A fascinating time: The global impact of rising interest rates on commercial real estate

A fascinating time: The global impact of rising interest rates on commercial real estate juillet 28, 2022

Avison Young’s Chief Economist Dr. Nick Axford identifies the ways in which changing economic and financial market conditions will be seen in the real estate market

On July 27, the Federal Open Markets Committee (FOMC) raised its key policy interest rate by 75 bps for the second consecutive month. “This confirms to real estate investors around the world that we are now in a new phase of the market cycle,” says Dr. Nick Axford, Chief Economist at global real estate services firm Avison Young.

The Fed is leading the global charge by central banks to tackle rates of inflation that are at their highest for four decades. Even as Gross Domestic Product (GDP) has now contracted for two consecutive quarters – signifying that the economy is in technical recession – the U.S. central bank is determined to prevent a return to the high inflation era of the 1970s and early 80s characterised by a “wage-price spiral.” Having started the year with a target rate of 0-0.25%, the Fed Funds Target Rate has been increased four times, now standing 225 bps higher at 2.25-2.50%.

Beyond the U.S., the Bank of Canada raised its main interest rate by 100 bps, from 1.5% to 2.5% on July 13, its biggest increase in 24 years. Looking to the U.K., this will put pressure on the Bank of England to increase the base rate significantly when it announces its next decision on August 4. The Monetary Policy Committee has already raised rates  five times in recent months, taking interest rates to 1.25%. Governor Andrew Bailey has already said that a rise of 50 bps is “on the table” which would be the first increase of this magnitude in nearly three decades. “The U.K. economy is already slowing, so a 75 bps increase looks unlikely but can’t be discounted,” comments Axford.

Real estate has been a key beneficiary of the low inflation, low interest rate environment that has characterised recent decades. The yield on commercial real estate has tracked the downward trend in 10 Year U.K. Government Bonds (Gilts) and U.S. Treasury Bonds, known as the “risk free rate”, pushing up values and encouraging record levels of capital into the sector. “That supportive economic and financial market environment is now changing, which is impacting commercial real estate in several ways,” Axford notes.

There are four key factors confronting real estate investors:

  • First, Axford highlights that real estate pricing is impacted by the rise in government bond yields and is particularly highly correlated with the price of BBB corporate bonds. The yield on those bonds in the U.S. has increased from around 2.9% at the start of this year to 5.0% today (4.6% for Canada). This increase of 210 bps is broadly the same as the 225 bps increase in the policy rate, suggesting that investors are not particularly concerned that we will see an increase in corporate failure – but highlighting that higher interest rates have a material impact on pricing across the spectrum of investment assets."These are the benchmarks against which real estate investments are priced, which will put upward pressure on yields (and downward pressure on values) in the property sector," comments Axford.
  • Second, higher rates are explicitly designed to slow the economy – which will impact occupier demand for real estate at a time when the market is already having to adapt to changing occupational dynamics. "The shift from in-store to online retail and higher levels of remote office working following the pandemic creates lots of interesting opportunities for investors," Axford notes. "But short term, the weaker economic outlook reduces the prospects for rental growth in some areas of the market, which also hits investor sentiment and pricing.”
  • Third, the costs of finance have gone up in line with higher interest rates. "Many real estate investors use debt to finance their activities and enhance returns," Axford points out. "Just as with homeowners, higher commercial borrowing costs make it harder for leveraged investors to justify current prices, and forces some buyers out of the market altogether," he says.
  • Finally, higher costs of materials and the very tight labour market have dramatically increased the cost of construction and refurbishment – with far greater uncertainty over what those costs will be. Construction companies are being forced to charge more for projects than they were six months ago - and prices are changing so rapidly that they will only guarantee their quotes for a week or two. "This makes it really hard to run the numbers on investments requiring refurbishment or repositioning to enhance their attractiveness to occupiers, which is a key strategy for value-add investors," says Axford.

Taken together, these four key factors are confronting real estate investors with a very different environment from the one they have become accustomed to in recent years. "Overall, there is no question we will see upward pressure on real estate yields, which means downward pressure on pricing for commercial property,” Axford states.

However, with central banks hoping their aggressive rate hikes will soon start to bring inflation back under control, many economists expect the slowdown to be relatively shallow and short-lived – Axford included. "Most investors believe that any downturn will be temporary, so those that don't have to sell are more likely to sit tight and await more favourable conditions rather than accept the prices that buyers are currently willing to pay. We are already seeing the bid-ask spread widening, and in many areas of the market we will see a slowing of transaction volumes rather than a dramatic repricing," Axford predicts.

The current market is not without its attractive opportunities, Axford is keen to point out. Real estate has many qualities that investors are still keen acute to pursue, especially in the current environment of heightened uncertainty.

"The relationship between real estate and inflation is more complex than conventional wisdom would suggest, but leases with indexation or fixed uplifts on rents offer some protection against inflation. And over the longer term, real estate values tend to keep pace with inflation over time – which will attract those investors for whom capital preservation is more important than returns in any one year," says Axford.

While volatile construction costs are tricky to manage, repositioning assets to take advantage of changing occupier requirements is still a hugely attractive strategy. "This is actually a very exciting market for active management players who see this as a time of opportunity. Occupiers are focusing on quality buildings in good locations with great environmental sustainability credentials; repositioning assets to take advantage of this demand will be a major driver in the months and years ahead. There is still a huge weight of capital looking to target the market – particularly if we see any softening of prices for top quality assets. Cash buyers not dependent on debt – and those with long term investment horizons – will quickly step in to take advantage. This will limit the impact on pricing for quality assets," Axford anticipates.

The market is already seeing the impacts Axford is talking about, coming through in both pricing and transaction levels. "It's important not to over-react – this isn't 2008 – but we are seeing deals being re-traded or transactions being pulled in various areas of the market. The adjustment process is already underway," Axford observes.

"In many ways, what we are seeing is a return to more normal financial conditions following the period of ultra-low rates that was the legacy of the Financial Crisis. There will be some short-term volatility as the market adjusts. However, if we think about where rates are forecast to peak – the US at 3.5%-4%, UK 2%-3%, and Canada 3%-3.5% - they will still be relatively low in historic terms. We are already seeing investors adjust – and many are building up war chests ready to move when they feel conditions are right. This is actually a really fascinating and exciting time for commercial real estate," Axford concludes.

To see more of Avison Young’s views on the implications of higher inflation for real estate, see “Is Real Estate an Inflation Hedge?

Dr. Nick Axford is Avison Young’s Chief Economist, based in our London office.