Rising interest rates increase the likelihood of a real estate crash


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

Prices in her area south of Toronto rose as much as 50 percent during the pandemic. “Houses were being sold almost before we could put the sign on the lawn,” she said. “15 to 30 offers were not uncommon. . . there was a feeding frenzy.”

But in the last six weeks the market has turned around. McKinley estimates homes have lost 10 percent of their value in the time it might take some buyers to complete their purchase.

The phenomenon is not unique to Ontario or the housing market. As central banks raise interest rates to curb runaway inflation, real estate investors, homeowners and commercial landlords around the world are asking the same question: Could a crash be imminent?

“There’s a definite slowdown everywhere,” said Chris Brett, head of capital markets for Europe, the Middle East and Africa at real estate agency CBRE. “The change in the cost of borrowing is having a major impact on all markets, everywhere. I don’t think anything is immune. . . The speed surprised us all.”

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Listed real estate stocks, closely watched by investors looking for clues as to what might ultimately happen to less liquid real assets, have fallen this year. The Dow Jones US Real Estate Index is down nearly 25 percent year to date. UK property stocks are down about 20 percent over the same period, falling further and faster than their benchmark index.

The number of commercial buyers actively looking for assets in the U.S., Asia and Europe has fallen 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 MSCI data.

Outstanding deals in Europe have also declined, according to MSCI, with a contract volume of €12 billion at the end of March compared to €17 billion a year earlier.

Deals already in progress will be renegotiated. “Anyone who sells everything is His [price] chipped by prospective buyers, or otherwise [buyers] going away,” said Ronald Dickerman, president of Madison International Realty, a private equity firm that invests in real estate. “Anyone who is underwriting [a building] must reevaluate. . . I cannot stress enough the current real estate revaluation.”

The reason is simple. An investor willing to pay $100 million for an apartment block two or three months ago could have taken out a $60 million mortgage with a borrowing cost of about 3 percent. Today they may have to pay more than 5 percent, killing any upside potential.

The rise in interest rates means investors must either accept lower total returns or pressure the seller to lower the price.

“It’s not showing up in brokerage data yet, but anecdotally, a correction is emerging,” said Justin Curlow, global head of research and strategy at Axa IM, one of the world’s largest wealth managers.

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The question for real estate investors and owners is how far reaching and deep a correction could be.

During the pandemic, institutional investors played defense, betting on sectors supported by stable, long-term demand. Prices for warehouses, rental apartments and offices equipped for life sciences companies rose accordingly in the face of stiff competition.

“All big investors sing from the same hymn sheet: They all want housing, urban logistics and high-quality offices; defensive investments,” said Tom Leahy, MSCI’s head of real assets research in Europe, the Middle East and Asia. “That’s the problem with real estate, you get a herd mentality.”

As cash spills into tight corners of the real estate market, there is a risk that assets have been mispriced, leaving little room to maneuver as interest rates rise.

For owners of “defensive” properties that were bought at the top of the market and now need to refinance, rate hikes create the prospect of owners “paying more on the loan than they expect to make on the property,” Lea Overby said , Head of Commercial Research on Mortgage-Backed Securities at Barclays.

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

Manus Clancy, a senior managing director at New York-based CMBS data provider Trepp, said that while values ​​in the more defensive sectors are unlikely to collapse, “there will be a lot of people saying, ‘Wow, we got this paid too much’.”

“They thought they could raise rents by 10 percent a year for 10 years and spending would stay the same, but consumers are being hit with inflation and they can’t pass the cost on,” he added.

When investments that were considered safe just a few months ago look precarious; Riskier bets now look toxic.

A surge in e-commerce and the shift to hybrid work during the pandemic left office and store owners vulnerable. Rising interest rates are now threatening to overthrow them.

A paper published this month titled “Work from Home and the Office Real Estate Apocalypse” argued that the total value of New York offices would eventually fall by almost a third — a disaster for owners, including pension funds and the government agencies that own them dependent on their taxes are proceeds.

“In our view, all office stock is worth 30 percent 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 report’s authors.

The drop hasn’t been registered yet “because there’s a very large part of the office market – 80-85 percent – that’s unlisted, very opaque and very little traded,” he added.

But when older offices change hands, when funds reach the end of their lives, or when owners struggle to refinance, he expects significant discounts. If values ​​fall far enough, he sees enough mortgage defaults to pose systemic risk.

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“If your loan-to-value ratio is over 70 percent and your value falls 30 percent, your mortgage is under water,” he said. “Many offices have more than 30 percent mortgages.”

According to Curlow, 15 percent of the value of US offices is already being deducted in final bids. “There’s higher vacancy in the US office market,” he said, adding that America “is ground zero for interest rates — it all started with the Fed.”

Office owners in the UK are also having to contend with changing work patterns and rising rates.

Landlords with modern, energy-efficient blocks have done relatively well so far. But rents for older buildings have been hit. Property consultants Lambert Smith Hampton hinted this week that more than 25 million square feet of UK office space may be redundant to meet demand, after a survey found 72 percent of respondents are trying to downsize their office space as quickly as possible.

Hopes were also dashed that retail, which is most disliked by investors caught up in the pandemic, could recover.

Major UK investors including Landsec have been betting on malls for the past six months, hoping to catch a rebound in trade as people return to physical stores. But inflation has thrown the recovery off course.

“There was this hope that a lot of mall owners had that rents would hold up,” said Jefferies analyst Mike Prew. “But they’ve had the rug pulled out from under them by the cost-of-living crisis.”

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As interest rates rise from extremely low levels, so does the risk of a turnaround in housing markets, where they have risen, from Canada and the US to Germany and New Zealand. Oxford Economics now expects prices to fall next year in the markets where they rose the fastest in 2021.

Scores of investors, analysts, brokers and homeowners told the Financial Times the risk of a fall in property valuations had risen sharply in recent weeks.

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

“In general, it feels like commercial real estate is about to take a downturn. But we’ve had strong growth in Covid so there’s some room for sideways movement before it impacts anything [in the wider economy]’ Overby said. “Before 2008 leverage was 80 percent and many reviews were fake. We’re not there yet.”

According to the head of a large real estate fund, “There is definitely stress in smaller areas of the market, but it’s not systemic. I don’t see many people say. . . ‘Like in 2007, I have committed to an acquisition worth 2 to 3 billion euros in a bridge format.’

He added that while more than 20 companies looked vulnerable in the run-up to the financial crisis, maybe five did this time.

Dickerman, the private equity investor, believes the economy is facing a long period of pain reminiscent of the 1970s that will plunge real estate into a long-term decline. But there will still be win and loss bets because “there has never been a time to invest in real estate when asset classes were so differentiated.”


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