Uncertainty over inflation, the health of the banking system and action by central banks puts real estate in a challenging position, writes Christopher Walker
The past few weeks have been particularly choppy for those using interest-rate forecasts as a foundation on which to build real estate decisions. While real estate is a long-term investment and less reactionary to short-term interest-rate movements, material shifts in expectations do matter, especially when they require a revisiting of investment assumptions.
This week, the US Federal Reserve and the Bank of England (BoE) will make their latest moves on interest rates. Today, it was revealed that UK inflation in February jumped above expectations to 10.4%, meaning the BoE is more likely to increase rates.
Zachary Gauge, head of real estate research and strategy for Europe (ex-DACH) at UBS, says: “We began this year with everyone being optimistic that inflation had peaked and that interest rates were trending down. Then expectations started to creep up, though this had yet to fully dent a positive investment case.” From there “we were suddenly hit with the SVB bankruptcy,” he says.
What started with SVB has morphed into a wider banking crisis and the merging of two giant Swiss institutions – including Gauge’s company, UBS, and Credit Suisse.
In just three days in March, the two-year US Treasury yield moved around 100bps, the biggest move since 1987. One CEO observed off the record that the current generation of decision makers has never seen anything like this. “Nobody under 50 can begin to understand this situation,” he said.
“Interest rates may seem high today if compared to the last 10-year window, but they’re really not unusually high if you have a longer timeframe,” says Jay Kwan, head of Europe at QuadReal Property Group. “It feels painful for a lot of people who don’t have that long-term timeframe, but all we are really doing is giving back the wealth we supposedly created over the past 10 years, as central banks give cash value again.”
Authorities are challenged globally by hot labour markets and sticky inflation – and a general concern that if the breaks are not working how do you stop the car? These concerns have only been raised by the banking crisis that started with SVB and saw Credit Suisse merged with UBS at the weekend.
Shiraz Jiwa, CEO of The Valesco Group, says: “The current backdrop is volatile and underpinned by sentiment – central banks don’t necessarily have the plethora of tools to effectively manage their respective economies, which heightens the potential for unpredictability and volatility.”
He adds: “We seek to understand the direction of travel and that informs our investment strategy. Our expectation is that interest rates will peak soon.”
While interest-rate forecasts changed almost daily in March, there was an emerging consensus – although one that might need to be revisited this week. Sabina Reeves, chief economist at CBRE Investment Management, characterises this as largely synchronised movements by the Federal Reserve and the ECB to reach peak rates in Q2 and then stop. “This means, in terms of the refinancing rate, whereas we had thought this would peak at 3.5% at the start of the year it now seems far more likely this will peak in a range of 4-4.25%.”
She adds: “It is quite possible that the ECB might be harsher than the others, because this is their first inflation crisis and to some extent they need to prove themselves.” But, then again, the rescue of Credit Suisse and fears of a wider banking crisis might give them reason to be more cautious.
In the UK, before the latest inflation numbers, economists thought there was less upside to interest rates. “We think there will only be 25bps more, and it is possible they won’t even do that,” Reeves says. Although there is a lot of focus on the very high level of UK food inflation, Reeves believes it is important to recognise “there are types of inflation you can change and types that you can’t”. She says: “Rises in interest rates will not bring down food inflation.”
It is also important to remember that the UK is different to the US and continental Europe in the higher proportion of variable mortgages. This means that rising interest rates has a much more direct impact on household spending. Sweden provides an idea of what could happen – the country has highly leveraged households with variable-rate mortgages, so the pass-through from policy rate rises through to consumer pain has been quick and painful. As Reeves observes, “house prices are down circa 20% and probably have another 10% to go”.
Therefore, the UK – and continental Europe – would appear to be coming to the end of the rate-rising cycle. Good news? Not entirely, as Gauge notes: “The flipside to this is realising that interest rates are peaking only because the economic situation has deteriorated. There is not an improvement in conditions for real estate.”
Preventing UK interest-rate cuts will be the weakness of sterling. Reeves thinks high rates will be maintained for the rest of this year when reached, and that interest rate cuts will not come until 2024.
Real estate versus bonds
The dramatic moves in interest rates and bond markets, raise the question of real estate’s role in a multi-asset portfolio. Is it really a good a hedge against inflation?
“The answer is yes and no,” says Gauge. “But really at the moment I think it is predominantly no. I think ultimately real estate is correlated to the economy not necessarily high inflation.”
Proponents of real estate’s inflation-hedging credentials often point to inflation-linked leases. But Gauge says the reality is many of these are capped at 4% and they are not that common in the UK anymore. Even in continental Europe, where CPI indexation is still common, tenants can be in a strong negotiating position to reject CPI increases if there is a significant supply of space in the market.
“At the end of the lease, if the asset is over-rented because CPI has outstripped rental growth, you still are faced with the rebasing effect and negative impact on values,” Gauge says. “And clearly, in a sector like offices we’re not seeing rental growth at all – rather flat rents or even rental decline.”
Kwan thinks inflation protection is “sector and country dependent”. He says: “In the UK office market, where you typically have upward-only five-year rent reviews, you have got some element of inflation protection, certainly over the medium term.”
The UK’s build-to-rent residential (BTR) market, meanwhile, acts as a stronger hedge against inflation. “Leases renew annually, which, given the granularity of individual leases, effectively means you have repricing on a daily basis in a market that is free and unregulated,” Kwan says.
The UK’s housing shortage, and the fact that rents are less dependent on discretionary income, means there is a high probability that inflationary movements will be reflected in rents and therefore valuations. “The UK BTR market is therefore an excellent inflation hedge,” Kwan says, contrasting it with the highly regulated Irish BTR sector, which has a cap fixed at the nominal rate of just 2% per annum with no inflation adjustment.
So where does this leave real estate allocations? For most of last year, according to Gauge, there was a perception among leading pension funds that they were under-allocated to real estate. “That has eroded as bond markets fell, and this indicates the importance of asset allocators having flexibility,” says Gauge. “The all-important question now is whether real estate looks attractive versus bonds?”
The answer to that question for Gauge is that “real estate actually looks a bit expensive purely on a yield spread basis”. But strong rental growth will make some sectors like industrial attractive. “The yield may only be 200bps over government bonds, but with 3% or 4% rental growth per annum, this may be seen as attractive,” he says.
“It would be more sensible to compare certain real estate yields with index-linked gilts rates in the UK, rather than nominal gilt rates,” says Kwan. “Inflation-linked gilt rates are a more appropriate benchmark for UK BTR. I think while UK BTR yield spreads to nominal gilt yields are tight, they’re less so when compared to inflation linked gilt yields.”
Kwan also finds it “somewhat ironic” that just 12 months ago real estate investors were competing to outbid each other by 1% or 2% on transactions and suddenly the market has “a newfound discipline insisting those same properties are apparently worth 20% to 30% less”.
He says: “I do wonder whether real estate’s intrinsic value should increase simply because cash is worth less and, conversely, should decrease simply because cash gains in value.”