New challenges sweeping the Real Estate market
The Real Estate market is facing a host of new challenges, including the increasing complexity of transactions, the impact of inflation and the incorporation of environmental regulations. In this interview, Edouard Corbière, Managing Partner at R&Co Real Estate boasting more than 20 years’ experience in the sector, gives us an overview of the French market.
Structure and market players
The real estate investment market is structured around two main segments. One is residential real estate and the other commercial or tertiary real estate (consisting of properties for professional use). While residential real estate is predominantly driven by transactions involving individuals and some institutional clients, commercial/tertiary real estate is fuelled by a multitude of players such as investment funds, listed property investment companies, primary and mutual insurance companies and other savings collectors.
It is also important to distinguish real estate production, which comprises real estate development (construction or renovation), from the investment market, which primarily consists of transactions in existing properties. Although both of these markets share the same ecosystem (with one partially driving business in the other), they meet different financial rationales.
Real estate developers are struggling in a highly adverse environment
Structurally, France is characterised by a sub-supply of homes and thus by a real estate development market historically driven by demand. One observation that is becoming increasingly prevalent today is that new environmental constraints are reducing housing production capacities.
And yet, there are currently multiple factors making a heavy impact on the profession. Rising construction costs and the sharp increase in borrowing rates, making it more difficult for real estate developers and end buyers alike to obtain loans, are causing reservations to plummet and selling prices to slide. Against this backdrop, developers are seeing their margins and cash holdings take a major hit. At the same time, institutional investors have steered away from this low-yield market towards assets offering more attractive profiles.
Real estate investment in the doldrums
Commercial real estate (offices, shops, manufacturing sites and warehouses) posted a very sharp drop in investment volumes in Q1 2023, shedding 35% compared to Q1 2022, to €3.3 billion1.
Adversely affected by the rapid rise in interest rates, implemented by the ECB in the hope of curbing inflation, this market - historically driven by liquidity provided by institutional investors and the general public, is now seeing very low-risk yields (term accounts for example) competing with returns offered by secured real estate assets. In these conditions, not surprisingly the trend taking shape is very clear: savings collectors in the real estate sector are seeing a decline in inflows coupled with outflows from certain vehicles.
Against this backdrop, the yields sought by real estate investors (ratio between rent and selling price) is climbing, mathematically sparking a drop in the value of properties.
A financing model that has reached its limits?
In addition to tighter borrowing conditions, the sectors has also been sharply affected by the fall in valuations. Most buildings are debt-financed, often through mortgages, and one of the main coverage ratios examined when considering an investment is LTV (Loan To Value). LTV is the ratio between the amount of the loan and the value of the asset. The declining valuation of real estate assets thus automatically causes LTV value to increase. Beyond a certain threshold, the lender sees the associated risk as too high and will thus contractually call for some or all of the debt to be repaid, putting the borrower in a very delicate situation.
Changing practices are radically altering property values
The impact of the health crisis, combined with new societal trends, are responsible for extensive changes. A very clear movement is taking shape in the office building segment, which historically makes up the large majority of investments in tertiary real estate: demand for real estate in city centres is holding steady, while offices in surrounding areas are left by the wayside and recording an increase in rental vacancy
This trend can be partially attributed to the steep rise in telework, which has radically transformed workplace practices, and thus demand. This phenomenon has also been observed in the United States. On the heels of “dead malls”2 (empty shopping centres, stemming from the sharp increase in e-commerce), changing practices have given rise to “dead offices”3, accompanied by a drastic decline in investments in these assets.
What’s more, it is challenging for office buildings located outside city centres to be re-purposed as homes. Not only is this type of conversion highly complex from a technical standpoint, but the creation of homes also calls for the creation of costly public facilities (gardens, nurseries, schools, stadiums, etc.). As a result, the valuation and liquidity of these assets have considerably decreased.
Despite these adverse conditions, certain assets have managed to come out on top. One example is “QCA”4 (downtown) offices, which have been boosted by the movement back into city centres, sparking higher rents, meaning their valuations have been less negatively impacted by rising interest rates. This trend once again confirms the importance of location, location, location as the key criterion in real estate investment.
Looking at other segments, retail, certainly one of the segments hit hardest in recent years, primarily due to the e-commerce revolution, has held up relatively well in this environment, with valuation levels in the last few years having already reached very low levels.
The logistics and warehousing sector is still very attractive, despite the recent readjustment in the valuation of assets triggered by rising interest rates.
The hospitality industry, very adversely impacted during the Covid health crisis, has now been split into two business categories. “Leisure” assets are currently thriving, while “business” assets are struggling hard due to the advent of telework and decreased business travel.
The digitisation of society calls for increasingly large data storage capacities, triggering heightened demand for investment in data centres. The development of these assets has skyrocketed in recent years.
Thanks to the sharp rise in R&D spending, Life Science assets used for medical research are still highly sought after. In addition to meeting the public's growing concern over health matters, these assets also serve as a source of diversification for investors. Again, the health crisis served as a catalyst in the emergence of these assets.
Lastly, we are also seeing renewed interest in coliving5. By facilitating access to housing via turnkey homes, while also providing flexibility, integrated services and cutting out multiple time-consuming formalities, these assets meet both the aspirations of younger generations and the structural need for housing in France.
The importance of ESG criteria in accelerating the transition
Multiple very strict environmental regulations are impacting existing real estate as well as the production of new properties. For example, the aim of ZAN (zéro artificialisation nette or zero net artificialisation) is to encourage the mobilisation of existing artificial surfaces in order to achieve 0% net artificialisation by 2050. For developers, this means adopting a change in business model, by building on top of existing artificial surfaces or by de-artificialising soil to offset the creation of new artificial surfaces. This need to reinvest in existing properties gives them significant renewed value while taking the previously established business model back to square one.
Along the same lines, the Tertiary Decree has imposed drastic reductions in the energy consumption of existing buildings. The goal of achieving the established targets, i.e. -40% energy consumption by 2030, -50% by 2040 and -60% by 2050, has made these criteria central to new investment strategies. The valuation of real estate assets is being directly impacted by these constraints, with price adjustments to integrate the cost of bringing buildings sold into compliance.
ESG criteria are thus generating a growing impact on the real estate sector today. While the focus is clearly on the E (environment) pillar, the incorporation of S (social) (with G referring to governance criteria and thus management structure and administration, having relatively little impact on the real estate sector) is becoming inevitable. Providing extensive support for major social causes such as childhood, education, training or disability, is becoming a new challenge for the sector to meet. R&Co Immobilier has elected to lead the way by combining the creation of co-living spaces where half of the occupants are affected by mental disability.
(1) Source Immostat / (2) Vacant shopping centres / (3) Vacant offices / (4) QCA : Quartier Central des Affaires (Central Business District) / (5) Coliving is a shared housing situation combining private areas (individual rooms or studios) and common areas (kitchen, garden, exercice room, etc...)