The foundations of a real estate revival?

Key takeaways

• The pandemic has changed the real estate investment environment, with the impact of high mortgage rates and working patterns still in flux
• Scarcity and rental indexing are helping to drive investor demand in developed many markets. A peak in borrowing costs should see direct prices stop their decline
• The UK’s potential for further price falls stands out, while the Swiss market has proven resilient
• We are neutral on real estate in multi-asset portfolios: with the market relatively undersupplied, prices remain elevated, but we see the net zero transition starting a new real estate cycle.

Mortgage holders do not need reminding that rising interest rates have translated into higher repayments. Among the many economic sectors disrupted by Covid, shifting working patterns, rising borrowing costs, tightening credit conditions and changing retail spending all have profound consequences for property markets. Yet limited supply and investment into the net zero transition are providing both support and opportunities. We offer an overview of the European, Swiss and US markets.

The Covid pandemic’s aftermath has changed real estate’s investment landscape. Mortgage rates are at their highest levels since the financial crisis 15 years ago, and after three years of hybrid working, workplace routines are still looking for an equilibrium, with demand for offices cooling. On the positive side, we see government investments into transition technologies, through incentives and subsidies to manufacturing, greener building and energy efficiencies, increasingly driving real estate design, as well as demand and supply.

Skipping the boom and bust

While mortgages are more expensive, making house buying less affordable across developed markets, the underlying demand for single-family homes remains firm by historical standards, as supply remains constrained. Meanwhile, the construction industry in the US looks better positioned than in previous economic cycles. Builders have been far more prudent when hiring labour, cushioning the impact on employment from slowing demand. The industry may also be anticipating a surge in the private investment that will follow government subsidies into building retrofitting and sustainable technologies.

An investor’s total real estate returns come from both income and price appreciation. It is almost impossible to generalise, but investments in the majority of developed real estate markets, with the exception of commercial offices in the US and secondary locations in Europe, are performing. These investments have delivered strong operating results among listed companies, generating solid first half earnings. This is because scarcity, in particular in residential and logistics buildings, as well as rental indexing, is driving demand. Indexing rents is important because rises in the reference rate directly translate into increases in rental income and commercial buildings often include indexation in their contracts. Investment portfolios active in the French and Spanish commercial markets posted as much as 10% rental growth in their first quarter 2023 results. In residential markets, indexation is less standard, and the risk is that governments cap rent increases, as recently happened in the US where housing rents jumped an average of 8.6% in 2022. The French government also introduced a cap on residential rent increases of 3.5%. Others, such as the City of Los Angeles, have prevented rent rises entirely.

Of course, rental increases are only possible in markets where demand is outstripping supply, and where leases lag current market prices. Landlords may also be reluctant to raise rents for weaker tenants, such as retailers. However, companies with sought-after assets and locations have started to report sales volumes and occupancy rates that are approaching pre-pandemic levels. NewRiver, a UK-based Real Estate Investment Trust (REIT) with a portfolio of retail property, for example announced that at the end of March 2023 it had a 97% occupancy rate. Conversely, the US office market is suffering from vacancies, especially where office buildings are in need of renovation. In June, a study by CommercialEdge reported vacancy rates averaging 17% for the overall office market. However, this masks a very varied picture as well-located, well-maintained buildings are fully occupied, while those at the other end of the spectrum may stand completely empty.

UK quick to correct

Most property markets are in what the investment industry likes to label ‘price discovery mode’ as they assimilate the impact of rising interest rates. The most important variable to maintain a healthy market, and investors’ interest, is of course the difference between a property’s yield and its financing costs. Recent interest rate hikes narrowed that spread, before falling prices compensated. That effect was first visible in the UK, where prices and companies’ valuations adjusted rapidly. The overall UK property market fell 21.1% between June 2022 and February 2023 and in June 2023, house prices in the UK dropped 2.6% compared with June 2022. However, with more rate rises likely from the Bank of England, and many mortgages set to reset to with higher repayments, we see more room for UK property prices to decline.

Swiss exceptionalism

Unlike in Europe and the US, in Switzerland, prices continue to rise. There was a 0.4% price increase in Swiss property investment over the first three months of 2023, according to CIFI, a research company. The country’s lower rise in financing costs, compared with the rest of the European market and the US, as well as solid macroeconomic fundamentals, have supported both Swiss residential and commercial real estate. In addition, Swiss markets have been less affected by the pandemic trend of working more from home, thanks to lower commuting times and a high proportion of small and medium-size firms. Switzerland has also experienced something of a buying rush as people try to purchase a house in anticipation of rising interest rates.

In this environment, we expect Swiss direct property prices to remain flat, or slightly decrease. In the US and Europe, we see prices continuing to fall, although less than the 20% decline seen in the UK, thanks to rental growth and indexation mechanisms. Of course, these expectations depend on changes in interest rates. Office prices will fall further than the wider market if rates continue to rise because of waning demand, particularly for less modern offices in secondary locations. Conversely, modern, well-located commercial properties that meet contemporary sustainability standards should remain relatively immune to weaknesses as they are still in high demand by tenants.