Rising rates raise the prospect of a real estate crash

Brenda McKinley has been selling homes in Ontario for over two decades and even for a veteran, the past two years have been shocking.

Prices in his parcel south of Toronto have risen 50% during the pandemic. “The houses were selling almost before we could put the sign on the lawn,” she said. “It was not uncommon to have 15 to 30 offers. . . there was a feeding frenzy.

But over the past six weeks, the market has reversed. McKinley estimates homes lost 10% of their value in the time it took some buyers to complete their purchase.

This phenomenon is not unique to Ontario or the residential market. As central banks raise interest rates to rein in runaway inflation, real estate investors, homeowners, and business owners around the world are all asking the same question: Could a crash happen?

“There is a marked slowdown everywhere,” said Chris Brett, head of capital markets for Europe, Middle East and Africa at real estate agency CBRE. “The change in the cost of debt is having a big impact on all markets, in all areas. I don’t think anything is immune…the speed has taken us all by surprise.

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Listed real estate stocks, closely watched by investors looking for clues about what might possibly happen to less liquid real estate assets, have plunged this year. The Dow Jones US Real Estate index is down almost 25% since the start of the year. UK property stocks are down around 20% over the same period, falling further and faster than their benchmark.

The number of commercial buyers actively seeking assets in the United States, Asia and Europe fell sharply from a pandemic peak of 3,395 in the fourth quarter of last year to just 1,602 in the second. quarter of 2022, according to data from MSCI.

Ongoing transactions in Europe also fell, with 12 billion euros in contracts at the end of March compared to 17 billion euros a year earlier, according to MSCI.

Agreements already in place are being renegotiated. “All those who sell everything are [price] chipped by potential buyers, or else [buyers] are moving away,” said Ronald Dickerman, president of Madison International Realty, a private equity firm that invests in real estate. “Anyone subscribing [a building] is forced to reassess. . . I can’t stress enough the amount of revaluation going on in real estate right now.

The reason is simple. An investor willing to pay $100 million for a block of flats two or three months ago could have taken out a $60 million mortgage with borrowing costs of around 3%. Today, they might have to pay more than 5%, wiping out any advantage.

Rising rates mean investors must either accept lower overall returns or push the seller to lower the price.

“It’s not showing up in the agent data yet, but there’s a correction being felt, anecdotally,” said Justin Curlow, global head of research and strategy at Axa IM, one of largest asset managers in the world.

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The question for investors and property owners is how wide and how deep any correction might be.

During the pandemic, institutional investors have played defensively, betting on sectors supported by long-term stable demand. The price of warehouses, rental apartment blocks and serviced offices for life sciences companies has soared amid fierce competition.

“All the major investors sing to the same song: they all want residential, urban logistics and quality offices; defensive assets,” said Tom Leahy, head of real assets research at MSCI Europe, Middle East and Asia. “That’s the problem with real estate, you have a herd mentality.”

With the influx of cash into tight corners of the property market, there is a risk that assets will be mispriced, leaving little room to erode as rates rise.

For owners of ‘defensive’ properties bought at the top of the market who now need to refinance, the rate hikes create the prospect that owners are ‘paying more on the loan than they expect to earn on the property’ , said Lea Overby, head of trade. mortgage-backed securities research at Barclays.

Before the Federal Reserve began raising rates this year, Overby estimated that “zero percent of the market” was affected by what is called negative leverage. “We don’t know how much it is now, but anecdotally it’s pretty widespread.”

Manus Clancy, senior managing director of New York-based CMBS data provider Trepp, said that while values ​​were unlikely to crash in more defensive sectors, “there will be a lot of guys who will say ‘ wow, we paid too much for this “.”

“They thought they could raise rents by 10% per year for 10 years and the expenses would be stable, but the consumer is hit by inflation and they cannot pass on the costs,” he added. .

If the investments considered safe a few months ago still seem precarious; riskier bets now look toxic.

The rise of e-commerce and the shift to hybrid working during the pandemic has exposed office and store owners. Rising rates now threaten to reverse them.

An article published this month, ‘Work from home and the office real estate apocalypse’, argued that the total value of New York office space would eventually drop by almost a third – a cataclysm for landlords. , including pension funds and government agencies that depend on their taxation. income.

“Our view is that the entire office stock is worth 30% less than it was in 2019. That’s a $500 billion hit,” said Stijn Van Nieuwerburgh, professor of real estate and finance at Columbia University and one of the authors of the report.

The fall has not yet registered “because there is a very large segment of the office market – 80-85% – which is not listed on the stock exchange, has very little transparency and where there has been very few exchanges,” he added.

But when old offices change hands, funds reach end of life or owners struggle to refinance, he expects the discounts to be steep. If values ​​fall enough, he forecasts enough defaults to pose systemic risk.

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“If your loan-to-value ratio is above 70% and your value drops 30%, your mortgage is underwater,” he said. “A lot of offices have over 30% mortgages.”

According to Curlow, no less than 15% is already reduced from the value of the American offices in the final offers. “In the U.S. office market, you have a higher level of vacancy,” he said, adding that America “is ground zero for rates — it all started with the Fed.”

UK office owners are also having to deal with changing working patterns and rising rates.

So far, owners with modern, energy-efficient buildings have done relatively well. But rents for older buildings have been hit. Property consultancy Lambert Smith Hampton suggested this week that more than 25 million square feet of office space in the UK could be surplus to requirements after a survey found that 72% of respondents were looking reduce office space at the earliest opportunity.

Hopes have also been dashed that retail, the sector worst hit by investors entering the pandemic, could see a recovery.

Big UK investors including Landsec have been betting on shopping malls for the past six months, hoping to catch the rebound in trade as people return to physical stores. But inflation derailed the recovery.

“There was this hope that a lot of mall owners had that there was a level in the rents,” Jefferies analyst Mike Prew said. “But the rug has been ripped from them by the cost of living crisis.”

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As rates rise from ultra-low levels, the risk of a reversal in residential markets where they rose, from Canada and the United States to Germany and New Zealand, also increases. Oxford Economics now expects prices to fall next year in the markets where they rose fastest in 2021.

Many investors, analysts, agents and landlords told the Financial Times that the risk of falling real estate valuations has risen sharply in recent weeks.

But few expect a crash as severe as that of 2008, in part because lending practices and risk appetite have moderated since then.

“Generally, it feels like commercial real estate is about to see a downturn. But we’ve had strong Covid growth, so there’s room for that to go aside before we have an impact on anything [in the wider economy]”, Overby said. “Before 2008, leverage was 80% and many valuations were wrong. We are not far there.

According to the head of a large property fund, “There is definitely stress in the smaller pockets of the market, but it’s not systemic. I don’t see many people saying. . . “I am committed to an acquisition of 2 to 3 billion euros in bridge format”, as in 2007.”

He added that while more than 20 companies looked precarious as the financial crisis approached this time, there were now perhaps five.

Dickerman, the private equity investor, believes the economy is poised for a long stretch of pain reminiscent of the 1970s that will send real estate into a secular decline. But there will always be winning and losing bets because “there has never been a time to invest in real estate where the asset classes are so differentiated”.

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