While there are signs that the pace of interest rate increases is decelerating, uncertainty about the economic outlook remains elevated, which is resulting in falling liquidity across real estate markets that in turn has started to negatively affect real estate pricing.

Investment volumes were weak in the fourth quarter of 2022. Usually investment activity picks up toward the end of the year as market participants are motivated to fulfill annual targets, and historically around a third of annual transactions by deal count are completed in the last quarter. However, in the fourth quarter of 2022 this number fell to 13%, marking the weakest 4Q recorded since 2007 (Exhibit 1).

As uncertainty about the outlook remains high, there are signs that existing owners are pulling deals from the market fearing a need for further price cuts to complete transactions, while buyers are waiting for prices to fall further. This has significantly affected transaction yields in the fourth quarter of 2022 (Exhibit 1).

While transaction yields were still holding up in the third quarter, drying up investment volumes in 4Q in Europe have added to pressures on pricing linked to a sharp increase in the cost of capital over the past year. As transaction volumes declined for the fourth quarter in a row for the first time since 2007 (just prior to the global financial crisis), all property transaction yields moved out by nearly 100 basis point in the fourth quarter 2022 alone.

Judging from available evidence, the drop in liquidity has also started to negatively affect real estate valuation yields, adding to the effects of higher interest rates and falling debt availability that started to be felt mid-way through 2022. The weak activity in 4Q22 suggests that smooth market functioning is being affected and all property valuation yields moved out by 50 basis points in the fourth quarter of 2022 (Exhibit 2), representing a pace of adjustment that is faster than even during the global financial crisis.

Falling liquidity is now clearly affecting pricing in European office markets (Exhibit 2), for example in Germany. In Berlin, transaction volumes fell by over 60% compared to their long-term average and capital values driven by yield shift fell by over 40% over the course of 2022, as rising interest rates quickly made debt financing of deals very challenging at previously very low yield levels of 2.5% and market participants pulled back as uncertainty spiked due to the Ukraine war.

Similarly in logistics, for example in the London metropolitan area, pricing has adjusted from levels that became unsustainable as interest rates moved up sharply in the second half of 2022 and which has been reinforced by falling transaction volume. The pricing move has come despite rental growth coming in stronger than had previously been expected, emphasizing that the repricing is very much a capital markets driven story and not much affected by fundamentals at this stage.

In short, in many parts of the market, falling liquidity is now exacerbating pricing movements, raising the risk of an overcorrection of pricing where volume declines most severely.