Land, Infrastructure and Tourism.

18 A superficial view of markets is that transactions are based on agreement on value. More accurately, buyers and sellers agree on a price, but their willingness to transact is based on disagreement on value. A seller, for example, may have a less bullish view on NOI growth prospects than a buyer. We expect the same disagreement on climate-related risk/reward trade-offs to be increasingly important.

LaSalle’s Brian Klinksiek and Zuhaib Butt (L-R) discuss how the 2024 elections should be looked at by investors.

Download the LMQ

Roughly 60% of the world’s population lives in countries facing major elections in 2024, markets representing 65% of the institutional investable real estate universe.¹ Elections are, of course, the cornerstone of the democratic process, which in turn underpins the appeal of the most transparent, investable markets; that said, elections come with the possibility of policy changes that may impact returns. Today’s geopolitical risks, whether they be this continuing election super-cycle (see LaSalle Macro Quarterly, or LMQ, page 4), or the various ongoing conflicts and trade disruptions, prompt important questions about how to manage investment risks related to these themes.

One of the protagonists in the Oscar-winning film Everything Everywhere All at Once says that being “’right’ is a small box invented by people who are afraid.” LaSalle’s risk management philosophy emphasizes optimizing risk/return trade-offs rather than minimizing risk-taking, while recognizing the limitations of point-estimate predictions and base-case scenarios — that is, attempts at “being right.” Today’s geopolitical events are especially likely to confound any forecaster seeking to be exactly right.

How should an investor manage their assets in the context of “unknowables” about which engaging in guesswork is tempting, but being “right” is elusive? What frameworks do we have to mitigate geopolitical risks? We propose six recommendations to keep in mind for investors taking stock of the many elections, and several conflicts, that may impact markets in 2024.

1. Be mindful of the tendency toward overreaction.

There are many examples of ex ante predictions of elections’ investment implications having been overstated. For instance, leading up to the 2016 US presidential election, there were widespread predictions that the US economy would be significantly negatively impacted by Donald Trump’s anti-immigration and protectionist stance were he elected.² In the event, equity markets rebounded strongly after a short-lived hit and the US economy proved resilient to the changes in rhetoric and policy that came with a new president.³

Looking ahead to the US elections later this year, almost certainly a rematch between Biden and Trump, coverage of the candidates’ differences should be accompanied by awareness of their similarities. Both candidates seek to prioritize domestic production, which could lead to greater levels of on- or near-shoring of supply chains.⁴ Moreover, election prediction odds (see LMQ page 6) suggest divided control of the two houses of Congress and the presidency is likely; divided government has typically been associated with relative stability in domestic policy, which is generally positive for markets.⁵ Both of these factors — at least in isolation — point to the potential for news cycle hype to overstate long-term market impacts of this particular election.

2. Consider an asset’s “geopolitical beta.”

Financial theory tells us that systematic risks are undiversifiable.⁶ Systematic factors are those with significant, far-reaching implications that affect the price of all assets. But financial theory also entertains that different assets may have different sensitivities to the same set of factors; an asset’s “beta” signifies the responsiveness of its price to a given factor. This is a useful way to think about an investment’s sensitivity to political and geopolitical events. For example, a property in a metro area whose economy is heavily driven by government spending would likely have a high sensitivity to political changes. Another example could be that a property located in the Baltic States, ex-Soviet countries on the border with Russia, is likely to be especially sensitive to developments concerning relations between Russia and the West. Investors should be mindful of assets’ expected sensitivities to geopolitics, whether assessed empirically or, as is more often the case given a lack of data, estimated through intuition.

3. Avoid excessive focus on catastrophic risks.

Systemic risks go beyond systematic factors; they involve severe shocks that have the potential to re-align entire markets in unpredictable ways. An example of such an extreme event is the remote but non-negligible potential that today’s so-called “proxy wars”⁷ escalate into a broader active conflict between great powers.⁸ The challenge of incorporating such eventualities into investment decision making is not only estimating appropriate probabilities that such events may occur, but establishing ideal strategic responses should they do so. Catastrophic shocks are exceedingly rare and have the potential to create winners and losers in asset markets that are difficult or impossible to predict.⁹ It may be more fruitful for investors to focus on more incremental — and more likely — eventualities that have the added benefit of being easier to model.

4. Do not neglect local political risks.

5. Practice diversification but engage in “pattern recognition.”

To a certain extent, political risks can be managed through diversification. This is especially true when they involve isolated events that impact one country or subnational division such as a specific city, province or state. But often political events are part of a broader arc with potentially far-reaching consequences. A smattering of small seeds can grow from obscurity into a thicket. Nothing illustrates this better than the rise of populism, nationalism and protectionism around the world, themes set to dominate elections this year and beyond. The very notion of “globalized nationalism” may sound like an oxymoron, but it has become a fact.¹⁰ While diversification is an essential portfolio construction concept that helps manage many types of risk, including political risk, care must be taken to recognize when what may appear to be “specific” risks are part of a broader pattern that is difficult to “diversify away.”

6. Conduct “what if” exercises around potential impacts.

Geopolitical and political risks are difficult to incorporate into traditional financial analysis. We find that thinking through scenarios can be helpful in identifying investment themes that may emerge from geopolitical trends. These can point to strategies to avoid — as well as potential new ones to pursue. The “Looking Ahead” section of this note expands on some of the key themes we have been tracking.

As geopolitical events are difficult to control and plan for, one may conclude, similarly to that same protagonist in the Everything Everywhere film, that “nothing matters.” But uncertainty is no excuse for ignoring geopolitical risks. We do stop short of directly feeding geopolitical themes into our formal risk management program, where the focus is on the specific risks that can actively be managed for our clients.¹¹ However, it remains important to observe and understand macro conditions from a holistic perspective. The work done in our regional research teams — particularly that focused on capital markets, the signals that foreshadow potential inflection points and the local political themes that impact real estate — is critical to this effort.

Looking ahead

We have argued that political and geopolitical risks are difficult to incorporate into investment processes, but that considering “what ifs” can be useful in uncovering relevant investment themes. Below are three potential real estate implications of the current geopolitical backdrop that we are monitoring today:

Policy uncertainty widens the corridor of possible market outcomes, and has been empirically shown to translate into greater volatility in financial markets and decreased investment decision-making in the real economy.¹² There are likely impacts on both broader investment at the macroeconomic level, as well as real estate transactions activity specifically. We continually monitor key indicators of policy uncertainty (see LMQ page 7).
Geopolitical factors should be assessed for their potential impact on inflation and monetary policy. To the extent these interrupt cooling inflation trends and thereby slow the rate at which interest rates moderate, there could be an impact on the trajectory of the real estate recovery. For example, continued attacks on the critical Red Sea shipping route (LMQ Page 10) have caused a five-fold increase in the cost of shipping goods from Asia to Europe. Estimates suggest the impact of this is likely small, temporarily adding just 0.3% back to global core inflation in the first half of 2024,¹³ but it does serve as a reminder of the volatility that geopolitics can trigger.
On a longer timescale, geopolitical fracturing could lead to increased levels of on- and near-shoring and could thus lead to the duplication of supply chains.¹⁴ This is less efficient than a fully globalized world where countries’ exports are specialized according to comparative advantage, and is therefore likely to correspond to higher long-term inflation.¹⁵ That said, analysis by LaSalle suggests that the localization of supply chains could be beneficial for real estate demand, particularly in the logistics sector and in politically aligned, lower cost markets adjacent to major ones, such as along the Mexico-US border.

Footnotes

¹ LaSalle analysis of data from Time and our proprietary investable universe estimates. See LMQ page 5 for more detail.

² Sources: “What do financial markets think of the 2016 election?” Brookings Institution paper, Wolfers and Zitzewitz, 2016. The article predicted that “a Trump victory would trigger an 8-10% sell-off”. See also “The Consequences of a Trump Shock,” a Project Syndicate article by Simon Johnson, 2016. He predicted Trump’s election would “likely cause the stock market to crash and plunge the world into recession.”

³On the news of the 2016 election result, Standard & Poor’s 500-stock index initially fell 5% but ended the day up more than 1%, according to Refinitiv. The US avoided a recession until the emergence of the COVID-19 pandemic, according to Oxford Economics.

⁴Source: “Biden vs Trump: Key policy implications of either presidency,” Economist Intelligence Unit, 2023.

⁵Sources: “What to Expect From Divided Government.” PIMCO article, Cantrill, 2022. According to the article, “the equity markets historically have tended to do well in years of split government.”

⁶Source: The Handbook of Risk Management: Implementing a Post-Crisis Corporate Culture. P. Carrel, 2012. “Systematic or market risk refers to the inherent danger present throughout the entire market that cannot be mitigated by diversifying your portfolio. Broad market risks include recessions, periods of economic weakness, wars, rising or stagnating interest rates, fluctuations in currencies or commodity prices, and other ‘big-picture’ issues like climate change. Systematic risk is embedded in the market’s overall performance and cannot be eliminated simply by diversifying assets.”

⁷According to the Oxford Dictionary, “proxy wars are the replacement for states and non-state actors seeking to further their own strategic goals yet at the same time avoid engaging in direct, costly, warfare.” Various observers have argued that the Russia-Ukraine and Israel-Gaza conflicts are proxy wars. For example, see “IKs the ware in Ukraine a proxy conflict?” Kings College London report, Hugues (2022).

⁸According to a research brief by RAND: “Great power wars — conflicts that involve two or more of the most powerful states in the international system. These have historically been among the most consequential international events.”

⁹Source: “What a third world war would mean for investors,” The Economist, 2023. The article highlights the virtual impossibility of positioning an investment portfolio to outperform through prior world wars, even if the investor had correctly predicted that these conflicts would occur.

¹⁰For further discussion of the global spread of nationalism, see “How cynical leaders are whipping up nationalism to win and abuse power”, The Economist, 2023; “Demonizing nationalist parties has not stemmed their rise in Europe,” The Economist, 2022; “The new nationalism,” The Economist, 2016.

¹¹We do, however, utilize tools that correlate to geopolitical risk. For example, the JLL Global Real Estate Transparency Index (GRETI) supports our monitoring of evolving investment conditions around the globe. Whilst the model does not explicitly consider political risk, the two are inexplicably linked through the inclusion of a number of governance and regulation data points.

¹² Source: “A global economic policy uncertainty index from principal component analysis,” Finance Research Letters, Peng-Fei Dai, 2019.

¹³ Source: “What are the impacts of the Red Sea shipping crisis,” J.P. Morgan, 2024.

¹⁴ Source: “The Great Rewiring: How Global Supply Chains Are Reacting to Today’s Geopolitics,” Center for Strategic & International Studies, 2022.

¹⁵ Sources: “The business costs of supply chain disruption,” Economist Intelligence Unit, 2021 and “Why Deglobalization Makes US Inflation Worse,” Project Syndicate, Moyo, 2022.

LaSalle’s Brian Klinksiek and Ryan Daily (L-R) discuss the latest on purpose-built student accommodation (PBSA) in Europe and beyond.

Purpose-built student accommodation (PBSA) in Europe ranks as one of our top-conviction sectors for investment in the coming years. No longer deserving of the “niche” label in the United Kingdom, it is already more institutional than any other type of living sectors property in the country and is rapidly maturing in Continental Europe as well. The rise of student accommodation on investors’ buy lists is for good reason. This ISA Briefing will set out why that is so and discuss how the sector stands out in Europe compared with student housing in the rest of the world.

Demand factors

After a brief, pandemic-induced interruption, in-person learning in Europe is back with more students enrolled than at any point in history. Higher education participation rates in the European Union have steadily risen across recent years, reaching an all-time high of 36% for 20-24 year-olds¹ in 2021/22, with the same proportion recorded for the UK in 2023.² A total of 18.5 million students were studying in the EU as of the 2021/22 academic year, with a further 2.9 million in the UK, having grown by 8% and 20%, respectively, over the previous five years.³

Demand for PBSA varies by profile of student. While domestic students are still crucial as a source of demand, particularly in markets where few students commute from home to study, international students are far more likely to reside in PBSA than domestic students (60% more likely to do so in the UK, as an example⁴). As shown in the chart below, international student mobility has been on a clear growth trend in recent years, with 2021/22 seeing a record number of foreign students in the EU and UK. European students studying outside their home countries elsewhere in Europe is a longstanding feature of the market, facilitated by freedom of movement within the EU, well-established student exchange programs, the rise of English-language courses and Europe’s dense geography.

A key driver of growth has been students from outside Europe. Europe has an outsized number of highly ranked universities relative to its size,⁵ a prevalence of English-language courses (which are increasingly no longer limited to the UK and Ireland) at a comparatively cheaper cost of tuition and living compared to North America.⁶ These attributes taken together can explain the sharp rise in non-EU students studying in the bloc, whose numbers have grown 31% since 2016.⁷ In the UK, the growth has been even faster, at 59% over the same period.⁸

That said, there are demand-side risks to be mindful of. The demographic outlook for Europe is mixed; forecasts for some countries such as the UK, Spain and Sweden show a demographic ‘bump,’ with the number of university-aged people growing ahead of national population levels. However, in other nations, numbers are forecast to be broadly flat (France) or negative (Germany and the Netherlands). This suggests uneven growth in demand for higher education going forward.⁹

This mixed demographic outlook will mean greater reliance on international student demand, but there are tentative signs that may also be facing some headwinds. A recent policy change in the UK has removed the right to visas for international students’ family members.¹⁰ For now, this change represents tinkering around the edges and is unlikely to have a major impact on demand. It does, however, indicate a directional change in policy aimed at restricting overseas student numbers, presumably in a bid to bring down immigration figures. Such policy changes may incrementally dissuade would-be foreign students from studying in the UK, though demand may shift elsewhere, potentially to the benefit of other European countries. Despite such risk factors, the overriding view is one of positivity for higher education demand in Europe and therefore PBSA.

Supply factors

European student housing should be viewed within the wider context of the region’s housing market. Europe is currently facing a long-term, persistent housing shortage. Housing scarcity is not limited to major gateway cities, but is also the reality within mid-sized cities and even smaller university towns. Since 2010, Europe has built homes at a rate only 40% below pre-GFC levels,¹¹ contributing to rising rents, increasing house-price-to-income ratios and worsening access to suitable housing. Demand for rental housing in cities remains robust, supported by long-term trends of immigration, urbanization and declining home ownership rates; as such, the imbalance between supply and demand is now fully entrenched.¹²

Students are, like all participants in the housing market, at the mercy of housing supply and demand. Shortages have fed through to the student market, with students finding accommodation increasingly unaffordable. Over the past two years, this has led to sharp growth in PBSA rents, with several UK cities reporting year-over-year growth in the high teens for 2023, and other markets experiencing growth well ahead of previous levels.¹³ The lack of supply is also leading to students being housed increasingly in unsuitable conditions; stories from the UK of students living in hotels or in completely different cities over an hour travel from campus are a clear symptom of insufficient student housing stock.

New investment in the sector should contribute to resolving the imbalance, but it will be a major challenge to fully close the wide gap between supply and demand. While there are nuances between markets, rising construction and development financing costs are making the delivery of new schemes less economical, evidenced by a sharp decline in the number of residential permits issued in several countries over the past year.¹⁴ Furthermore, restrictive planning laws and burdensome safety regulations are lengthening the time it takes for projects to be realized.

These factors inform our positive outlook on the rental housing market in Europe, which carries over into PBSA. The imbalance between supply and demand will likely persist and even worsen, driving very low vacancy and supporting strong rental growth for owners of residential and student housing real estate, or those who can deliver new schemes in those sectors.

Regulation haven

Regulations in Europe can act as a handbrake for residential rents, as we set out in our ISA Briefing, Controlling Interest: Keeping tabs on residential regulations. In nearly all continental European rental markets, rents cannot be increased annually at the landlord’s discretion, with rental levels for in-place tenants typically linked to a backward-looking index. During the recent ‘great reflation’ period, this has meant income from many rented residential properties did not keep pace with inflation. But student housing stands out from more traditional rental housing investments as having a cash flow profile far less impacted by the growth-muting tendencies of regulation.

In part, this is because PBSA often faces less regulation or stands outside of regulatory systems altogether. Students’ nature as transient, temporary residents means that their needs are rarely prioritized by local politicians, particularly compared to those of permanent residents. They typically only stay in a city for a few years, do not have dependents and their rental obligations often come with implicit or explicit parental guarantees. This means that PBSA is targeted for rent controls far less often than the wider rental market. Moreover, zoning and classifications for student accommodation are often distinct from standard rental housing, exempting it from regulations that limit absolute rent levels or restrict annual rental increases. Moreover, regulatory requirements on minimum unit sizes or lease lengths usually do not apply.

Even where regulated, PBSA benefits from its relatively short duration of tenancy. Given the vast majority of students study for 3-4 years, there is far greater annual turnover of tenants compared with the wider residential market. Faster turnover allows for landlords to more effectively mark rents to market levels. This means PBSA rents may better keep pace with inflation, even in jurisdictions where regulations do apply to the sector.

Increasingly mature

The increased maturity of student accommodation is another factor in its favor. The UK is clearly ahead of the rest of Europe in this regard, with a deep, liquid investment market, publicly traded REITs and a large number of established specialist operators. The sector’s wide acceptance from both tenants and investors means that we would consider it a ‘Core’ sector on our ‘going mainstream’ framework, as detailed in our ISA Portfolio View. Elsewhere in Europe the sector is considered more niche, but its growing acceptance means we would consider it ‘Near-Core’ on the same framework. Investment figures support the observation of a varying level of maturity for the sector—UK PBSA has made up 66% of investment volumes annual on average since 2014, despite the EU having 6.4 times the number of students.¹⁵

Over time, we expect this to change; the opportunity for investors to take advantage of the structural trends outlined above is likely to drive increased investment in the sector. Countries like as Spain or Italy have PBSA provision rates¹⁶ of below 10%, compared to more than 30% in some major UK markets,¹⁷ suggesting there is significant scope for delivery of new supply. Cities such as Milan, Madrid and Barcelona all have student populations of over 100,000 and multiple well-ranked institutions, giving them diverse demand bases and making them likely to be key growth markets for the sector in the coming years.

As niche sectors mature, greater liquidity and investor acceptance tends to lead to any yield premium they offer versus traditional sectors narrowing, as investors require less compensation for liquidity and transparency risks; such a pattern has already been observed in UK PBSA. This potential narrowing of yields in European markets is another factor behind our conviction that the sector is likely to offer attractive returns.

Comparisons with other regions

Student accommodation in much of Asia Pacific is still in a nascent stage, with relatively limited PBSA stock, few specialized operators and comparatively little institutional investment. The major exception in the region is Australia, which has characteristics similar to those of the sector in Europe and the UK, but is a number of years behind in its evolution. This suggests a similar path to maturity may lie ahead. Like Europe, Australia benefits from English-language courses at comparatively lower tuition costs than the US, while also offering post-study work visas. As a result, it has an even higher proportion of international students than most major European countries.¹⁸ Still, the Australian PBSA sector remains in its infancy as an investable property type. Stock numbers are low even compared to the most immature countries in Europe, with a student-to-bed ratios of 16-to-1¹⁹ and significantly higher than the UK where it is around 3-to-1.

Traditionally, international students in Australia tap into private rental housing for accommodation. Both the private rental market and the PBSA sector in Australia have experienced tight occupier market fundamentals and experienced double-digit rental growth over the past two years.²⁰ The solid performance has been primarily driven by strong migrant inflows, including international students, as well as high interest rates that encourage Australians to rent rather than buy, and relatively limited existing stock and new supply of all types of housing.

The United States, by contrast, has a more established student housing sector, but our view of the property type there is less favorable as compared to other regions. For a start, the demographics are less favorable given the population of 18-to-24 year-olds in the US is forecast to decline through 2033²¹ and enrollment rates at 4-year institutions have remained roughly flat since 2010.²²

An additional point of difference between US and European universities is their locations. Many top-tier US universities are in small cities in which a single school dominates the population and economy. Student housing properties in these markets are dependent on a single source of demand that controls enrollment growth and housing policy. Additionally, barriers to new supply are generally lower compared to major European cities, which allows for more new development to come in and disrupt the market. Taken together, these factors mean rent trends in these markets can be volatile. While there are similar university-centric towns in Europe, our investment focus is on the larger markets, where housing markets are tightest and there is a diverse demand base from multiple universities.

Looking ahead

Europe’s leading universities should continue to attract demand from students, both domestic and international, positioning student housing for further growth. However, this growth may be uneven given mixed demographic outlooks and the potential for government interference. Investors should focus on the most-supply constrained markets, where there are resilient and varied sources of demand from multiple universities.
European PBSA can act as a proxy for investment in the housing markets of supply constrained cities that face regulation, while generating cashflows more akin to investments in unregulated markets. We maintain our previously stated view that residential regulations can lead to lower cash flow volatility and thus may even mean better risk-adjusted returns. However, given the persistent housing shortages and continued demand for rental housing of all forms, we forecast rental growth across many European residential markets to be well ahead of inflation. This means in markets where residential landlords are constrained by inflationary indexation, owning PBSA may give investors a better opportunity to capture that market growth than does traditional residential.
Elsewhere in the world, the investment case for student accommodation is less compelling. The US market, for example, is characterized by a relatively weak demographic profile for student demand. Moreover, in many cases investing in it involves exposure to smaller cities to which investors would not otherwise seek exposure. That said, PBSA markets with similar characteristics to Europe, such as Australia, can offer interesting opportunities for global investors. For investors seeking higher returns, entry into sectors can be especially interesting when they are at the early stages of their emergence.

Footnotes

¹ Source: Eurostat

² Source: Higher Education Statistics Agency (UK)

³ Source: Eurostat, Higher Education Statistics Agency (UK)

⁴ Source: Savills

⁵ The number of European universities in the top 2000 spots Center for World University Rankings (CWUR) league tables per capita is the highest of any world region, according to data from CWUR, Oxford Economics, and analysis by LaSalle.

⁶ Source: Educationdata.org

⁷ Source: Eurostat

⁸ Source: HESA

⁹ Assuming no change in the propensity of people in that age cohort to attend university.

¹⁰ UK Government introduced policy on January 1^st 2024

¹¹ Source: European Central Bank

¹² For deeper analysis of European housing markets and the underlying supply imbalance see LaSalle’s ISA Outlook 2024.

¹³ Source: JLL

¹⁴ LaSalle analysis of data taken from the national statistics agencies of major European countries (Germany, UK, France, Spain, Sweden, Denmark, Finland, Italy, Portugal, Netherlands, Ireland)

¹⁵ Source: MSCI Real Capital Analytics

¹⁶ Metric defined as number of purpose-built student beds as a share of total enrolled population of students in higher education.

¹⁷ Source: JLL

¹⁸ Source: UNESCO

¹⁹ Source: CBRE

²⁰ Source: SQM Research (for private rental market), as of November 2023; CBRE (for PBSA), as of August 2023

²¹ Source: Oxford Economics

²² Source: National Center for Education Statistics (US)

Important Notice and Disclaimer

LaSalle’s Global CEO Mark Gabbay sat down with The Schwab Networks’ Oliver Renick to discuss the state of commercial real estate on the Friday, March 1 edition of Market on Close. He talks about regional banking and commercial real estate and goes over what potential Fed cuts mean for commercial real estate.

(L-R) LaSalle’s Brian Klinksiek, Rich Kleinman and Jen Wichmann discuss migration trends and urbanization in the US.

Download ISA Outlook 2024

In the past decade, the urbanization narrative in the United States has shifted from the “rebirth of cities” to the “rise of the suburbs.”¹ What are the drivers of this shift, and how does it impact real estate? In this ISA Briefing, we tackle these questions and share our outlook for how future dynamics could impact migration and urbanization trends.

Demographics is destiny

Demographic cohort effects are a key driver of the current shift. The generic, or median, location preferences of a cohort change as that cohort ages; as the relative growth of different age groups ebbs and flows it impacts the national trend towards urban and suburban location preference.

In the US, there are two outsized cohorts, the Baby Boomers and the Millennials, which as they age have a disproportionate impact on national averages (see chart below). In the early 2010s, the bulk of the Millennial cohort was in their 20s, and as young adults they had a preference for living in urban locations. In the present decade the same cohort is aging into their 30s and 40s, entering a life stage that tends to prefer living in suburban locations. Young families move to the suburbs to seek more space and because the local school funding system in the US tends to mean suburban schools are better funded. This shift began in the latter half of the 2010s as the older members of the cohort reached their mid-30s but was accelerated by the Covid-19 pandemic in 2020.

Sunbelt supremacy

Regional shifts also accelerated in the late 2010s as migration to the southern Sunbelt markets increased,² driven in part by households moving in search of more affordable living and warmer weather compared to northern cities. While in-migration to high-cost metros slowed throughout the 2010s, and eventually turned negative, inflows to Sunbelt metros accelerated through 2016 before slowing because of lower international immigration. This also contributed to a national shift toward suburban living because Sunbelt metros such as Houston, Dallas, Atlanta and Phoenix lack the dominant central city with a strong central business district that is characteristic of older cities like New York, Boston, Chicago and Washington, DC.

As these Sunbelt metros grew faster, it led to a shift in the mix of apartments nationally towards suburban locations. This is shown in the NCREIF Property Index (NPI) data in the chart below. It shows that the NPI’s share of apartments in the south has increased since 2018; the same time when the share of suburban apartments started reversing the gains achieved in urban apartment share in the 2010s. (This analysis is done based on unit count, so is not driven by trends in relative values.)

Post-pandemic realities

The pandemic not only accelerated the urban and regional shifts already underway, but it set into motion a new set of forces that influence where households choose to live. The enduring popularity of remote work requires more space for a home office, which is cheaper in the suburbs, and commuting only a couple days per week makes living further from city centers more palatable. Owners of suburban apartments and shopping centers have benefitted as a result.

Conversely, having fewer downtown workers has hurt office values and urban retail, and the reduction in activity is a contributor to the increase in crime that has occurred in urban areas. Although violent crimes have come down after a pandemic-era spike, theft and property crimes increased in 2022 according to the FBI.³ Both types of crime remain significantly below the highs of the early 1990s, but public awareness seems elevated relative to the hard data. The crime issue extends into city neighborhoods as well, which can motivate some residents to move out of the city.

Evidence of an urban rebound

Despite the challenges, residents returned to urban areas as the pandemic receded. Chicago and San Francisco saw the number of occupied units in urban submarkets⁴ decline 4.0% and 7.4% from peak to trough during the early days of the pandemic.⁵ But they have since recovered; as of September 2023, Chicago had 6.6% more occupied units in urban submarkets compared to the prior peak and even hard-hit San Francisco had 1.9% more. The decline in urban renters was smaller in Sunbelt markets, with just a 1.2% and 1.4% decline in Dallas and Atlanta, respectively, and the rebound has been greater with 9.9% and 8.2% more occupied urban units compared to the previous peak.

At the same time, the relative affordability of the Sunbelt has declined. Home values have increased 47.8% in Dallas, 56.3% in Atlanta and 57.5% in Phoenix since 2019 as compared to 26.4% in New York, 36.0% in Boston and 21.3% in San Francisco.⁶ While major Sunbelt markets remain less expensive compared to Gateway cities, the narrowing of the relative affordability gap should, all else equal, reduce their draw.

Clarifying “urbanization” in DTU+E

As is typically the case, the “rise of the suburbs” narrative overstates the situation, but there are real dynamics behind the shift from urban growth to suburban growth that real estate investors need to pay attention to and build strategies around. At LaSalle, we have long sought to capture secular changes shaping real estate around the world through our Demographics, Technology, Urbanization and Environmental factors (DTU+E) framework. However, the term “urbanization” in this context is often misinterpreted as a one-direction shift towards urban places, when it is better understood as “urban and regional change,” which encompasses broader population shifts within and across metropolitan areas.

Indeed, it was with this lens that LaSalle Research and Strategy forecasted the suburban shift in the mid-2010s and redirected our apartment investment strategy from urban submarkets (what we labeled “Millennial Magnets” at the time) to suburban locations. In 2016, we recommended targeting apartments in the best school districts, which are mostly suburban. We continued to reinforce that focus as our internal target market recommendations shifted towards the suburbs and our risk assessments flagged the challenges facing urban markets. It is not sensible to assume “urbanization” is a one-way street, or that the direction of flow doesn’t change.

Globalizing the urban/suburban debate

To this point, our comments have applied to the US. Elsewhere in the globe, comparisons of suburban versus urban patterns can get tricky for a range of reasons. Even the terminology is challenging. In Australia, all neighborhoods other than CBDs are called “suburbs,” even if they are adjacent to the CBD. In Hong Kong, one might consider transit-centric high-rise New Towns to be “suburbs,” but they do not at all resemble American ones. At some point, the right question is simply: What locations are attracting people?

Looking at it this way requires a deeper dive into demographic, social and urban planning considerations that differ significantly from the US situation. For example, in Japan and Germany, declining rural populations is paired with migration into key cities. In Canada, very strong international in-migration combined with “greenbelts” that limit urban sprawl have led to an intensification of urban density. In the UK, which also has greenbelts, planning restrictions have had the unintended consequence of pushing demand for suburban living into rail-connected satellite cities that are discontinuous to the main built-up area of the metro. To dig into all these and other variations is beyond the scope of this ISA Briefing. However, applying the same lenses of demographic cohort effects, relative affordability and urban structure is a globally relevant approach.

LOOKING AHEAD

Suburban areas in the US continue to benefit from Millennials and then Generation Z seeking more space for their young families. That said, we do not expect an urban “doom loop,”⁷ but city taxes could increase more than other locations, limiting urban NOI growth.
We believe that “E factors”—or environment-related secular changes—are likely to represent generally positive demand drivers for cities. The lower carbon intensity of urban living could boost urban demand if carbon is taxed or otherwise regulated. Moreover, climate change could increase summer heat in southern markets while making northern winters milder. This could tip migration back toward the north.
High barriers to supply—or the inverse—can equally characterize both urban and suburban locations, depending on local circumstances. That said, the higher share of land value in total asset value in urban locations may imply greater potential for appreciation. Investors should remain on the lookout for urban locations with the best demand dynamics.
In-migration to Sunbelt markets has driven up housing prices, narrowing affordability gaps with older northern and coastal cities. This should allow other metro areas to emerge as destinations for affordability-driven migration; Columbus, Indianapolis and Louisville are example of cities that may be well positioned to benefit.

¹ This is the US definition of a suburb. The concept of what is urban is both hard to define and varies in different markets around the world. In the US urban is generally understood as a dense area at the center of a metropolitan area. Suburbs are defined in contrast to that as being less dense areas that are still highly economically linked to the overall metropolitan area.

² Commentary in this paragraph based on LaSalle analysis of Census Bureau data.

³ Federal Bureau of Investigation Crime Data Explorer, https://cde.ucr.cjis.gov/LATEST/webapp/#/pages/explorer/crime/crime-trend

⁴ Urban submarkets as defined by RealPage as the most densely populated submarket(s) in a given market based on a metro’s Central Business District, the highest concentration of the market’s tallest multifamily assets, and/or higher rent per square foot than the market average. This includes the following RealPage submarkets: The Loop, Streeterville/River North, and Lincoln Park/Lakeview in Chicago; Downtown and SoMa in San Francisco; Buckhead, Downtown, Midtown, and Northeast in Atlanta; and Oak Lawn/Park Cities and Intown in Dallas.

⁵ Data from RealPage as of September 2023

⁶ Zillow, as of September 2023

⁷ “Doom loop” refers to a situation in which cities get stuck in a self-reinforcing loop of lower tax revenues requiring cuts to city services that reduce the quality of life which cause residents to leave and further reductions in tax revenues and the loop repeats ad infinitum.

Important Notice and Disclaimer

Brian Klinksiek recaps his keynote address at the Global Property Market Conference

On November 28, LaSalle’s Global Head of Research and Strategy, Brian Klinksiek, gave a keynote address at Canadian Real Estate Forum’s annual Global Property Market conference in Toronto where he discussed our global real estate investment themes for 2024:

The ongoing search for peak rates
Solving the capital stack equation
Favored sectors coming off the boil
Moving beyond bifurcation in the market
The changing definitions of quality and core

These themes are discussed in detail in ISA Outlook 2024, our annual publication designed to help our clients and partners navigate the year ahead. It brings together smart perspectives and investment ideas from our teams around the world, based on what we see across our more than 1,500 assets that span geographies, property types and risk profiles.

Go to ISA Outlook 2024

With shifting interest rates, dynamic occupier fundamentals and deepening bifurcation within sectors, ISA Outlook 2024  asks how real estate investors should respond to rapidly changing market conditions. To answer these questions and more, we published four separate chapters covering the global and regional outlooks over the course of November and December.

Download the full document now, or individual chapters covering the Global, European, North American and Asia Pacific outlooks are available in the tabs below.

Chapters

The global macroeconomic context for real estate remains unsettled, and more so than earlier in 2023. Until late summer, interest rates in most major markets exhibited high volatility, but little overall trend. They moved mainly sideways, owing to cooling inflation and expectations that central banks were reaching the end of their tightening cycles. This was helpful in setting a pricing baseline for real estate investors. But the outlook for rates and thus real estate pricing has become more unsettled of late.

What does this mean for real estate and how does it intersect with other key trends?

Authors

Brian Klinksiek

Global Head of Research and Strategy

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Eduardo Gorab

Managing Director, Global Research and Strategy

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European property markets have been waiting for a peak in European Central Bank and Bank of England policy rates, for an end to the war in Ukraine and for bid-ask pricing spreads to resolve. Investors ready to move out of waiting mode in 2024 can benefit from rebased prices, opportunities to solve capital stack equations, and strong fundamentals in many sectors.

In this chapter of ISA Outlook 2024, we examine the state of the European market and conclude with recommendations for specific investment strategies – underpinned by realism and targeted toward areas of forecast resilient income growth.

Authors

Daniel Mahoney

Europe Head of Research and Strategy

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Petra Blazkova

Europe Head of Core and Core-plus Research and Strategy

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Dominic Silman, PhD

Europe Head of Debt and Value-add Capital Research and Strategy

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Against a volatile macroeconomic backdrop and with growth expected to slow, we believe that in 2024 it will be the trajectory of interest rates that will have the greatest impact on real estate values in the US and Canada.

As investors continue to adapt to cooler conditions, this chapter of ISA Outlook 2024 examines the current landscape and looks ahead to the coming year, including where we see select opportunities emerging, as well as variation between the two markets. We conclude with three broad strategic themes and recommended strategies where investors may consider deploying their capital.

Authors

Richard Kleinman

Americas Head of Research and Strategy

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Chris Langstaff

Canada Head of Research and Strategy

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The sheer size and complexity of the Asia Pacific region means real estate markets and investment opportunities are as diverse as the region itself.

In the final chapter of ISA Outlook 2024, we discuss this complexity and how China’s new economies – such as high-tech manufacturing and biotechnology – are growing rapidly and, after more than two decades, Japan is hoping to bid sayōnara to deflation. In other key parts of the region – Australia, Hong Kong, Singapore and South Korea – central banks are near the end of their rate-hiking campaigns in a bid to lower inflation which, as in the rest of the world, could lead to a rebound in transaction activity.

Authors

Elysia Tse

Asia Pacific Head of Research and Strategy

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Fred Tang, PhD

China Head of Research and Strategy

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Dennis Wong

Senior Strategist, Asia Pacific Research and Strategy

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Published every year since 1993, LaSalle’s annual ISA Outlook is designed to help our clients and partners navigate the year ahead. It brings together smart perspectives and investment ideas from our teams around the world, based on what we see across our more than 1,500 assets that span geographies, property types and risk profiles.

As always, we welcome your feedback. If you have any questions, comments or would like to learn more, please get in touch by using our Contact Us page.

(L-R) LaSalle’s Brian Klinksiek, Matthew Wapelhorst and Frederik Burmester

The real estate investable universe in 2023

In an uncertain market, it is tempting to prioritize cyclical questions such as the risk of recession and the path of interest rates over structural topics with longer-run implications. But challenging periods in real estate markets can also be attractive times to build exposure to the asset class.¹ Questions about how to build portfolios do not diminish in importance just because bond market volatility makes front-page news. In our view, one of the most useful starting points for approaching portfolio construction is having a sense of the size of the real estate investable universe and its subcomponents. This is why we regularly update our estimates of the real estate investable universe and have done so consistently since 2005.

We first shared our latest estimates for the size of the global real estate universe in the 2023 edition of ISA Portfolio View. As described there, the vast scale of real estate as an asset class is among the key pillars supporting the case for including property in multi-asset portfolio. But putting a thoughtful number on the size of the asset class is easier said than done. We believe it is worth the effort because quantifying the size and distribution of the market — rather than just a subset covered by a particular index or data source — helps investors sharpen their thinking on target allocations by asset class, geography and investment structure. A full description of our methodology, data sources and summary table by country is available here, and we are glad to provide additional detail upon request.

We estimate market size, defined as aggregate gross asset value, for three nested segments, shown below. The largest and most comprehensive estimate is for all property held for the income it provides, inclusive of all types of owners (except owner-occupiers) and all quality levels. Using a separate methodology, we also estimate real estate owned by institutional investors, and by one particular type of institutional investor — those whose equity is publicly traded.

Our analysis shows that one fifth of global real estate is owned by institutional investors, and 40% of that institutional ownership is by listed companies. The estimates also break down market size by country, property type and city, using a methodology combining several bottom-up and top-down sources.

We take a closer look in this ISA Briefing at three key findings from the real estate universe analysis: (1) global income-producing real estate has recently ebbed to a below-average size relative to GDP, (2) real estate value has a fairly even distribution across the three major global regions and (3) those regions differ significantly in how real estate is distributed across metros, implying different optimal diversification strategies.

1: Real estate is large, but at a cyclical ebb

Figures in trillions can be so enormous that they lose some meaning — so it is helpful to put those numbers in context. An illuminating comparison is to put income producing real estate alongside other asset classes like stocks and bonds, as shown in the graph below.

These estimates show global real estate is a smaller sibling to stocks and bonds but very much in the same family of major asset classes. Notably, owner-occupied residential real estate, which is not included in LaSalle’s real estate estimates, is significantly larger in size than all income-producing property, and even larger than the global fixed-income market.

Another useful comparator, shown below, is against global GDP. We estimate that real estate is equal to 60% of global GDP in 2023. This puts it at a low ebb relative to recent history. This is consistent with the historic pattern of real estate comprising a higher share of GDP late in expansions and then a lower share of GDP in repricing episodes. Currently our real estate market size estimate is near previous cyclical lows as a share of GDP seen in 2009-2012. Since 2000, our real estate market size estimates have averaged 68% of global GDP.

2: Still a global asset class

A second key finding from LaSalle’s universe estimates is the relatively even split in value observed between the three major regions of the Americas, Asia Pacific, and Europe. We estimate that 35% of income producing property is in the Americas, 31% in Asia Pacific, and 29% is in Europe. We believe these estimates from LaSalle’s real estate universe analysis better reflect the true opportunity set than other splits based on simple GDP or real estate indices, which can sometimes be lopsided based on where coverage is greatest or which types of investment fund products predominate. For example, 67% of the MSCI Global Property Fund Annual Index AUM is in North America.²

The split above suggests an even distribution of opportunities by region. At the same time, our national estimates also show global diversification can be achieved with a small number of countries. The eight countries with the most institutional-invested real estate together account for 70% of the invested universe. A focus on these larger countries — as well as multi-country funds — can enable investors to efficiently achieve diverse exposures, while also managing the challenges that come with differences in market practices, currency, regulation and building market knowledge.

3: Big regional differences in universe at city level

Our third notable finding emerges when zooming in one level further from the national level to individual cities. Cities and their surrounding metropolitan areas form the underlying building blocks of the real estate universe; they are often the basic level of analysis investors have in mind when comparing market allocations.

LaSalle estimates institutional real estate market size are for the entire metropolitan (metro) market — including the principal city and its suburbs that are economically connected to it, adopting official metropolitan area definitions from national statistical agencies where available.

Real estate held in institutional investor portfolios is highly concentrated in the largest metros, and these local market size estimates highlight the degree of that concentration. The 40 largest metropolitan real estate markets account for 58% of all institutional property. Some of the world’s largest metro areas dwarf many individual countries when it comes to institutional real estate ownership. Our latest estimates show that there is likely more institutional-owned real estate in Greater Tokyo than in all but three of the 201 countries covered in our estimates.

The metro market size distribution varies considerably across regions, with important implications for portfolio strategy. Institutional real estate ownership in Asia Pacific is more concentrated in its largest metros than in any other region. And its real estate is far more concentrated in a few cities than its population. In Asia Pacific, 18 metros account for 75% of institutional property, whereas the equivalent metro total is 52 in the Americas. In Europe, real estate is the most dispersed across cities, reflecting its more fragmented quilt of different jurisdictions. Over 100 European metros must be amalgamated to account for 75% of the regional total. Such dispersion makes the task of setting target markets even more complex, which is where tools like the recently released LaSalle European Cities Growth Index (ECGI) can help.

These differences impact investment strategy and approaches to diversification. Asia Pacific’s concentration of large institutional markets implies that investors may be able to achieve diversification by investing in fewer metros, but that it is also a region where each “bet” on geo-market allocation matters more. In Europe and North America, investors are more active across a larger number of medium-sized markets, offering diversification benefits as well as challenges in terms of access and efficiency.

Looking ahead

The real estate universe is massive — it constitutes a meaningful portion of all global investable assets across asset classes — and therefore is a key piece of diversified mixed asset portfolios. Its ratio to global GDP is now below its long-term average, near past cyclical lows seen on this measure. Over a ten-year horizon, we expect real estate to grow as a share of GDP.
The real estate universe is evenly dispersed by region (though concentrated by country and city). A globally balanced portfolio would give roughly a one-third weighting each to North America, Asia Pacific and Europe.
The concentration of institutional real estate in highly transparent countries and in major metro areas implies that investors can achieve a good degree of diversification with a small number of countries and moderate number of metro markets, with differences across region.
Investable universe estimates can help investors devise ‘neutral weights’ for markets and sectors, which they can then adjust based on structural considerations (e.g. tax status) and their views of relative value. We look forward to sharing our outlook and strategic recommendations for 2024 real estate investment in our upcoming ISA Outlook 2024, the first installment of which will be released on November 14.

Footnotes

¹ Vintages around the time of market disruption tend to outperform, according to LaSalle analysis of data from the INREV Global IRR Index through Q4 2022. See page 30 of our ISA Portfolio View for a more complete discussion of this analysis.

² Source: MSCI. Data as of 2022 (most recent available).

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Copyright © LaSalle Investment Management 2023. All rights reserved. No part of this document may be reproduced by any means, whether graphically, electronically, mechanically or otherwise howsoever, including without limitation photocopying and recording on magnetic tape, or included in any information store and/or retrieval system without prior written permission of LaSalle Investment Management.

(L-R) LaSalle’s Brian Klinksiek, Elysia Tse, Fred Tang and Wayne Qin

Download the Q4 2023 LaSalle Macro Quarterly

We have been fielding questions on two big macroeconomic topics impacting the Asia-Pacific region: (1) the outlook for China’s economic recovery and (2) the path of the Bank of Japan’s monetary policy. These involve legitimate worries about China’s growth engine and the risk of interest rate hikes in Japan. Nonetheless, we find that media coverage of these topics can sometimes sensationalize their implications without going below the surface.

In this ISA Briefing, and the accompanying LaSalle Macro Quarterly (LMQ), we dissect these concerns and share our views on several frequently asked questions. Our analysis points to a nuanced picture that is more supportive of investments in these two countries than the media coverage might suggest.

China’s economic recovery

China’s economic recovery has been slower than in past cycles, as we anticipated in our ISA Briefing from early March (China’s Great Reopening). While exports and for-sale residential investment have been sluggish, domestic consumption, industrial output, manufacturing and infrastructure investment continue to support the economy (see the chart below). The for-sale residential market could bottom in the next 6-12 months as demand-supply dynamics gradually improve. Unlike previous downturns, the government has not announced a blast of mega monetary or fiscal stimulus. This conservative approach could help ensure a sustainable long-term growth environment for the Chinese economy without unintentionally creating new imbalances.

We expect economic activity in China to continue to recover through 2024. Various supportive economic measures designed to boost business and consumer confidence were rolled out after the Politburo meeting on July 24; however, it takes time for stimulus measures to take effect. We continue to expect a modest recovery in China this year, likely close to the 5% GDP growth target. But oft-cited concerns over the Chinese economy such as the weak for-sale residential sector, the defaults of highly leveraged real estate developers, high youth unemployment and deflationary pressures deserve to be addressed, as we do in this FAQ.

GDP growth and key economic indicators in China in Q2 2023

Note: The growth rate of industrial value-added is the y-o-y growth rate of the YTD data. The growth rates of other indicators are the y-o-y growth rates of quarterly data. The historical ranges of the indicators are based on historical y-o-y growth rates in the 20 quarters in 2015-2019.

Sources: The National Bureau of Statistics of China (GDP growth, retail sales volume, fixed asset investment growth, and industrial value-add growth), as of Q2 2023; General Administration of Customs (export growth), as of Q2 2023; LaSalle Investment Management (retail sales growth), as of Q2 2023.

Q: How concerning is the outlook for China’s housing market?

A: The for-sale residential sector is stabilizing in the largest cities.

Despite short-term volatility in sales volume and prices, China’s for-sale residential sector is experiencing a slowing decline in sales volumes and prices compared to the second half of 2022. In Tier 1 cities, however, both sales volume and prices are already improving [LMQ page 24]. In the next 6-12 months, the overall for-sale residential market could reach bottom, supported by government policies, a decline in supply and a reduction in mortgage rates and down payments. We expect the subsequent recovery to be gradual. For-sale residential prices may improve, though sales volumes are unlikely to recover to their prior peak. We expect housing markets in Tier 1 and top Tier 2 cities to lead the recovery of low-tier cities.

Q: What about the troubled developers?

A: Highly leveraged developers are likely to have only a marginal impact on the Chinese financial system.

Despite our expectation of an eventual recovery in China’s for-sale residential sector, the outlook for over-leveraged developers with large exposures to low-tier cities, including Evergrande and Country Garden, remains gloomy. The resolution of these developers’ onshore and offshore corporate debt is expected to take time, which will continue to draw media attention. However, the impact of the default or bankruptcy of these troubled residential developers on the Chinese financial system has been limited so far, and we expect it to remain so, given the exposure of Chinese commercial banks to real estate construction loans only accounted for ~4% of their total assets as of the second quarter of 2023.¹ Even for the more vulnerable trust companies, the exposure to real estate declined from ~13% of their total assets in the second quarter of 2019 to ~5% in the second quarter of 2023.²

Q: What is the story with rising youth unemployment?

A: The high youth unemployment rate is misleading.

The unemployment rate of the labor force aged 16-24 in China is rising. However, the direct impacts of this on retail sales and the broader economy are likely to be limited. Those aged 16-24 accounted for only around ten percent of the Chinese population as of 2021.³ In addition, many of those aged 16-24 are still in school, given that young people in China finish education at around age 20, on average.⁴ There could be some indirect impacts of high youth unemployment on household confidence, although we do not expect them to be significant given that the unemployment rate for the key labor force in China (aged 25-59) is at its lowest level since 2018 [LMQ page 25].

Q: Is China at risk of deflation?

A: It is premature to make the call that China is entering a deflationary period.

It is true that China’s headline inflation rates have been fluctuating around 0% in recent months, primarily driven by food and energy prices coming off peak levels post lockdowns. However, the core inflation rate (excluding food and energy) remains in positive territory [LMQ page 16]. As the Chinese economy gradually recovers and the post-lockdown effects fade, we expect inflation to gradually escalate.

Looking ahead

Western commentators have generally been disappointed at China’s lack of bazooka stimulus to reinvigorate the economy. The Chinese government’s approach has been to instead focus on smaller stimulus measures or targeted policy shifts. We believe that even if all these supportive actions fail, China still has many options it can implement to boost the economy. In our view, there is a high probability that the Chinese economy could reach its 5% GDP growth target by the end of the year.
China’s mild economic recovery and slowly improving business and household confidence suggest the demand recovery for income-producing real estate in China could be modest in the near term. Net absorption of major sectors including office, logistics, retail and rented multifamily in the next 12-18 months is likely to be below the levels seen in 2021.
Troubled for-sale residential developers may continue to offload assets to repair their balance sheets. Over the past decade, Chinese developers have built large portfolios of commercial real estate, mainly composed of offices, retail malls, and hotels. A small number of these developers also own assets in our favored sectors, such as multifamily rental and logistics. Distressed sales at attractive prices could continue to surface in the next 6-12 months.

The path of Japanese monetary policy

The Bank of Japan (BoJ) remains an outlier among global central banks, as it continues to maintain ultra-accommodative policy in the form of yield curve control (YCC). The BoJ introduced YCC in 2016, with the intent to keep 10-year government bond yields low to stimulate consumer spending and business investment. Over the past year, speculation has mounted as to whether this policy would be sustained, with volatility being triggered around moments of policy adjustments or speculation that YCC would be abandoned.

Most recently, on September 22, the BoJ kept the YCC policy unchanged with a unanimous vote. The 3-month rates used a reference for borrowing costs have been bouncing around -0.2 to -0.1%, while the 10-year Japanese government bond (JGB) yields have increased to 0.73% since the BoJ’s surprise tweak to the YCC in December last year [LMQ page 7].⁵ Inflation in Japan has been running above the BoJ’s two percent target over the past 17 months,⁶ which in theory could be a catalyst for the BoJ to make more tweaks to its YCC policy or even exit it in the near term. But the answers to complex questions about the trajectory of rates in Japan aren’t so simple; policy actions and capital market reactions are inherently difficult to predict, but are likely to be less dramatic than feared.

Q: Isn’t the BoJ under pressure to change policy to tackle above-target inflation?

A: The two percent inflation target is likely to be achieved in the short term, but the BoJ is focusing on whether the target can be achieved sustainably.

The latest BoJ inflation projections and Tankan survey results⁷ suggest that inflation could remain above the BoJ’s 2% target at least over the next 12 months [LMQ page 19]. Wages in Japan, a key component of inflation, grew by 2.3% y-o-y in July 2023 due to a tight labor market.⁸ Employment conditions are expected to tighten further in the near term,⁹ potentially reaching levels last seen in 1990s. The 2024 Shunto (spring) wage negotiation is the next key event to monitor. Hence, it is as yet uncertain whether wage growth in Japan could remain consistently above its 2% target.

Inflation and core inflation in Japan

Source: The Japan Statistics Bureau (historical inflation data), as of August 2023. The Bank of Japan (inflation projection for fiscal year 2023 and 2024), as of July 2023.

Inflationary pressures do not exist in a national vacuum. Thankfully, inflation is now declining in other developed markets [LMQ page 12], potentially giving the BoJ more time to evaluate the prospects for inflation in Japan. Many central banks, following the lead of the US Federal Reserve, are seen to be at or near the end of their tightening cycles as inflationary pressure tapers. That said, global central banks are highly unlikely to cut interest rates sharply any time soon, unless economies fall into deep recession. Therefore, we expect the interest rate differential between Japan and the US to remain wide but may narrow somewhat in the near term. Moderation in the interest rate differential could help the weak yen to regain some ground, which might also alleviate some pressure on the BoJ.

Q: How do you read the political tea leaves around BoJ’s policy?

A: Policymakers will tread carefully as they do not want to upset the labor market and the financial system.

Inflation in Japan has been outpacing wage growth, putting pressure on Prime Minister Fumio Kishida’s approval ratings, according to a poll conducted by the Asahi Shimbun newspaper on September 18. There is a strong political impetus for Kishida and the new cabinet to ensure wage growth consistently exceeds the inflation rate. Moreover, as more than 70% of the mortgage loans in Japan have floating rates,¹⁰ there is a strong incentive for the BoJ to keep short-term interest rates relatively low. BoJ measures that could derail Japan’s economic recovery or disrupt the capital markets could be considered politically risky and thus less likely.

Looking ahead

Forward markets indicate that 3-month interest rates are expected to enter positive territory but remain below 0.2% over the next two years, which implies that borrowing costs in Japan would remain much lower than those of other developed economies. Leveraged real estate yields in Japan remain higher than unlevered yields, in contrast to many other markets where real estate debt is now priced at levels that lead to “negative leverage” at today’s pricing. Japanese real estate debt costs could remain relatively low if the forward markets’ prediction is accurate.
Yields on 10-year JGBs have increased sharply by Japan’s historical standards since the BoJ loosened the YCC in December 2022. The forward markets imply that 10-year JGB yields could increase to close to 1.1% by September 2025, near the level last seen in the second half of 2011. Such an increase would be modest by global comparison but could be viewed as a step closer to interest rate normalization. Given “the math” of rate rises when the starting point is low in absolute terms, even a modest increase in 10-year JGB yields could have some impact on Japanese real estate valuations, a risk that investors should anticipate and plan for accordingly.
Nonetheless, there are still wide gaps between JGB yields, current yields on other asset classes and real estate yields. This makes income-producing Japanese real estate investments attractive, especially for domestic investors, who dominate the market. With a uniquely wide positive spread between borrowing costs and cap rates, we expect Japan to continue to remain the most liquid institutional real estate market in Asia-Pacific for the foreseeable future, albeit with some volatility at times.

Footnotes

1 Source: The People’s Bank of China (total amount of outstanding real estate construction loans), as of Q2 2023; State Administration of Financial Supervision and Administration of China (total assets of commercial banks), as of Q2 2023
2 Source: The China Trustee Association, as of Q2 2023
3 Source: The National Bureau of Statistics of China, as of 2021
4 Source: LaSalle Investment Management, as of 2021. The estimation is based on the average years of education among the young labor force in China published by the Ministry of Education of China in 2021.
5 Source: Bloomberg, as of September 25, 2023
6 Source: The Japan Statistics Bureau, as of August 2023
7 Source: The Bank of Japan’s Tankan survey on the inflation expectation and the output price expectation among corporates of all industries, as of June 2023
8 Source: The Japan Statistics Bureau, as of August 2023
9 The Bank of Japan’s Tankan survey: all-industry employment conditions, as of June 2023
10 Source: The Japan Housing Finance Agency, covering home loans between October 2022 and March 2023.

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Petra Blazkova discusses our findings in LaSalle’s ECGI 2023 report.

Our latest LaSalle European Cities Growth Index (ECGI) ranks European cities with the strongest economic prospects based on data inputs of economic growth, human capital, business risk and – for the first time – extreme heat.

The 2023 edition highlights the steady strong positions of both London and Paris, which are set to account for more growth than Europe’s next nine top-ranked cities combined. Interestingly, Paris has overtaken London as the top destination for venture capital funding for the first time since LaSalle began tracking this data in 2006, receiving particularly elevated levels of investment into its technology sector.

Nordic cities appear to have an increasing advantage due to demographic trends, a skilled workforce and world-leading pharma, industrial tech and creative industries; they account for a quarter of the top 20 cities. German cities have continued to perform strongly in the index despite slow population growth. On the other hand, Rome and other Italian cities’ rankings are most negatively impacted after a new factor accounting for extreme heat days was added to the ECGI this year.

Elsewhere, Prague and Warsaw have been identified as having promising growth prospects as more expats return and high-skilled workers remain, with this “brain gain” leading them to their highest scores since the global financial crisis. The index also reflects that Warsaw is becoming an attractive place for employment in the technology sector and Prague is forecast to benefit from a jobs boom.

Want to read the full report?

Download the LaSalle ECGI 2023 here

Brian Klinksiek, Julie Manning, Amanda Chiang and Tobias Lindqvist discuss investing in ‘green’ real estate.

The transition to a lower-carbon built environment is reshaping the definition of quality real estate. We can point to numerous anecdotal examples of green building features driving higher rents and values, as well as better overall performance. However, showing this rigorously and quantitively is challenging.

Various academics, real estate agencies and other researchers have attempted to measure the difference between assets that possess and those that lack green features. They use a range of datasets that vary widely and have enjoyed varying degrees of success in drawing clear, convincing findings from their analysis.

So is there a green premium? Or a brown discount?

Price, value and performance differentials between assets that possess and those that lack certain sustainable credentials are often called one of the other. In our view, the difference between the green premiums and brown discounts is a matter of perspective and can vary with time, as given attributes transition from novel, to highly valued, to standard.

For simplicity’s sake, we think of them as a single concept that we call “the value of green.”

Our approach for this report is to examine the existing work on the topic and identify the most helpful and relevant analyses. This sits alongside our monitoring of outcomes within our own portfolio, a few examples of which we highlight as case studies.

We find that while the range of estimates are wide, and depend on a variety of methodological considerations, the studies consistently find a statistically significant financial impact of asset sustainability features on metrics such as achieved rent, capital value, leasing success and overall performance. We will continue to monitor the evolving evidence of these differentials, both in the broader literature and within our portfolios.

So does “green” actually have value?

Download our full report to find out

Brian Klinksiek, Global Head of Research and Strategy (L) and Eduardo Gorab, Head of Global Portfolio Research and Strategy, LaSalle Global Solutions (R), take a look at the why and how behind building diversified and resilient global real estate portfolios.

Download the ISA Portfolio View 2023

The art and science of portfolio construction matters most when market conditions change suddenly. This has never been truer than in the past few years, which saw major pivots in capital markets as policymakers shifted from trying to stimulate the economy at the start of the pandemic, to applying the breaks to prevent inflation running out of control. The speed and unpredictability of these changes highlights the importance of planning ahead by thinking carefully about how to create portfolios that can be expected to be resilient. Foundational concepts of portfolio management such as diversification and risk management should be considered alongside an investor’s objectives and values to devise a strategy for their portfolio.

It is with these factors in mind that we release first edition of LaSalle’s ISA Portfolio View, which seeks to answer five foundational questions about real estate:

Why real estate lays out the case for property exposure in a multi-asset context?
Why global considers the benefits of expanding horizons beyond an investor’s domestic market?
Why be sector smart tries to make sense of the recent changes in relative sector performance with an eye to building resilient portfolios?
Why be quadrant smart addresses the interplay among the “four quadrants” of real estate?
Why manage risk explores the importance of—and our approach to—managing investment risk?

In many ways the ISA Portfolio View is the continuation of a longstanding strand of LaSalle’s analysis that would typically form the latter chapters of the Investment Strategy Annual. In this new standalone edition, we draw from a deep pool of experts from around the firm, acknowledging the interconnectedness of real estate opportunities: across borders, across sectors, and across quadrants. We welcome your questions and feedback.

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Global Head of Research and Strategy Brian Klinksiek (L) and Canada Head of Research and Strategy Chris Langstaff (R) discuss how rising mortgage rates will impact the residential real estate market.

Download our Q3 2023
LaSalle macro quarterly

In recent editions of LaSalle Macro Quarterly (LMQ), many charts have highlighted interest rate rises. LaSalle has especially focused on the repricing of income-producing real estate that rate rises have triggered in much of the globe. But the spike in rates is also having an impact on owner-occupied residential real estate, which accounts for a much larger share of the global property pie than do institutional assets. As we release the LMQ for Q3 2023, we look at the broad implications of higher residential mortgage rates, and how they vary by country. Even if institutional investors do not directly touch owner-occupied housing, they should consider the risks (and a few opportunities) caused by these dynamics.

Higher residential mortgage rates have implications for both new buyers and existing owners. For new buyers, higher rates reduce the purchase price they can pay (assuming a fixed amount of debt service). In practice, buyers cope with this by dedicating a larger share of their income to housing, or by scaling back or postponing their home purchase ambitions. For economies in which housing constitutes a meaningful share of the economy, this can create a noticeable drag on GDP growth. It may also put downward pressure on home prices, which can have indirect wealth effects on consumer spending. (So far, house prices for key countries have held up reasonably well during this period of rising rates—as shown in the chart on page 7 of the LMQ—but risks remain.)

For existing owners, much depends on the specific terms of the mortgage. The US mortgage market is unique globally in having a very large share of loans with rates that are fixed over a fully amortizing term (typically 30 years), according to data from Fitch. Assuming they do not move, borrowers can continue to enjoy low fixed payments. Elsewhere in the world, residential mortgage rates are usually floating or fixed only for a limited time. When rates rise, they filter through to borrowers gradually as fixed rate periods end—in other words, when rates reset. Depending on the mechanism for rate resets, they can cause a direct hit to disposable incomes. Households may react to this by scaling back spending elsewhere, or in the extreme, leaving the ranks of homeownership. These impacts will be more significant in places where consumers already have a high debt service burden.

For investors in income-producing institutional real estate, there are two aspects of these dynamics that are especially relevant. One is the broad recession risk that comes from weaker housing markets and stretched consumers. Oxford Economics has cited differential exposures to mortgage resets as a driver of divergence in near-term economic growth between the US and Canada. Second, the substitution effect from owned to rented housing may provide a boost to both multifamily and single-family rental demand, potentially driving stronger performance for residential strategies.

Canada: An illustrative case

Canada is an interesting case study because the structural characteristics of its residential mortgage market and the availability of transparent data permit a relatively clear identification of mortgage rate resets. Most residential mortgages in Canada have 25- or 30-year amortization periods, with typical fixed rate periods (known as “terms”) running from as short as one year to as long as ten years, according to the Bank of Canada. Some mortgages have a fixed interest rate that is reset for the next term according to the prevailing market rate. This occurs through a renewal at the end of each term, until the mortgage is fully paid off. According to Bank of Canada (see table), fixed-rate mortgages account for two-thirds of balances outstanding in the country among lenders. Most fixed-rate mortgages have remaining terms of five years or more (40% of overall balances), followed by three-to-five years at 18.4%. Only 8.5% of all fixed-rate mortgages expire in the next three years

Composition of outstanding residential mortgage balances, Canada (April 2023)

Sources: Bank of Canada, LaSalle. Data as of April 2023.

However, the remaining one-third of Canadian mortgages are variable rate, which float based on short-term interest rate movements. The Bank of Canada has hiked interest rates nine times since March 2022, pushing up rates on some variable-rate mortgages to around 6.0%, from roughly 2.8% a year ago. The most common type of variable-rate mortgages in Canada have fixed monthly payments. As interest rates rise, a higher proportion of the payment goes toward interest and less toward principal. Rising rates over the past 18 months have put some borrowers in the position of having monthly payments that do not cover the interest portion of the mortgage. The excess (unpaid) interest for that month gets added to the principal, increasing the original mortgage amount. Compared to countries where the absolute monthly payment amount adjusts directly with rates, this mechanism prevents an immediate near-term hit to disposable income from rising rates. But it does effectively embed the impact of higher rates into a longer-term increase in debt on household balance sheets.

The rest of the world

Beyond Canada, which countries are impacted by rising residential mortgage rates? Cross-border comparisons are not straightforward; the devil is in the detail. Nuances to consider include variation in fixed-rate terms, amortization periods, interest rate levels, and when and how rates reset. Many factors, including macro indicators like household debt levels and the structure of countries’ residential mortgage markets, need to be considered in assessing a market’s exposure.

One persistent issue is that data on the relative shares of fixed- versus variable-rate mortgages by country tend to classify any mortgage as fixed rate if it is fixed for a period of time, even if it that rate will reset in the near term. Analysis by Fitch Ratings attempts to correct for this with a metric that includes any mortgages with rates that are expected to expire or reset within 24 months. On this analysis, Australia leads in exposure to resets, followed by Spain, the UK, and Canada. Australian mortgages with fixed rates generally have shorter fixed-rate periods of around two years; this compares with five years in the United Kingdom and Canada, and 30 years in the U.S. (Although not in the Fitch dataset, we understand that Sweden is also relatively highly exposed to resets.)

Expressed as % of 2020 loan originations. Analysis as of December 2022.
Sources: Fitch Ratings

Fitch extended their analysis to combine and layer in pre-reset mortgage debt-service-to-income (“DTI”) ratios by country. This allowed them to estimate how much an increase in DTIs would be caused by a five-percentage point increase in interest rates. They found that the impact roughly followed the rank ordering above, with Australia and the UK most exposed, and the US least exposed. It should be noted that many of the same mitigating factors that apply to Canada (e.g., strong immigration, shortages of housing, low mortgage arrears) also apply to Australia, Spain and the UK.

The outlier case of the US is not quite as positive as it may appear. As a country with high internal mobility and (unlike many other markets) mortgages that are not “portable” between different collateral, the effective exposure of US households to mortgage rate changes is probably higher than implied by these data alone. Moreover, there are some downsides to having a large share of long, fixed rate mortgages. For one, the lesser impact of higher rates on consumer spending potentially requires more interest rates increases to have the same desired impact on inflation. Another factor, which is already evident, is that having a low interest rate locked in creates a barrier to moving, limiting the supply of housing for sale and making home prices sticky.

Looking ahead

As mortgages reset at higher rates, a greater share of household budgets will be diverted to mortgage payments. This could be particularly acute for households that live “paycheck to paycheck.” While some households may have excess savings to cushion the blow of higher mortgage payments, overall discretionary retail spending is at risk of moving lower. This, in turn, could impact retail real estate market fundamentals. The composition of retail spending could also shift, as households with lower discretionary incomes move more of their spending to discount retailers, and away from discretionary or luxury items. In the case of Canada, Oxford Economics forecasts that consumer spending will drop 1.8% from its pandemic-era peak, potentially tipping the economy into recession.
While interest rate hikes since early 2022 have increased financing costs for owners of multifamily apartments and reduced transaction volumes, ongoing housing shortages in various countries are contributing to higher apartment demand. With higher mortgage payments putting the cost of home ownership out of reach for many, demand for relatively lower-cost rental housing has increased. This has clearly been the case in Canada, where according to the Canada Mortgage and Housing Corporation, apartment vacancy declined by 120 basis points in 2022 as apartment absorption reached an all-time high of 100,300 units, an increase of 59% over 2021.

Sources:

1. ECONOSIGHTS: Three reasons why Australia is more vulnerable to higher rates – Mousina, Diana, AMP Capital, September 2022.

2. Fear of Renewal: Most new homebuyers ‘very worried’ next term will bring much higher monthly payments – Angus Reid Institute, May 2023

3. How Do Mortgage Rate Resets Affect Consumer Spending and Debt Repayment? Evidence from Canadian Consumers – Bank of Canada, May 2020

4. Statistics on Mortgage Arrears in Canada – Canadian Bankers Association, Table DB50 Public, June 2023

5. Global Housing and Mortgage Outlook – 2023 – Fitch Ratings, December 2022

6. Mortgage Interest Payments in Advanced Economies – One Channel of Monetary Policy – Reserve Bank of Australia, Statement on Monetary Policy, February 2023

Important Notice and Disclaimer

Global Head of Research and Strategy Brian Klinksiek discusses recent bank failures and the impact on real estate with Dominic Silman and Zuhaib Butt.

Silicon Valley Bank (SVB) and Signature Bank failed. Regulators hastily arranged the sale of Credit Suisse to UBS. Concerns spread about numerous other small and major global banks including Deutsche Bank. Recent events have raised fears that the global economy is in for a credit crunch of unknown magnitude and duration. As we release our first LaSalle Macro Quarterly (LMQ), a revamp of our long-standing “macro indicators deck,” banking sector strains represent the number one macro risk we are assessing.

The proximate cause of each recent bank failure was deposit flight, a drain from the liabilities side of the bank balance sheet. This is fundamentally not a toxic assets problem of the sort that banks faced in the Global Financial Crisis (GFC). Rather, it is a liquidity issue that can be addressed by temporary emergency funding from central banks. But solvency, the greater concern for banks in the longer run is closely tied to the duration of the asset book.

When investors in interest rate-sensitive assets refer to duration, they typically mean the change in value associated with a change in risk-free rates. SVB failed, in large part, due to a perception that it had sustained severe losses on riskless (but long-duration) US Treasuries and near-riskless agency mortgage-backed securities as these assets had mechanically repriced in the higher interest rate environment.

Just as there was a mechanical element to the initiation of this crisis, there is a mechanical feedback loop that can help the crisis partially self-resolve. As worries around bank solvency, credit conditions and the real economy spread, expectations for policy rates fell, causing long-duration assets to once more increase in price, shoring up balance sheets.

As a result, there has been a 360-degree round trip in interest rate forward curves between the beginning of February and the end of March. At first, curves shifted upward due to spiking inflation data, before falling substantially as banking systems came under pressure, followed by a return to the status quo as resolution measures stabilized markets and inflation seized the attention of policymakers and investors once again. As a result of this volatility in rate expectations, the MOVE index of bond option volatility¹ has reached the highest levels since the GFC.

There are many media, economic and financial industry sources to turn to for a deeper discussion of the underpinnings of the recent financial sector instability, or to track the daily news flow and the resulting volatility. Our focus is on the practical considerations for investors in property. We have identified four key recommendations for how real estate investors can assess risks and manage through volatility.

1. Don’t miss the forest for the trees.

A lot of analyses have focused on idiosyncratic aspects of individual banks. For example, Silicon Valley Bank has been highlighted for its tech sector links and an unusually large share of its deposits not covered by deposit insurance. Credit Suisse had faced multiple controversies in recent years, including a recent disclosure of reporting irregularities which triggered an equity sell-off, as well as an outsized exposure to losses in cryptocurrencies.

Fundamentally, however, the current pressures impact all banks, with the weakest links facing the greatest strain. The question is: How far beyond those weakest links will the challenges spread? This will depend on how the vagaries of sentiment and fear interact with the willingness of policymakers to take action to protect the banking system. Thus far, action taken to resolve liquidity issues seems to have had the intended stabilizing effect, with banks such as Deutsche tested, but not forced to failure.

2. Monitor the path of monetary policy and bear in mind duration.

Central banks meeting at the end of March faced a dilemma between continuing their path of tightening to fight inflation, versus moderating or pausing to prioritize financial stability. In the end, the European Central Bank (ECB), Federal Reserve (‘Fed’) and the Bank of England (BoE) all opted to press ahead with rate rises². Their decisions were helped in part by data showing an unexpected re-acceleration in inflation, and perhaps also wishing not to betray significant concern about the stability of financial systems.

Volatility in rates markets has a symmetric aspect, so both the initial fall in expectations and the return to a higher implied path for rates have contributed to the MOVE index reaching decade highs. Research suggests³ that bond volatility is less tied to meeting-by-meeting central bank decisions, which may be well-telegraphed, and more to expectations about the ‘terminal’ rate—the highest level that policy rates will reach over a cycle. As we near that peak rate, bond options are more sensitive to news at the margin than they were even to 75bp rate increases when it was well understood that the terminal rate was still far higher.

Long duration—and therefore high sensitivity to interest rates—is a characteristic not just of bonds, but any long-hold assets with uncertain cashflows, including income-producing real estate. It follows that real estate values, especially in sectors and geographies which have repriced furthest and most quickly such as UK industrial, are also more tightly linked to terminal policy rates at this point than month-to-month central bank decisions.

3. Take an active approach toward real estate debt.

Bank lending is likely to become more conservative as duration risk attracts both external regulatory attention and enhanced internal risk management scrutiny. Any pullback in bank lending activity should further increase the importance of private credit across the economy, including in real estate. This could be beneficial to non-bank lenders funded by sticky capital, who can be expected to originate a greater proportion of mortgage loans. On the equity side, investors should cautiously manage their debt maturity schedule in the near term and diversify their sources of debt capital over the medium term.

4. Manage risk and diversify.

The failures of SVB, Signature and Credit Suisse, and the pressures on other banks, have elicited a policy response that some banking experts consider to be sufficient to prevent severe additional damage to the economy. Certainly, rate-setters have felt sufficiently confident to press ahead with policy rate increases. But as in all cases of banking sector turbulence, there is considerable uncertainty and outcomes will depend on difficult-to-predict sentiment factors. Ultimately, the systemic nature of financial market risks makes them inherently difficult to control. As real estate managers and investors, our best approach is to understand and monitor these risks and practically diversify investments to mitigate the impact on the overall portfolio.

Looking ahead

We recommend focusing on the overall health of the financial system, rather than sector-specific concerns, such as sizing incremental negatives on tech-related real estate from the failure of SVB. Surely, the loss of a sector-focused relationship lender will have some impact on tech companies. But well before the failure of SVB, the same duration-driven hit to the value of bonds and real estate was affecting early-stage technology companies. We do not think the incremental negative for tech is as important as the broader macro uncertainties.
Investors should bolster their monitoring of banking health generally and their banking relationships specifically. This includes careful mapping of where deposits are held and sources of debt finance, especially credit lines. These exposures should then be continuously compared to assessments of bank health and market measures of risk, such as credit default swap (CDS) spreads⁴ and Liquidity Coverage Ratios (LCRs). LaSalle has undertaken a comprehensive global exercise to match such exposures and compare them against a dashboard that tracks the health of close to 100 major banks globally.

Footnotes: 1 [LMQ slide 3], 2 [LMQ slide 4], 3 Based on work by Natixis, a French corporate and investment bank, 4 [LMQ slide 6]