Rising rates increase the chances of real estate collapse

Rising rates increase the chances of real estate collapse

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

Prices in its part south of Toronto rose by as much as 50 percent during the pandemic. “The houses were selling out almost before we were able to put a sign on the lawn,” she said. “It was not unusual to have 15 to 30 offers. . . it was madness to feed. ”

But in the past six weeks, the market has turned upside down. McKinley estimates that homes have lost 10 percent of their value in the time that some buyers may need to complete their purchase.

The phenomenon is not unique to Ontario or the housing market. As central banks raise interest rates to curb escaped inflation, real estate investors, homeowners and commercial renters around the world are asking the same question: can it collapse?

“There is a significant slowdown everywhere,” said Chris Brett, head of capital markets for Europe, the Middle East and Africa at the CBRE real estate agency. “The change in the price of debt has a great impact on all markets, throughout everything. I don’t think anything is immune. . . the speed surprised us all. ”

Listed real estate stocks, closely monitored by investors looking for clues as to what might eventually happen to less liquid real assets, have fallen this year. The Dow Jones U.S. real estate index has fallen nearly 25 percent in the year to date. British real estate stocks fell about 20 per cent over the same period, falling further and faster than their benchmark.

The number of commercial buyers actively seeking assets across the U.S., Asia and Europe fell sharply from the peak of the pandemic from 3,395 in the fourth quarter of last year to just 1,602 in the second quarter of 2022, according to MSCI.

Pending contracts in Europe also fell, with a 12 billion-euro deal in late March from 17 billion euros a year earlier, according to MSCI.

Jobs that are already on the train are being renegotiated. “Everyone who sells everything exists [price] chipped by potential customers, or otherwise [buyers] they are leaving, ”said Ronald Dickerman, president of Madison International Realty, a private real estate investment company. “Everyone who takes out insurance [a building] must re-evaluate. . . I can’t overemphasize the amount of price changes that are currently happening in real estate. ”

The reason is simple. An investor who was willing to pay $ 100 million for a block of flats two or three months ago could take out a $ 60 million mortgage with a borrowing cost of about 3 percent. Today, they may have to pay more than 5 percent, which would erase any advantage.

An increase in rates means that investors must either accept lower total returns or force the seller to lower the price.

“It’s not yet included in the agent data, but there’s a correction, anecdotally,” said Justin Curlow, global head of research and strategy at Axa IM, one of the world’s largest asset managers.

The question for investors and property owners is how widespread and deep each correction is.

During the pandemic, institutional investors played defense, betting on sectors supported by stable, long-term demand. The price of warehouses, blocks of flats for rent and offices equipped for natural sciences has risen properly amid fierce competition.

“All the big investors are singing from the same song: they all want housing, urban logistics and high-quality offices; defense assets, ”said Tom Leahy, MSCI’s head of real estate research in Europe, the Middle East and Asia. “It’s a real estate problem, you have a herd mentality.”

Given that cash is pouring into the narrow corners of the real estate market, there is a danger that the value of the property is wrong, leaving a small margin to shrink as rates rise.

For owners of “defensive” real estate purchased at the top of the market who now need to refinance, the increase in interest rates creates the prospect of owners “paying more on credit than they expect to earn on the property,” said Lea Overby, head of commercial mortgage securities research. Barclays.

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

Manus Clancy, senior executive at New York-based CMBS data provider Trepp, said that while values ​​are unlikely to fall in the defense sectors, “there will be a lot of guys saying ‘wow, we overpaid for this.'”

“They thought they could increase rents by 10 percent a year for 10 years and the costs would be flat, but consumers are affected by inflation and can’t pass on the costs,” he added.

If investments that were considered safe only a few months ago seem uncertain; riskier bets now look toxic.

The rise of e-commerce and the transition to hybrid work during the pandemic has left office and shop owners exposed. Rising rates are now threatening to bring them down.

An article published this month, “Work From Home and the Apocalypse of Office Real Estate,” claims that the total value of New York offices will eventually fall by nearly a third – a cataclysm for owners including pension funds and government bodies that rely on their income taxes.

“Our view is that the total office supply is worth 30 percent less than it was in 2019. That’s a $ 500 billion hit,” said Stijn Van Nieuwerburgh, a professor of real estate and finance at Columbia University and one of the report’s authors.

The decline has not yet been registered “because there is a very large segment of the office market – 80-85 percent – which is not publicly traded, is very non-transparent and where there has been very little trade,” he added.

But when older offices change owners, as funds come to a lifetime or owners struggle to refinance, he expects discounts to be huge. If values ​​fall far enough, it anticipates enough mortgage defaults to pose systemic risk.

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

According to Curlow, as much as 15 percent has already been deducted from the value of U.S. offices in final bids. “In the American office market, you have a higher level of vacancies,” he said, adding that America is “a zero basis for rates – it all started with the Fed.”

Office owners in the UK also have to cope with changing work patterns and rising rates.

Landlords with modern, energy-efficient blocks have done relatively well so far. But rents on older buildings have been affected. Real estate consulting firm Lambert Smith Hampton suggested this week that more than 25 million square feet of office space in the UK could be surplus in demand after a survey found that 72 per cent of respondents wanted to reduce office space as soon as possible.

Hopes have also been dashed that retail, a sector most at the mercy of investors coming into the pandemic, could enjoy a recovery.

Major British investors, including Landsec, have been betting on malls for the past six months, hoping to catch a return trade as people return to physical stores. But inflation has diverted the recovery from the exchange rate.

“There was hope that many mall owners had that there was a level of rents,” said Mike Prew, an analyst at Jefferies. “But the carpet beneath them pulled out a cost-of-living crisis.”

As rates rise from ultra-low levels, so does the risk of reversals in the housing markets in which they grew, from Canada and the United States to Germany and New Zealand. Oxford Economics now expects prices to fall next year in those markets where they rose the fastest in 2021.

Numerous investors, analysts, agents and property owners told the Financial Times that the risk of falling property values ​​has risen sharply in recent weeks.

But few expect the decline to be as severe as it was in 2008, in part because lending practices and risk appetite have declined since then.

“Overall, commercial real estate seems poised to decline. But we’ve had strong growth in Covid, so there’s room for him to step aside before it affects anything [in the wider economy]Said Overby. “Before 2008, leverage was 80 percent and many estimates were false. We are not far away. “

According to the leaders of a large real estate fund, “there is definitely stress in the smaller pockets of the market, but it is not systemic. I don’t see a lot of people saying. . . ‘I committed to the acquisition of 2 to 3 billion euros using the bridge format’, as was the case in 2007.

He added that while more than 20 companies looked uncertain ahead of the financial crisis, this time there may be five.

Dickerman, a private equity investor, believes the economy is poised for a long period of pain reminiscent of the 1970s that will bring real estate into secular decline. But there will still be winning and losing bets because “there has never been time to invest in real estate when asset classes are so different.”

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