Investment property prices in the wake of inflation-driven interest rate hikes
March 31, 2023
High levels of uncertainty in the property investment market are raising questions about the potential impacts in 2023. What negative impacts will interest rate increases have? Could high immigration levels and the robust economy impact the real estate market positively? What changes can we expect with the prices of investment properties? In a previous blog post from November 2022 about the impact of the current market environment on investment properties, we looked at how these are closely linked to interest rate developments, as well as how real interest rates also play a role (see Investment properties in a turbulent market environment).
This post also highlighted that, in addition to the effects of interest rates, the economic environment and the user market are also of great importance when assessing the development of property prices. Below, we explore the effects of various pricing factors and and also consider the effects that a typical scenario, with increased inflation and further interest rate hikes, will have on the prices of investment properties. To shed light on the fundamental relationship between interest rates, the economic environment, and other influencing factors, we look at patterns in historical time series to derive insights for today. If enough historical data is available, we can create scenarios based on the interrelationship between specific influencing factors.
Various environmental influences
There are three particular areas where interest rates have an impact on real estate prices and yield: Firstly, yield expectations increase when real estate investment alternatives pay better interest rates. This is because, in principle, an increase in interest rates leads to an outflow of money from the capital market, resulting in a decline in investment-driven demand for real estate. Secondly, owners that have financed their property with debt face higher interest costs and higher interest costs on debt lead to higher expected returns. Thirdly, an inflationary environment with rising wages and interest rates typically results in a rise in rents. Higher existing rents can be realized with rent adjustments in the wake of higher reference interest rates. In an environment like that of the current market, with buoyant demand for housing, low housing production, and falling vacancy rates, the land market typically favors an increase in rents, rental income and consequently property prices too. The current market environment is an example of how diverse influencing factors can affect real estate prices, and sometimes in contradictory ways.
A statistical model for correlation analysis
How big an impact do changes in interest rates and other influencing factors have on real estate prices? This question can be answered using a cointegration analysis assuming that a stable equilibrium exists between two or more variables and that deviations from this equilibrium are temporary in nature. As real estate prices depend not only on interest rates, but also on a number of other factors, we can use this analysis to apply the Vector Error Correction Model, which estimates both the short- and long-term relationships of various influencing factors. In this study, we modeled investment property prices as a function of interest rates, gross domestic product (GDP), vacancy rates, and asking rents, based on the time series of 1980 to 2020.
Abbildung 1: Impuls-Response-Funktionen
Figure 1 shows how the price index for residential or commercial properties behaves when the relevant influencing factors change. The prices of investment properties react particularly sensitively to changes in the interest rate level (red line), compared to the other influencing factors, with the price effect being greater for residential properties than for commercial properties. Most significantly, the respective functions converge only after about 5 years, which suggests that residential and commercial property prices take not just months, but years to return to equilibrium after macroeconomic shocks. Response lags can also be seen in changes to vacancy rates, GDP, and asking rents, also seeing a higher sensitivity in the residential segment than in commercial properties. For commercial properties, this sensitivity is reduced due to segment-specific characteristics such as fixed contract durations, or higher inflation indexation in the case of commercial leases
Inflation-driven rise in interest rates and the prices of investment properties
Figure 1 shows the effect of a single factor on the price of an investment property. In reality, however, it always depends on the overall construction of factors. For example, in a typical scenario, rising interest rates are accompanied by rising inflation, resulting in rising supply rents.
Such a typical scenario – an inflation-driven rise in interest rates – is depicted below. Here, we assume an average inflation rate of 2.5% over a period of 5 years and an interest rate increase of 250 basis points, in an expansive economic environment with average real growth rates of 2.0% (nominally 4.5%), and in a solid user market with above-average rent increases and decreasing apartment vacancy rates.
Tabelle 1: Parametrisierung des inflationsgetriebenen Zinsanstiegs
|Influencing factor||Measurement over 5 years||Inflation-driven rise in interest rates|
|Apartment vacancy||Change in percentage points (5 years cumulative)||– 0.2 PP|
|Commercial vacancy||Change in percentage points (5 years cumulative)||– 1.0 PP|
|Nominal GDP||Annualized growth rate||+ 4.5 %|
|Inflation||Annualized growth rate||+ 2.5 %|
|Yield on federal bonds (10 y.)||Change in percentage points (5 years cumulative)||+ 2.5 PP|
|Asking rents residential properties||Annualized growth rate||+ 3.0 %|
|Asking rents for offices/commercial properties||Annualized growth rate||+ 2.5 %|
The simulation of this scenario of an inflation-driven interest rate increase calculated price declines of 15% for residential properties and 14% for commercial properties. This corresponds to an average annual price decrease of 3.0% for residential properties and 2.8% for commercial properties. Figure 2 shows the cumulative effect of this scenario on prices over 5 years.
Figure 2: Expected effects of the scenarios to the market values of investment properties.
Despite a 15% reduction in prices of residential properties, according to this model, the increase in market rents over five years leads to a net cash flow return of around 20% overall. This results in a total return of just under 5% in nominal terms, accumulated over this period and before large-scale renovation measures. With adjustments for inflation, the total return is a loss of over 10%, since higher rents are also accompanied by higher inflation rates. Figure 3 shows the simulated development of the price effect, net cash flow yield and the total return accumulated over 5 years.
Figure 3: Development of average total returns in the cumulative interest rate increase scenario over 5 years
It wasn’t long ago that a scenario of inflation-driven interest rate rises was mainly a theoretical one. Today, it's no longer unrealistic to consider. While there is still hope that inflation will be contained and anyinterest rate rises will be minimal, if inflation and higher interest rates continue, a scenario like this could occur. In this case, the model calculates a 15% decline in prices for residential properties. Nevertheless, the properties generate nominal positive cash flow returns on average over five years - thanks to rent increases and vacancy declines (excluding large-scale refurbishment measures).
Although the real dynamics of real estate markets are significantly more complex than modeled here, interesting insights can still be gained from the results. Apart from the magnitude of the expected price effect and expected effect lags, investment property prices respond with a significant time lag to changes in interest rates and the environment, with adjustment processes to restore equilibrium conditions taking several years. This means that the prices of investment properties are also crucially dependent on the duration and intensity of macroeconomic developments. Therefore, the effect of a rise in interest rates must always be considered in the contexts of the overall economic environment and market forces. A solid real economic environment and a large and unmet demand for housing are both likely to provide considerable support for real estate prices in the current market. Interest rate sensitivity is still disproportionately stronger, relative to these factors and it is likely to be stronger today than in the past. With current low discount rates, any increase in interest rate sensitivity will have a stronger percentage effect on real estate prices. Despite this, increased transparency of real estate markets will lead to a better information situation and therefore to a tendency toward shorter adjustment times in the investor market. The hope remains that the phase of uncertainty and adjustment processes in the Swiss market for investment properties will come to a swift end, allowing a new confidence to emerge.
Contact us today to stress test your real estate portfolio, using the methodology presented in this article.
Further explanations of the figures presented here, including a mathematical explanation, can be found in the basic report "Investment properties explained economically"(German). For example, pages 37/38 show how the prices of investment properties have developed over the past 40 years during times of rising interest rates. Starting on page 41, we show the mathematical relationship between interest rates and discount rates.
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