Given elevated interest rates, a weak economic growth outlook, a large bid-ask spread and higher returns on other asset classes, real estate transaction volume in real terms has fallen to levels last seen during the Global Financial Crisis (GFC) when investment volume deteriorated as credit effectively disappeared amidst financial market turmoil (Exhibit 1).

There are echoes of this today as financial markets adjust to higher real estate debt costs, which are currently above prime yields in many major European markets, implying debt is dilutive to investment returns unless significant rental growth is underwritten. This restriction on leverage is dampening investment activity, especially for large deals where substantial financing is required and in sectors in which the rental growth outlook is downbeat.

The larger the gap between real estate debt costs and property yields the more pressure for yields to move up. Currently this is clearly playing out in the UK (Exhibit 1), in particular inoffice markets, where financing costs have risen by more compared to Continental Europe, and as such we are expecting further pressure and a bigger correction on UK yields before the market can clear, which is going to lead to market dislocation.

On the flipside, pressure on yields from elevated debt costs is less of an issue in logistics, where the typical deal size is smaller and where yields have already expanded the most, and in residential, which is benefiting from higher nominal growth potential via a strong link with inflation.