Those under 36 or 37 probably didn’t work in property at a time when interest rates were above 1% in the UK, or perhaps 3% in the US. Now they might be in shock.
Since 2008, when US and UK central banks cut interest rates to near zero to stimulate the economy, rates have been lower than property yields (cap rate for US readers) . Investors paid far less in interest rates than they received in rent and could sweep the difference off the table. This spread between rates and yields has drawn more and more investors into the sector, driving up prices.
But last week the Federal Reserve and Bank of England hiked rates, 0.5% and 0.25% respectively, to tackle rapidly rising inflation and hitting highs not seen in more than 25 years. years. Rates are still below property yields, but both central banks have said there are more hikes to come – and that comfortable cushion is rapidly eroding.
The Eccles Building, home to the US Federal Reserve in Washington, DC
So how do you make money investing in real estate when this trade-off is no longer so pronounced and rates are rising to fight inflation? bisnow spoke to industry veterans who have worked through more than one period of high rates, usually caused by high inflation, to better understand how to invest in an environment that is less than benign for real estate.
One thing seems certain: it’s much harder to be a debt-dependent investor when interest rates are higher.
“Make sure you keep your gearing low,” said Manish Chande, senior partner at Clearbell Capital.
At various times in the 1970s and 1980s, property yields were actually lower than interest rates as economic uncertainty pushed investors into the safe haven of real assets.
But the investment market at those times was dominated by institutions that didn’t need to use debt to buy – if yields are lower than rates, then on day one investors pay more interest they only receive income, which is not impossible to maintain, but not ideal.
“We believe that as rates go up, debt-backed guys won’t be able to be as competitive in areas like logistics, and that will benefit equity investors like us,” Sabina said, Chief Economist of CBRE Investment Management and Head of Insights & Intelligence. said Reeves.
As interest rates rise, if there is a need for debt, the market favors large investors who can issue corporate bonds. These tend to have lower interest rates than loans secured by individual properties.
In addition to using more equity than debt, real estate investors are going to have to think of something that hasn’t needed to be at the forefront of their minds for the past 15 years, but is still enjoyable. to have: the growth of rents.
“In some ways, because bond yields have been so low, people have been less focused on the growth potential of assets,” said Mickola Wilson, co-owner and director of Seven Dials. “When people are pricing assets against bond yields of zero, and real estate can produce a 6% total return without debt and that outperforms bonds and stocks, you didn’t have to worry as much. growth rates.”
If one has only ever known an environment in which interest rates are zero, it does not matter whether rents increase or not: it is possible to collect more rents than what is paid in interest, and it is there is probably someone who is ready to do it. buy it for what was paid or more when it came time to sell.
This will not necessarily be the case now. Mickola compared the current situation to that of the 1970s and 1980s when the real estate industry needed to improve the quality of its analyses.
“Real estate was decades behind bonds and equities in terms of research undertaken and substantiation of the rent growth projections it offered,” she said. “You basically just lick your finger and stick it up. People are going to have to start understanding where the rent growth for individual buildings is coming from in a lot more detail.
When it comes to finding assets that will perform well in an environment of higher inflation and subsequent upside rates, CBRE IM’s Reeves said, “You want to be in sectors that benefit from structural trends like the urbanization and digitization, rather than in those that are cyclical”.
Whether real estate is a good inflation hedge is perhaps the biggest real estate investing question of the day (Reeves thinks it generally is; Chande isn’t so sure). But this question is perhaps too blunt. Some real estate assets will be a good hedge against inflation and will perform well if rates rise because the rents they generate will increase either in line or faster than inflation.
Those that seem most likely to benefit, according to market participants, are logistics assets, rental housing and assets in sectors like life sciences. All of these sectors have a good balance between supply and demand, and prices can be raised to capture the growth of inflation.
“Some people think logistics is a price for perfection, but if you look at the big guys like Prologis or Pannatoni, they’re all optimistic and expect rents to grow by 20-30% next year,” Reeves said. .
Rented residences, like multi-family or rental buildings, have the ability to capture price inflation – but just because you can raise rents doesn’t mean you should. Raising residential rents in line with inflation when it is 5% or more may seem attractive to landlords, but it risks creating political backsliding. In areas like affordable housing, which mainstream real estate investors have embraced widely in recent years, the idea of raising rents by 5% for low-income tenants is likely to create an uproar.
“Even before the current surge in inflation, you were getting political pushback against the idea of rent increases,” Reeves said, citing cities like Berlin and Barcelona in Europe where rent controls were introduced or is in progress. The debate over rent control in the United States in major cities like New York is constantly simmering.
Once you’ve chosen your asset that you believe will benefit from inflation and resist rising interest rates, at this point your lease structure becomes important, Clearbell’s Chande said.
“Ideally you want to have something with annual increases linked to inflation, or with short leases, maybe every two or three years, which allows you to increase the rent,” he said. declared. “A 10-year lease with a review every five years isn’t very good for you.”
Chande pointed out that alternative asset classes like student housing or rentals tend to have shorter tenancies, allowing this opportunity to capture growth.
There is no one-size-fits-all approach to real estate and rising interest rates. There never is with real estate, which makes it such a unique asset class.