Rising interest rates and recession risk weigh on commercial real estate; offices and companies located on the periphery face new headwinds.
- The indexation of rents partially offsets the increase in operating and financing costs. Prices will be supported by shortages of warehouses, affordable housing projects and energy-efficient offices located in city centers
- Valuations of European real estate companies reflect too much bad news, although some highly leveraged companies may need to raise capital and/or cut dividends
- We maintain a cautious stance on real estate, with a neutral weighting, and see the possibility of increasing allocations when rates peak in 2023.
The real estate market is going through difficult times. In 2022, listed real estate investment companies suffered. Still, the real estate sector could see a strong recovery when interest rates peak. We analyze market trends and future opportunities.
The housing market bears the visible scars of rising interest rates. Home prices are falling in the US and UK, and further in Canada, New Zealand and some Nordic countries. Declining housing affordability poses a major risk to the global economy in 2023, but what does this mean for real estate investors?
The risk/return dynamic is very different between direct investments in commercial real estate – where both rent growth and capital appreciation must be taken into account – and indirect investments in a fund or real estate portfolio management company. Direct investment is a long-term strategy, while indirect investment is more liquid and volatile. As rents are indexed to rising prices, both types of investment act as a hedge against inflation; however, this year both have suffered. On the direct market, October saw the biggest drop in commercial property values on record in the UK; according to MSCI data, transactions declined in most countries around the world in the third quarter. As for indirect investments, they have been hurt even more than stocks and bonds, which are already in bad shape: listed European properties have lost around 35% since the start of the year. Rising yields on liquid, “risk-free” European sovereign bonds and corporate credit also reduced the relative attractiveness of real estate investments. After the Liz Truss government’s proposed ‘mini-budget’ in September, the yield on 10-year government bonds hit 4.5%, close to the level investors could get on UK industrial property1🇧🇷
Rates and the risks of recession
Rising interest rates and the risk of recession are largely responsible for the sluggishness of the European property market. In times of economic downturn, demand for office and retail space drops. Concerns are emerging about tenants’ ability to pay their rents or absorb rising prices in the face of galloping inflation, particularly with rising heating and electricity costs. The slowdown in consumer spending is hitting a retail sector already struggling with the structural shift to online shopping, accelerated by the pandemic.
Office real estate faces additional challenges. The trend towards teleworking is proving to be sustainable. Cities with lots of apartments in the center, like Madrid, or a strong workplace culture, like Cologne, saw a significant return of workers to the office. However, according to real estate agency Savills, the average office occupancy rate in Europe is now just 43%, compared to 70-75% before the pandemic. Businesses are downsizing as multi-year leases come to an end. Traditional supply and demand dynamics also influence: following Brexit, London experienced a slowdown in office building, which limited supply and supported prices; on the other hand, Warsaw has yet to recover from the construction boom of the early 2010s. Furthermore, office buildings often require significant investments in energy efficiency, raising concerns that some older workspaces located on the periphery will not become “idle assets” on real estate investors’ balance sheets.
Real estate companies are also struggling with rising operating and maintenance costs, borrowing and debt service, while falling valuations boost loan-to-value ratios, currently around 40% in Europe, well below the 60% seen during the global financial crisis (GFC), but which has already led to a fall in share prices and the launch of asset disposal plans. In August, the leading German real estate group Vonovia announced its intention to sell apartments for a value of 13 billion euros, but is struggling to find buyers. UK property funds have received a flood of bailout requests from investors. In the United States, the Blackstone firm said it would limit withdrawals from two real estate vehicles managing several billion dollars after these requests increased. With large real estate companies managing portfolios of long-lived assets, their problems may take time to materialize, but for some heavily indebted European companies, investors fear the need for diluted capital increases for existing investors or a reduction in dividends.
Not everything is gloomy and 2022 is not 2008
Still, real estate companies are less dependent on short-term bank loans than they were before the global financial crisis and more dependent on long-term bonds (5 to 10 years). They are therefore better prepared for rising interest rates. They may also raise rents to cover rising borrowing costs. Of course, there is the issue of tenants’ ability to afford these increases, and many real estate companies may choose to forgo them, especially for struggling retailers or substandard office buildings where they want to keep their tenants. Legally, these companies can pass on all or a substantial part of increases in the consumer price index to commercial real estate (in France and Switzerland, for example, they can pass on 100% of increases to office rents). Homeowners can pass on more modest increases, which may be contested. In August, Denmark introduced a temporary cap on residential rent increases, allowing for 4% adjustments over the next two years. In Switzerland, we expect residential rents to grow by 3% to 5% in 2023 alone and a minimum of 2.5% for indexed commercial rents.
However, supply shortages may support rent growth and capital appreciation. In the European property market, this shortage has been concentrated in three sectors. The first concerns warehouses, despite an exceptional year 2021 in terms of construction, particularly in large logistics centres, as is the case in Rotterdam. The second is affordable residential projects. Many developers stopped building after the global financial crisis as population growth continued. In Switzerland, the vacancy rate for apartments in Geneva and Zurich is less than 1%. The third sector is that of offices located in city centers and with high sustainability characteristics. With companies striving to achieve ‘net zero emissions’ these areas are in high demand; companies are also trying to bring their employees back by offering offices in attractive locations near restaurants or stores, favoring smaller but better locations.
A more optimistic view under construction
For investors, perhaps the main attraction of listed properties is the amount of bad news already priced in (see chart). Despite the recovery seen from mid-October, European real estate agents recorded a discount of around 45% compared to their net asset value (NAV), which implies an expected depreciation of 30% in the value of their portfolio, corresponding to a increase in real estate income of 1.6% on average.
This seems excessive to us. However, entry point timing is critical. History has shown that real estate often underperforms the equity markets when rates rise, but when rates peak, it outperforms both 3 and 12 months. As a result, we see strong upside potential when rates stabilize in 2023.
In the coming months, we expect interest rates to rise further and growth to slow. Therefore, we remain cautious on the European and Swiss property market, with a neutral weighting compared to our benchmark. We favor quality assets, such as offices located in city centers or commercial spaces in the main commercial areas of cities, as well as geographic diversity, with a slight preference for European listed companies over Swiss listed companies, including titles that have a premium compared to their NAV . In Europe, we overweight the logistics sector – mainly warehouses – and direct investments in residential real estate. We are underweight commercial and office real estate. In Switzerland, where our allocations are limited to indirect real estate investments, we are overweight offices, primarily for valuation reasons, we maintain a neutral position in commercial real estate and underweight residential real estate.