There is no good real estate investment strategy without thorough analysis.

Uncompetitive buildings will experience a drop in yields and value. The question of which assets to invest in will become essential to avoid downside risks.

In times of higher and volatile interest rates due to inflation and dynamic energy markets, detailed industry analysis is increasingly important when selecting real estate investments. Olafur Margeirsson, Head of Global Real Estate Research at Credit Suisse Asset Management, explains how to identify opportunities and mitigate risks.

Rising interest rates and the risk of recession are taking a toll on real estate investor sentiment around the world. But real estate remains relatively attractive as an asset class, especially in an inflationary environment. Indeed, even if the prices of assets such as stocks, bonds or real estate are under pressure, when inflation and interest rates rise, the real estate sector can benefit from an increase in yields.

The impact of inflation on real estate investments

In the case of real estate, this income corresponds to the contractual rent. And because real estate rents in Europe are usually linked to the local consumer price index, inflation can also lead to higher rents for landlords, which increases the value of buildings.

Additionally, multiple data sources tell us that global cities are generally growing faster than national economies, allowing local real estate assets to benefit from stronger underlying growth than current numbers indicate. For these reasons, real estate can provide long-term inflation protection: it can capture the growth needed to protect inflation-adjusted returns.

In our view, real estate can continue to generate attractive long-term (inflation-adjusted) risk-adjusted returns. However, in the future, the type and location of a property will play an even more critical role than before: non-competitive buildings with reduced demand from tenants will see a decline in their returns and value. The question of which assets to invest in will become essential to avoid downside risks.

So far, in an environment of falling interest rates, even non-competitive assets have risen in value, thanks to the fact that lower interest rates have caused their market value to rise. From now on, however, interest rates will no longer fall. Being able to find, select and manage the right properties to generate attractive risk-adjusted returns is again becoming an essential component of any successful real estate investment strategy. The traditional “buy and hold” strategy has lost its competitive position against the “buy and manage” strategy.

Supply and demand determine risk-adjusted returns

Inevitably, real estate investments run the risk of being affected by rapid macroeconomic developments in the short term. At the same time, real estate investors often have long-term investment horizons, which makes it all the more important to be aware of major long-term trends that create imbalances between supply and demand. 🇧🇷 These megatrends include continued urbanization and homelessness, structural e-commerce growth and shifts in industrial production, and an increased focus on energy efficiency and the low carbon footprint of buildings.

The current housing market downturn is also unusual. Yes, property values ​​remain under pressure as both the apparent economic slowdown and rising interest rates are contributing to a cyclical downturn in markets. However, rental activity and rental demand are relatively strong, contrary to what happened, for example, during the recession of the early 2000s and the global financial crisis, while Construction activity has not increased as much as it would have expect based on previous recoveries. This has caused different imbalances between supply and demand by city and sector, resulting in different market prospects for rent growth and overall returns. In such an environment, detailed analysis is important: only certain markets will be able to generate aggregate returns that can offset investors’ risks.

A good analysis helps to see things more clearly

The manufacturing sector in the US is a good illustration of this, as cities are spread across the risk-return spectrum (see fig. 1). All markets are under pressure due to rising interest rates, but some are managing to offset this pressure thanks to the expected momentum of rent growth. Rent growth prospects are the main influencing factor in determining the ranking of cities based on overall returns. Therefore, several markets, especially cities above the shaded area such as Los Angeles and Miami, appear capable of generating returns over the forecast horizon, both in absolute and risk-adjusted terms. However, we also look at markets such as Chicago or Houston (see those below the shaded area), where expected returns may be too low to be considered attractive on a risk-adjusted basis. Finally, the cities in the shaded area are those for which we expect returns commensurate with current market risk.

A detailed analysis of this type is essential: if one market manages to generate returns well below expectations given the market risk, it is perfectly possible that another will do so due to a performance superior to income growth. While it may be tempting to look at the situation from the outside and wait for better times, the risk prevails that good real estate objects will already be pulled from the market when the economy recovers.

Leave a Comment