Update: Rising interest rates - a threat to real estate investments?
In June 2022, we looked at Swiss real estate in the interplay between inflation and rising interest rates. After key interest rates were raised further and inflation has probably peaked, we offer an update on the situation in Switzerland.
Dieter Galli, Senior Portfolio Manager Multi-Assets
In the past, real estate investments have provided effective protection against rising inflation. In the current market environment, low discount rates used in the capitalised earnings value calculation mean that properties still have a valuation buffer. Premiums on listed real estate funds have been reduced; we consider the current price level to be attractive.
Interest rate environment
Since only short interest rates rose significantly compared to spring 2022 (see chart), no additional pressure on the real estate market can be seen in long-term financing; the short-term SARON mortgages, on the other hand, have become significantly more expensive.
Interest rate trends in Switzerland
Discount interest rate even lower
As in the analysis of June 2022, the broadly diversified real estate fund Swisscanto (CH) Real Estate Fund Ifca serves as an approximation for the valuation of real estate. The average discount rates are derived from the fund (see chart below). When determining the return, the discount rate of a property is used to discount future cash flows and thereby determine the value of the property. The latter decreases if the discount rate increases, and vice versa. The discount rates are compared in the chart with the 10-year SARON rate.
Connection between the discount rate and long-term interest rates
Discount interest rate even lower
As in the analysis of June 2022, the broadly diversified real estate fund Swisscanto (CH) Real Estate Fund Ifca serves as an approximation for the valuation of real estate. The average discount rates are derived from the fund (see chart below). When determining the return, the discount rate of a property is used to discount future cash flows and thereby determine the value of the property. The latter decreases if the discount rate increases, and vice versa. The discount rates are compared in the chart with the 10-year SARON rate.
Discount rate and long-term interest rates
The chart shows that the yield on 10-year Confederation bonds is negatively correlated with the premium/discount of real estate funds. This means if interest rates rise, premiums fall. As can be seen, certain swings such as 1993, 2001, 2008, 2015 and 2018 cannot be explained by the interest rates alone. The other factor that had an impact in these years was the performance of the Swiss equity market.
Premiums at a low level
As we predicted last year, premiums have fallen further. The premiums are now back at levels that are only slightly above the values of the financial crisis in 2008. In view of the still low interest rates in the long-term comparison and the still positive economic situation in Switzerland compared internationally, premiums are likely to stabilise instead of continuing to decline.
Summary
Higher interest rates will slow down the persistently higher valuations of real estate, but as long as the long-term interest rates remain below the discount rates of the valuers, there will be no significant valuation corrections in directly held real estate. In the case of listed funds, premiums have already suffered greatly from rising interest rates and have now reached a level that we consider to be attractive.
Real estate – whether in the commercial or residential sector – continues to offer good protection against inflation, because rents in the commercial sector are generally linked to inflation. For residential real estate, the foreseeable increase in the key interest rate will lead to rent increases this summer.
Excursus: Comparison with the 1970s
How did real estate investments develop in the turbulent 1970s and what can be learned from this for the current market situation? We already looked into this issue last year; this time, we are also showing how similar the current inflation trend is compared to back then.
In 1971, a turning point in monetary policy was reached
The trigger of this turning point in monetary policy was US President Richard Nixon, who detached the dollar from gold. Since then, the world's reserve currency has only been a paper currency that can be arbitrarily inflated. Nixon needed more liquidity. The USA had to finance the Vietnam War and the comprehensive "Great Society" social programme.
In 1973, another serious incident followed.
In the Yom-Kippur war, a coalition of Arab states led by Egypt and Syria fought Israel. Since the USA provided military support to Israel, the Arab states issued an oil embargo against the entire West. This led to sharply rising commodity and gold prices and an inflation shock. Like today, the central banks initially only acted tentatively to counteract this. A wage-price spiral was set in motion due to the greatly expanded money supply. Inflation became self-propelling. It could only be stopped with drastic interest rate hikes in the early 1980s by the President of the US Federal Reserve, Paul Volcker.
Parallels to today
As already pointed out last year, today's situation is similar to that in the 1970s. The chart shows US inflation in the 1970s compared to today, and the trend so far is surprisingly similar. Whether inflation will also make a second wave this time remains to be seen.
US inflation in the 1970s and today
Like then, rising interest rates are currently leading to price losses in bonds. The increased cost of raw materials resulted in a recession in 1974, with inflation remaining high. As a result, Europe, Switzerland and the USA slipped into stagflation. Companies suffered from high raw material and interest costs and declining sales. Consequently, equities went through a bear market for two years.
Real estate – solid as a rock
In the 1970s, Swiss real estate funds delivered relatively stable returns compared to equities and bonds. Only in 1974 did real estate funds experience significant price discounts – similar to what we saw in 2022. Whether real estate stabilises again this year, as was the case in 1975 when a positive total return was achieved, is yet to be established. YTD performance of the SWIIT Index is +2.3% (as of 26/04/2023)
In addition to gold and commodities, real estate was the asset class that was able to more than compensate for inflation in the 1970s. Contrary to commodities and gold, real estate also achieved a positive performance in the following decade. In our view, the opportunities for real estate to compensate investors for any inflation are still good today.
Inflation and various asset classes in the 1970s
