Real estate investing in a ‘higher for longer’ interest rate environment

Real estate investing in a ‘higher for longer’ interest rate environment creates new risks and opportunities for investors to navigate. In the second half of last year, UK commercial property values fell more than 20%, Bloomberg reported on MSCI data, as high inflation and rising interest rates made the asset class more expensive while debt pricing also increased. These dynamics slowed the transaction market as investors paused new investment decisions to absorb the impact of the most aggressive monetary tightening cycle on either side of the Atlantic since the 1980s.

The precipitous inflation rise triggered a near synchronised hawkish shift in central banks’ monetary policy worldwide – which was faster and steeper than investors and central bankers had foreseen. Inflation catalysts included soaring energy and food prices, exacerbated by the war in Ukraine, tight labour markets, pandemic-era supply chain disruptions, and China’s “Covid zero” policy. An additional contributing factor is the slow-moving, accumulative impact of 15 years of unchecked quantitative easing (QE) on the purchasing power of fiat currencies.

In less than a year the Federal Reserve increased the Fed funds rate by 425 basis points in seven separate increases. The European Central Bank’s (ECB) governing council followed four months later, raising rates by 250 basis points in four policy decisions. In comparison, the Bank of England (BoE) increased the base rate by 340 basis points last year over nine consecutive rate hikes. By the end of last year, annual headline CPI inflation fell to 6.5% in the US, 9.2% in the euro area and 10.5% in the UK, down from peaks of 9.1% last June, and 10.6 % and 11.1% last October respectively, according to government data. However, while headline inflation looks to have crested, price pressures have shifted to services as seen in still rising core inflation globally. Furthermore, the inflationary impact of the reopening of China’s economy cannot be overlooked, as more demand pressure re-enters the global economy, particularly in liquefied natural gas (LNG) prices. Far from declaring victory on inflation, all three central banks remain adamant that interest rates must remain higher for longer. Persistent tighter financial conditions have implications for real estate investment, leasing activity, and financing costs.

For institutional multi-asset class investors, fast-rising interest rate rises caused public asset valuations to fall very quickly, relative to a far slower real estate repricing, prompting the ‘denominator effect’ to kick in. It leaves multi-asset investors technically over allocated to real estate, creating a conflict between maintaining asset allocation targets and achieving the best possible investment returns. If investors honour the former, it could force redemption requests to sacrifice the latter, as disposals in this market would be below prevailing valuations. While most investors are content to wait for real estate repricing to complete – which is already underway – internal pressure at some institutions may prompt some disposals, presenting opportunities for bargain-hunting investors with dry powder.

But, overall, the trimming by real money investors is marginal, as the current bid pool is much shallower than 12 months ago. For the most part, investors are sitting on their hands, not making new allocation decisions and waiting for valuations to come down. Investors want to see where the discrepancy between inflation expectations between central banks and markets converge. When a consensus is reached, the impact of the anticipated recessionary environment on real estate will become clearer to navigate.

Refinancing markets are another tricky landmine for real estate markets in the macroenvironment. The rapid rebasing of interest rates caused property yields and the cost of debt to spike while investment volumes plunged. The perfect storm of downward repricing asset values as occupier cash flows continue to come under pressure and the UK and Europe navigates a recession, raises the prospect of a new wave of defaulting loans. At the same time, banks – whose loan books are over-extended post the government-backed Covid-era loan schemes – will be more cautious, refinancing loans at maturity in a weakening economy. Banks are reluctant to lend against high-risk projects, including new construction, legacy offices and capital-intensive refurbishments. That said, there will be far less forced selling compared to after the global financial crisis as banks will be unlikely to want to take on the asset management of distressed real estate in a weakening economy. In the near term, banks are incentivised to keep borrowers working on troubled assets and not force a sale because foreclosure would require a sale well below valuation. However, some sales should be expected, particularly by investors unable to secure a bank refinancing at loan maturity, while the non-bank lending market will absorb some of the funding gap. Real estate investors requiring a refinance, and those seeking acquisition finance, will have to accept lower LTVs, higher senior margins and tighter covenants. For many, refinancing events will lead to a new relationship with non-bank lenders and increasing market share for alternative lenders even further. All of which is a reminder of how attractive the current year should be for debt investors.

By mid-year, most asset repricing should complete, along with easing inflationary pressures in the economy, which should support moderated debt margins and modestly improved liquidity, which may help to narrow the current bid-ask spread between buyers and vendors. But with interest rates unlikely to return to historic lows, the cost of capital and transactional activity is unlikely to return to five-year averages anytime soon. One way this could manifest is in the transaction data – who is deploying capital and who is not. For example, opportunity funds may be less active, given their reliance on high leverage. Elsewhere, residential, logistics and select next-generation real estate sectors (e.g. life sciences and data centres) may still have space to outperform, supported by structural demand drivers. But, even here there is reason for caution given the economic outlook.

 Central banks are still in the nascent stages of reducing their oversized balance sheets, and markets are still getting used to the end of 15 years of ultra-cheap capital. The relative value argument of real estate, relative to equities and bonds loses salience in a protracted higher for longer interest rate environment. Inflation and interest rates will dominate the outlook for real estate investment markets for years.

 A recession is still the base case among economists throughout 2023, coinciding with corporate earnings erosion, which may spill over into major redundancies and reduced real estate demand, while financing conditions are unlikely to return to recent historic accommodative conditions. This changed macroenvironment throws up new prospects for bargain hunters and lenders, but the real estate investment strategies that served well in an accommodative monetary policy environment may not work as effectively in the years ahead.