Rising interest rates – a threat to real estate investments?

The ten-year US Treasury climbed from 1.5 percent at the beginning of the year to currently around 3 percent. In the same period, the average yield on ten-year Swiss Confederation bonds increased from -0.13 to around 1 percent. How do these significant changes in interest rates affect real estate investments?

The Swisscanto (CH) Real Estate Fund Ifca provides the data basis for determining the value of real estate. It is used as an approximation for the overall market. The average discount rates are derived from this (see figure below). 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 to the ten-year swap rate in CHF.

Connection between the discount rate and long-term interest rates

The chart shows that the difference between the swap rate and the discount rates currently remains large. There is therefore no immediate need for adjustments to the values for properties. The discount rates are likely to move sideways from here, unless the ten-year CHF swap rises towards 4 percent.

Looking back, we can also see that when the swap rate climbed above the discount rates in 1989, there was also a delay of around two years for an increase of the discount rate and subsequently falling property prices. Interest rates then fell again on average. However, there were frequently periods with smaller interest rate rises. But these never had a notable impact on discount rates.

Premiums on listed real estate funds

We maintain that real estate valuations are not directly threatened by interest rate hikes. Listed real estate funds, however, do not trade at the net asset value (NAV), but at a market price that may have a premium or discount on the NAV. Premiums have risen over the past 20 years due to falling interest rates. The main reason for this was that real estate investments returned more than bonds.

Development of premiums and interest rates (inverted) since 1990

The chart shows that the average yield for ten-year Swiss Confederation bonds are inversely correlated with the premium/discount of the real estate funds. This means if interest rates rise, premiums fall. As can also 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.

Since we now see rising interest rates and falling equity prices again, premiums are likely to decline further.

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. The premiums of listed funds are already suffering from rising interest rates and this is likely to continue. What's more, real estate offers good protection against inflation. On the one hand, inflation makes construction more expensive, and on the other hand, many rental contracts in the commercial sector are linked to inflation. Returns therefore rise with inflation.  Over time, real estate thus proves to be a stable return anchor in a portfolio.

Digression: 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 would now like to briefly examine these questions.

In 1971, there was a turnaround in monetary policy. The trigger 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 event followed, namely the Yom Kippur War between Israel and a coalition of Arab states led by Egypt and Syria. Since the USA provided military support to Israel, the Arab states issued an oil embargo against the West. This led to sharply rising commodity and gold prices and an inflation shock. The central banks initially only acted tentatively to counteract this. A wage-price spiral started with the greatly expanded money supply. Inflation started to run off by itself and was only stopped by Paul Volcker, then President of the Federal Reserve, with drastic interest rate hikes.

Parallels to today

The situation back then is similar to that of today. The central banks fired up the printing presses to mitigate the financial and Covid crisis. Moreover, the war in Ukraine is pushing oil and gas prices up sharply. Inflation is currently as high as it was in the 1970s. As was the case at the time, the central banks' countermeasures are hesitant 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

Nonetheless, in contrast to equities and bonds, Swiss real estate funds delivered a relatively stable return. Only in 1974 were there price reductions for real estate funds (the interest rate for first mortgages had risen to over 8 percent), which were greater than rental income. However, thanks to the easing of interest rates, a positive overall return was achieved again as early as 1975. Apart from gold and commodities, real estate was the only asset class that more than compensated for inflation in the 1970s. Contrary to commodities and gold, real estate also achieved a positive performance in the following decade.

Development of inflation and various asset classes in the 1970s