Claus Thomas has been working in the European real estate industry for many years. Yet the speed at which interest rates have risen this year is something the CEO of BNP Paribas REIM Germany has, in his own words, “never seen before”. Thomas believes that investors will be considering how real estate fits into their overall capital allocation strategy in this new interest rate environment.

The first months of 2022 brought an abrupt end to the long era of ultra-low interest rates. In the spring, the US Federal Reserve announced a series of interest rate hikes, with the European Central Bank following suit in July – albeit much more hesitantly – by raising key interest rates by 50 basis points. Rates that matter to the real estate industry had already risen sharply prior to that. The five-year swap rate climbed from minus 0.3 to around 2.3 percent between mid-2021 and mid-2022, representing an increase of 260 basis points, as calculated by Helge Scheunemann, Head of Research at JLL Germany. He adds that the total increase was 300 basis points within twelve months, because the banks’ margins rose at the same time. “That is all bound to impact the investment and real estate markets,” notes Scheunemann.

Transaction volume down, returns still largely stable

One thing is clear: when interest rates rise, leveraged investors need to revise their profitability calculations. The consequences are a marked reluctance to invest and much lower transaction volumes. In Germany, for example, figures from Savills indicate that the volume of commercial property transactions fell by 60 percent in the second quarter of 2022 compared to the first quarter. The slump was less severe in other European countries, though, points out Marcus Lemli, CEO Germany and Head of Investment Europe at Savills. In the southern European countries, for example, there was hardly any dropoff in transaction volumes until mid-2022. “That’s partly because those countries never had the extremely favourable financing terms seen in Germany,” Lemli explains. There are also differences between asset classes. Savills reports significant price corrections on logistics properties in the UK, for instance, while Union Investment’s experience in Poland is that demand for logistics properties is much stronger than for office buildings, for example.

Developers are feeling the turbulence, pipelines are shrinking

It is nevertheless doubtful whether as many new projects will come to market across the various asset classes in the next few years as was expected even quite recently. Developers are facing major challenges, not only because of rising interest rates, but also due to the huge increase in construction costs (see infographic on page 24), caution among banks and the hesitancy of many investors.

“A lot of market players are adopting a wait-and-see approach at present, monitoring the situation and pausing decisions on projects,” observes Manuel Köppel, CFO of financing provider BF direkt, with reference to the German market in mid-2022. Yet even in the current market situation, forward deals can be done under certain conditions, as Michael Bütter, CEO of Union Investment Real Estate GmbH, explains (see interview on page 8). In June, for example, at a time of great uncertainty, Union Investment acquired a planned timber-framed office building in Helsinki via a forward funding deal, with completion slated for mid-2022.

Periods of adjustment such as the one we are now experiencing offer an excellent opportunity for equity-rich long-term investors.

In theory, a combination of rising interest rates and declining demand should cause real estate prices to decline significantly. But that has not been the case across the board, at least up to mid-2022. “Despite higher interest rates, there’s no sign of a widespread price slide in the main European countries,” says Hela Hinrichs, Senior Director, EMEA Research and Strategy at JLL. “Prices have held up so far, especially for ESG-compliant properties in good locations.” Hinrichs does not expect prices for good quality properties to fall significantly going forward, either, citing two reasons. Firstly, some sellers are holding back because they are unsure about how to invest the resulting sale proceeds. Secondly, there is still a lot of capital sloshing around that is earmarked for investment in real estate. “Real estate is a tangible asset, and rents are often indexed to inflation in the lease,” Hinrichs explains. She adds that quite apart from that, rents for centrally located, high-quality office space are still rising in many markets. The research specialist expects transaction volumes to return to normal in the fourth quarter of 2022. “By then,” she says, “the great uncertainty will be over and market players should be re-engaging.”

Prices have held up so far, especially for ESG-compliant properties in good locations.

In the short term, however, it could well be that capital previously invested in real estate is allocated to other asset classes instead, such as government bonds, points out Matthias Pink, Head of Research Germany at Savills. The main factor here is the significant rise in yields, especially on government bonds. Yields on ten-year German government bonds reached 1.92 percent in June 2022, which is only around 0.8 percentage points below the return on core office properties. What is not clear, is the exact extent to which capital will flow out of the property segment, says Pink. Given elevated inflation, it is likely that market players will be willing to accept a lower risk premium for investing in real estate, he concludes. 

Equity-rich investors coming to the fore

However things pan out, market observers believe the balance is likely to shift on the investor side. “Fund companies and other equity-rich investors now have a better chance of making the running than in the past, when investors with more than 50 percent leverage almost always outbid traditional institutional investors,” comments JLL researcher Hela Hinrichs. Savills CEO Marcus Lemli takes a similar view: “Periods of adjustment such as the one we are now experiencing offer an excellent opportunity for equity-rich long-term investors to secure high-quality properties.”

By Christian Hunziker