Despite the US Federal Reserve’s decision not to raise rates in September, the fixed income market still expects, with a 66% probability, that the Fed will raise rates within the next 6 months. In Europe, the rate hike cycle will come later given the problem of patchy economic growth and the specter of weak inflation. With this prospect on the horizon, what will the impact be on real estate markets once central bank policy turns?
Rate rises won’t directly impact real estate assets in the short term
In the short term rate rises won’t impact real estate assets too significantly. The correlation between the Bank of England Base Rate (lagged, for six months to take account of liquidity) and prime yield for London offices is 0.4 – a pretty moderate link to short term interest rate movements.
Prime assets will remain attractive for investors despite the rising cost of debt
Prime assets will always be of interest for investors looking to acquire trophy investments with relatively little sensitivity to yield, pension funds looking for stable income or emerging market investors looking for safe havens with FX revenue. These investors will stick around, even as QE unwinds
Stronger demand will feed into positive rental growth
The short end of the yield curve is driven by improving economic expectations. For example, the relationship between London prime yield and global exports shows a 0.6 negative correlation – a slightly stronger link than that for short term interest rates.
Lack of supply in CBD markets will offset rate rises
Supply dynamics cushion the impact of rate moves. CBD markets globally are experiencing a shortage of space and in Europe office vacancy rates fell to 9.4% in Q2 2015. Supply constraints are likely to significantly lessen any negative impact on the real estate market of interest rate moves.
Eventually capital values will fall
Over the longer term, the theory should hold that higher bond rates relate to falling capital values. Indeed, prime London capital values have a strong negative correlation to 10 year UK gilt yields of -0.7. This link would probably be even stronger were it not for the exuberance of 2006-2007
Prime assets will outperform assets of lower quality
The combination of a higher cost of debt and strong demand should mean that prime assets will outperform assets of lower quality, which tend to be more debt linked and vulnerable to interest rate fluctuations. Demand for prime assets tends to be ‘stickier’ than for average assets, meaning it will be easier for landlords to pass on rents in line with inflation to cushion the higher cost of debt. In an environment where the debt market is increasingly competitive, the discount between prime and secondary assets should widen. Investors will become increasingly selective in their asset allocation.
Rates will rise slowly, giving the market time to adjust
It is unlikely that in the UK the base rate will approach 2.5% much before the end of 2019 and a sub 5% rate is likely even in a normalized market. If there are no surprises, the market should have plenty of time to adjust. A gradual pick up in rates might even be a good thing for the market as it would give investors ample time to adjust their return expectations accordingly.